LONDON (Reuters) - Banco Sabadell's (>> Banco de Sabadell SA) plans to buy TSB (>> TSB Banking Group PLC) could be scuppered by Britain's financial services regulator, analysts said on Friday.

TSB, Britain's seventh-biggest lender, said on Thursday it had received a takeover approach from Sabadell valuing the business at 1.7 billion pounds ($2.5 billion), which it would be willing to recommend to shareholders.

But the deal could be derailed if the regulator - the Bank of England's Prudential Regulation Authority (PRA) - and lawmakers intervene, banking analysts said.

Berenberg analysts said the regulator may require Sabadell, Spain's fifth-biggest bank, to maintain high levels of capital in its British business and to ring-fence the capital and assets of the business, including its computer systems, limiting potential cost savings.

They also identified political concerns, with an April 9 deadline for Sabadell to make a formal offer coming only about a month before Britain's general election.

"We think that the government may come under political pressure about the sale of a newly created UK challenger bank," said Berenberg analyst Andrew Lowe.

The PRA, Sabadell and TSB all declined to comment.

TSB was created because state-backed Lloyds Banking Group (>> Lloyds Banking Group PLC) was ordered to sell 631 branches by European regulators as a condition of its 20-billion-pound government bailout during the financial crisis of 2007-9.

Lawmakers are keen for challengers to break the dominance of the country's "big four" banks - Lloyds, Royal Bank of Scotland (>> Royal Bank of Scotland Group plc), Barclays (>> Barclays PLC) and HSBC (>> HSBC Holdings plc) - which account for over three-quarters of personal current accounts and nine out of 10 business loans.

The opposition Labour party has committed to creating two new banks with the scale to effectively challenge the big four if it wins the election.

Macquarie analysts said the regulator could oppose the deal if it has concerns over Sabadell's capital strength. The Spanish bank is considering a 1.5-billion-euro ($1.6 billion) capital hike via a share issue to help finance the deal.

Analysts at Macquarie said although Sabadell's core tier one ratio, a key measure of a bank's financial strength, looked solid at 11.5 percent at the end of 2014, it included a 500-basis-point benefit from relief on deferred tax assets which would not be recognised by British regulators.

"Given the UK regulator doesn't afford UK banks such relief and given the ECB has been sounding a tougher line on such derogations from the original Basel III rules we think it is far from clear the deal automatically receives a green light," Macquarie analysts said.

(Editing by Pravin Char)

By Matt Scuffham