Britain's TSB urges rethink of banking surcharge

* Gross new mortgage lending 1 bln stg for quarter ended June 30

* Compares with 479 million in first quarter

* H1 pretax down 44 pct from year before to 23.2 mln stg

* Net interest income 376.7 mln stg vs 374.6 mln (Recasts with CEO comments, adds detail and context; also adds editing credit in signoff)

By Aashika Jain

July 23 (Reuters) - TSB Banking Group, being bought by Spain's Banco Sabadell for $2.5 billion, has urged British finance minister George Osborne to rethink his banking surcharge if he wants to encourage the growth of smaller "challenger" banks.

British lawmakers and regulators want to break the dominance of Lloyds Banking Group, from which TSB was spun off last year, Royal Bank of Scotland (LSE: RBS.L - news) , Barclays (LSE: BARC.L - news) , HSBC and the UK arm of Spain's Santander.

Together those five control more than four out of five personal current accounts in Britain, but Osborne's taxes on banks have already been attacked by the industry as harming their ability to lend.

The British government recently announced an 8 percent surcharge on bank profits above 25 million pounds, effective January next year, but TSB said the level could be higher.

CEO Paul Pester said that while supportive of the government's approach, he would urge it to consider raising the lower limit for exemption of the surcharge to about 200 or 250 million pounds.

"My understanding is that the real income from this tax will be raised on the 2 to 5 billion pounds worth of profit that the big banks make, rather than on the hundred or so millions of profit that banks like TSB make," Pester said.

The CEO said growing a bank in the UK was a challenge and a surcharge would only make it more difficult for TSB to invest in growth and to bring more competition to the market.

TSB also reported strong home loan demand, with gross new mortgage lending soaring to 1 billion pounds for the quarter ended June 30, compared with 479 million in the first quarter.

It said a mortgage broking service launched in January had received 1.9 billion pounds of gross mortgage applications at the end of the first half, with gross lending through this channel totalling 665 million.

TSB also posted a decline in the share of new personal bank accounts to 6.7 percent from 7.9 percent in the first quarter, but said this was above its target of 6 percent.

TSB's first-half pretax profit fell 44 percent from a year before to 23.2 million pounds, hurt by lower average loan balances and recognition of a Financial Services Compensation Scheme levy charge of 14.8 million pounds.

Net interest income reached 376.7 million pounds against 374.6 million.

Sabadell said this month it would move to compulsorily buy out remaining minority TSB shareholders. TSB will be delisted from the London Stock Exchange (Other OTC: LDNXF - news) on July 28. ($1 = 0.6410 pounds) (Reporting by Aashika Jain in Bengaluru; Editing by Gopakumar Warrier and David Holmes)