UPDATE 6-Trio of British banks take $3 bln mis-selling hit

* Banks drop challenge to PPI ruling - BBA

* Barclays to take 1 bln stg provision on PPI mis-selling

* RBS takes 850 mln stg hit, HSBC takes $440 mln provision

* Ombudsman says average PPI payout is 2,750 pounds

* Bank shares fall

(Releads, adds detail from RBS)

By Sudip Kar-Gupta

LONDON, May 9 (Reuters) - British banks gave up their fight to avoid compensating customers wrongly sold loan insurance, forcing a trio of top banks to take a combined hit of more than $3 billion in the latest blow to the industry.

Barclays (BARC.L) and Royal Bank of Scotland (RBS.L) on Monday each took near 1 billion pound ($1.6 billion) provisions for the second quarter of 2011 to cover costs related to mis-selling payment protection insurance (PPI).

HSBC (HSBA.L) (0005.HK) said it had set aside $440 million.

British banks, already under pressure from regulators to clean up their act following the financial crisis, said they would not appeal against a ruling they should pay compensation.

The total bill is in line to top 6 billion pounds and may end up near 8 billion, with several million Britons potentially in line for a payout -- Britain's financial ombudsman said it had, so far, received more than 200,000 complaints over PPI and average compensation payout was 2,750 pounds.

Events have moved fast since Lloyds Banking Group (LLOY.L) was first to capitulate over the issue, unveiling a shock 3.2 billion pound charge last week to cover compensation, after years of legal wrangling. [ID:nLDE7432FG]

"This is another negative for the banking sector. It means even more costs for the banks, which were already facing mounting costs on their capital structures," said John Smith, fund manager at British investment firm Brown Shipley.

Barclays shares fell 1.3 percent and HSBC dipped 0.5 percent, compared to a 0.6 percent decline in Britain's benchmark FTSE 100 index .FTSE. RBS, which made its provision after the market closed, fell 2.4 percent.

PREVIOUS SCANDAL

Banks face higher costs from plans by a government-appointed commission to make them hold more capital and form separate subsidiaries for retail and investment banking operations, an effort to better protect retail customers and shield the banks in the event of another financial crisis. [ID:nLDE7371AX]

Overdraft fees also remain in the spotlight after being criticised for being opaque by business secretary Vince Cable and parliament's Treasury Select Committee.

The PPI payouts have parallels with a previous mis-selling scandal involving endowment mortgages, which became popular in the late 1980s and early 1990s as homebuyers took interest-only home loans backed by investment plans intended to pay off the principal.

But returns often fell short and providers were subsequently forced to pay compensation to many lenders. The Financial Services Authority (FSA) said in 2006 banks had paid out 2.2 billion pounds compensation for endowment mis-selling.

PPI policies were typically taken out alongside a personal loan or mortgage to cover repayments if customers fell ill or lost jobs. [ID:nLDE73J18Y]

But the policies were sold to self-employed or unemployed people who would not have been able to claim and to consumers who did not realise they were taking out a policy.

Last month, a court ruled the banks were at fault.

"I hope the banks learn the lessons of this debacle, adopt a more constructive attitude towards serving their customers and make sure this never happens again," said opposition Labour MP Chuka Umunna, who sits on the Treasury Select Committee.

Barclays said it had agreed with the FSA to contact customers and assess the situation. It took a charge of 200 million pounds last year, so its bill is set to be 1.2 billion.

"We do not always get things right for our customers. When we get them wrong, we apologise and put them right," chief executive Bob Diamond said.

RBS said it would take an 850 million pound charge this quarter, taking its total hit for the policies to 1.05 billion.

Bank of America (BAC.N) has also raised its provision for mis-selling to $650 million from an original $592 million.

Spanish group Santander (SAN.MC), which acquired struggling British lenders during the downturn , had not challenged the findings of regulators and has already been paying compensation.

"It should not really affect banks' long-term earnings forecasts, but the PPI issue is yet another negative for the sector," Royal London Asset Management fund manager Jane Coffey said. (Additional reporting by Steve Slater; Editing by Dan Lalor and David Holmes) ($1 = 0.6100 pound)