Regulators have blocked UBS's application for a banking licence in India as the country's Finance Ministry probes an alleged $8 billion (£4 billion) money laundering racket that it says was masterminded by a high-profile Indian stud farm owner.

The Reserve Bank of India said that preliminary approval for a much sought-after Indian branch licence that was granted to UBS last year has now been "put on hold" pending an investigation.

It is understood that India's Finance Ministry is behind the move and blocked UBS because of what it regards as the bank's lack of co-operation in a probe of alleged money laundering by Hasan Ali Khan, a controversial businessman best known in India for his stud farm in Pune, near Bombay.

"There is a political imperative to bring Mr Khan to book," one source close to the process said.

In June 2007, the Finance Ministry's Enforcement Directorate registered a case against Mr Khan under India's Prevention of Money Laundering Act. Investigators claimed that they had uncovered documents suggesting that Mr Khan had stashed as much as $9 billion in an account purportedly registered at a Zurich branch of UBS. The authorities said that they had requested confirmation – or "direct evidence" – from the Swiss bank by writing to the Swiss Government.

Mr Khan has reportedly denied that he had any Swiss bank account. He could not be contacted for comment today.

A spokesman for UBS in Hong Kong said the bank was co-operating fully with the Indian authorities and declined to give further details.

The effective revoking of its only Indian branch licence is the second regulatory set back to hit UBS in India since December, when the troubled group failed to gain clearance for its bid to buy part of Standard Chartered Bank's mutual funds business. At that time, the RBI effectively counted down the clock on the $118 million deal, sources say, in a move also linked to the Khan investigation. Standard Chartered said in a statement that its contract with UBS had expired and it was moving on to find a new purchaser.

UBS, the world's largest wealth manager, is also reeling from more than $18 billion in writedowns linked to the US sub-prime crises, a debacle from which it emerged the worst hit of Europe's banks.

Its latest setback will be all the more frustrating given the scarcity of Indian retail banking licenses and the difficulties that beset foreign firms attempting to enter one of the most attractive growth markets in the world. UBS, which runs a brokerage and investment banking business in India already, first applied for a retail licence in 2004.

In recent years the RBI has limited the number of new branch licences to between about 12 and 20 a year – in a country with a population of more than one billion. A successful application would allow UBS to market its products to India's increasingly wealthy middle classes.

There are widespread expectations that India's banking regulators will choose to liberate the market in 2009, when a new policy roadmap for the sector is due.

However, Indian bankers privately give warning that their Western peers who anticipate large opportunities are being too optimistic.

"India works at its own pace," one senior Indian banker said. "That is not always understood in London and New York."

Lord Jones of Birmingham, the Trade and Investment Minister, recently criticised India's policy of "sheer protectionism" in banking after he claimed that the Indian Government had stonewalled attempts by Standard Chartered to open a new network that would service India's underbanked population.

However, Western bankers in Bombay have since criticised Lord Digby's intervention as potentially unhelpful, suggesting he failed to understand the nuances of the Indian system.

Standard Chartered executives themselves admit that their plan to open scores of bank branches in semi-urban areas of India do not fall into any pre-set criteria of the RBI and that they did not expect a quick proposal to what they regard as radical suggestions.

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