LLOYDS TSB Scotland, the 185-branch banking operation which The Co-operative Group is in talks to buy, suffered a near-17% tumble in profits in 2011 and blamed this fall on higher funding costs and "subdued demand" for credit.

And it warned that, with Scottish economic conditions likely to "remain challenging for most of 2012", growth in lending and income was likely to be "limited".

The drop in Lloyds TSB Scotland's pre-tax profits from continuing operations, from £161.8 mil- lion to £134.4m, is revealed in accounts which have just become available from Companies House.

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These accounts underline the difficult backdrop against which Lloyds Banking Group is attempting to negotiate the sale of Lloyds TSB Scotland, and other assets including Cheltenham & Gloucester mortgage operations and the Intelligent Finance business, to The Co-operative Group.

Lloyds Banking Group is keeping open another option of trying to float these "Project Verde" assets, which it has been ordered to sell by the European Union under state aid rules. In all, 632 branches are up for sale, including some Lloyds TSB outlets south of the Border, and the disposal will include an operations centre at Livingston.

Lloyds TSB Scotland's profits dropped last year even though its charge for impairment losses on loans and advances fell from £56m to £37.9m. It warned that Scottish economic conditions meant the improvement in impairments "may not be maintained".

There was a 1% net reduction in Lloyds TSB Scotland's lending to small and medium-sized enterprises in 2011. The bank's directors say that new loans to SMEs totalled £139m in 2011, up 9% from £128m in 2010, but add that these "failed to exceed customer repayments and resulted in a net reduction in customer lending".

There have been major changes at the top of Lloyds TSB Scotland in recent times. It is now chaired by Mark Fisher, the former Royal Bank of Scotland executive who is Lloyds Banking Group's operations director.

Peter Navin, Lloyds Banking Group's network director, is chief executive of Lloyds TSB Scotland. A Lloyds spokesman noted Mr Navin was due to move with the Verde business when it was sold.

Lloyds TSB Scotland directors, in their review of the business in the accounts, say: "Lloyds TSB Scotland, in common with other UK banks, faced a challenging set of economic circumstances in 2011, and in particular higher funding costs and subdued demand for credit."

They note Lloyds TSB Scotland's total income fell by 10.9% in 2011. Net interest income dropped from £293.8m in 2010 to £257m last year, while net fee and commission income rose from £33.7m to £36.9m. The interest margin fell to 1.66% in 2011, from 1.82% in 2010.

The directors attribute the

reduction in the bad and doubtful debt charge in 2011 largely to "the improved arrears position on unsecured personal lending".

Total lending to customers by Lloyds TSB Scotland fell by 3.1% last year. Residential mortgage balances reduced by 4.2%, with the directors noting that "customer repayments exceeded demand for new mortgages".

In the retail or personal banking operations, savings balances rose by 6% and current account balances by 3% in 2011 but lending balances fell 5%. Total income in retail banking fell 25%, impairments on loans dropped 30%, and the pre-tax contribution of this division decreased by 29%.

The directors say Lloyds TSB Scotland's commercial banking income was "static", compared with 2010, on a continuing basis. Commercial loan impairments fell by 10%.

Lloyds TSB Scotland's operating expenses rose 8.6% on a continuing basis in 2011.

It employed an average of 1475 people last year –down from 1858 in 2010. But Lloyds TSB Scotland saw two of its businesses, Lloyds TSB Commercial Finance Scotland, and its London Interbank Offered Rate-related corporate lending business, transferred to elsewhere within Lloyds Banking Group in March 2010. The £52.2m of pre-tax profits made by these transferred businesses are not in the £161.8m figure for 2010 earnings from continuing operations.

The Lloyds spokesman said of Lloyds TSB Scotland: "The business has changed shape quite dramatically over the past few years as we have been preparing it to be part of the Project Verde proposal.

"Some of the business customers which we were not required to divest have moved out [to other parts of Lloyds Banking Group]. It is a good business and, of course, we will continue to invest in the business [ahead of its sale]."