Britain's banks could have to pay out at much as GBP5 billion ($7.9 billion) to compensate customers who accuse them of mis-selling insurance policies after a US rival warned it faces a big hit.

Britain's competition watchdog has for several years been probing the possible mis-selling of payment protection insurance (PPI), which typically covers a purchase in case the buyer of a product becomes sick or unemployed.

Bank of America last week took a $592 million reserve related to future payment protection insurance claims.

Big UK banks are likely to be even more exposed.

Britain's competition watchdog has estimated that customers were being overcharged by over 1.4 billion pounds a year from the sale of PPI, and revenues from the sales have plunged since regulators stepped up scrutiny on sales practices.

Lloyds Banking Group and the next four biggest UK retail banks could have to pay out 5.1 billion pounds to compensate customers under a worst case scenario for them, analysts at Morgan Stanley said on Wednesday.

The five banks will have to pay out GBP2.6 billion under a "base case" scenario -- a manageable cost for the industry, according to Morgan Stanley.

In August the Financial Services Authority (FSA) introduced proposals for banks to handle PPI complaints and redress customers fairly where appropriate. The British Bankers' Association this month brought a judicial review of whether the FSA can apply new standards to old sales.

There are 12 million outstanding PPI policies, and Morgan Stanley's base case cost was based on one-fifth of those making a claim and almost half of those claims being upheld. Banks could pay an average of 2,000 pounds for each of those 1.1 million claims, and incur 400 million pounds in administration costs and fines, it estimated.

Lloyds, 41 per cent owned by the UK government, could suffer a GBP1.5 billion hit under the more extreme scenario, or a GBP770 million hit under the base case, Morgan Stanley said.

Under the base case, Royal Bank of Scotland and HSBC could have to pay out about GBP400 million each and Barclays and Santander each face payouts of just over GBP300 million, the note estimated. – Reuters