LONDON (Reuters) - Revised UK bank capital rules have thrown a lifeline to smaller lenders struggling to poach market share from Britain's biggest banks, boosting their chances of offering more competitive rates in the 1.7 trillion pound ($2.22 trillion) mortgage market.

The Bank of England said on Thursday it would lighten capital reforms on UK banks in a revised interpretation of global rules, known as Basel III, aimed at bolstering the financial system from future crises, echoing moves by regulators in the United States.

The amendments reflect the BoE's twin goals to make the sector more resilient to shocks, while at the same time supporting its competitiveness, with smaller lenders set to reap considerable benefits, industry analysts and sources said.

Britain's smaller banks have been pushing for regulatory change that would allow greater use of internal models to calculate risk weightings on loans, rather than standardised models which can be more punitive.

"We have taken the view that if Basel 3.1 is our best estimate of the risk weights, then that is going to be true whether large firms or small firms are doing the activity," Phil Evans, BoE director of prudential policy, said in a speech.

He pointed to "a significant narrowing of the gap" between the standardised approach and modelled approaches that market leaders would typically use, sending shares in some smaller banks higher.

Metro Bank was trading up 4.9% at 1134 GMT, while smaller mortgage lender OSB Group rose 2.2% and Paragon Group was up 0.6%.

"The package will boost competition among UK banks, by broadening access to the more favourable internal ratings-based approach and giving small domestic deposit takers interim relief from the new rules," said Tom Callaby, a financial services partner with law firm CMS.

The UK's mortgage market is dominated by several domestic heavyweights including Lloyds Banking Group ( LYG ), NatWest ( NWG ) and Barclays ( JJCTF ), and a smaller cluster of mutually owned building societies led by Nationwide.

The six largest lenders had a combined market share of 71.6% of all mortgages in Britain at end-2023, according to a Reuters calculation from Bank of England data.

COSTS COULD FALL

With base interest rates poised to fall against a backdrop of limp economic growth and sticky inflation, industry sources had predicted some so-called challenger lenders would likely need to consolidate to survive.

While some small banks have made a dent in the current account market, few have made real headway in mortgage lending. Rising compliance, technology and labour costs have heaped pressure on returns, reinforcing a case for mergers of the strongest brands to achieve scale.

M&A activity in the sector has already soared in the last year, with Nationwide swooping for Virgin Money and Coventry Building Society joining forces with Co-Op Bank.

But the changes announced on Thursday are likely to relieve some of the operational pressures on smaller lenders, giving them greater opportunity to build market share on their own.

Michelle Adcock, a director in KPMG's Regulatory Insight Centre, said the BoE's new rules could reduce the smaller banks' cost to income ratios, as they would likely need fewer and less senior people to oversee mortgage lending reporting.

"This is not about weakening the capital requirements on smaller banks, but there are some reporting requirements that are simply less relevant for them, and some of those have been dialled down," she said.

($1 = 0.7664 pounds)

(Editing by Alison Williams)