UPDATE 2-Woodford fund managers exploited flawed EU rules - FCA head

* Fund pushed rules to limit before suspension

* Bailey in spotlight as potential new Bank of England head

* EU rules were not flexible enough (Adds more quotes, background)

By Huw Jones, Carolyn Cohn and David Milliken

LONDON, June 25 (Reuters) - Neil Woodford's flagship fund took full advantage of flawed European Union rules before withdrawals had to be halted, Financial Conduct Authority Chief Executive Andrew Bailey said on Tuesday as he faced questions over the British regulator's role.

The high profile suspension of the LF Woodford Equity Income Fund fund has raised questions about the FCA's competence at a sensitive time for Bailey, who is viewed as a leading candidate to replace Mark Carney as Bank of England governor next year.

Hundreds of thousands of retail investors are unable to get their cash out of the fund run by Woodford, one of Britain's best known money managers, after it suspended withdrawals this month after a rise in redemptions.

The suspension must be reviewed next week.

"They were using the rules to the full and they were not telling us they were doing that," Bailey told lawmakers on parliament's Treasury Select Committee looking into the issue.

Bailey said the fund could have been better policed if what he called flawed European Union regulations had left more scope to crack down on behaviour that complied with the rules technically but not in spirit.

"SAILING CLOSE TO WIND"

One of the key issues for the fund was how it met rules on how much was held in liquid assets -- those that could be sold quickly if money was needed.

The fund navigated these rules by listing some assets on an exchange in the offshore dependency of Guernsey where there is very little if any activity.

"Having had these two breaches early last year - some people describe them as technical - but actually they were symptomatic of the fact that they were sailing close to the wind, and that's what triggered our interest."

The FCA has opened a formal investigation into events surrounding the suspension and the listing of some of the funds' assets in Guernsey.

"Listing something on an exchange where trading doesn't happen, as far as I can see, doesn't actually count as liquidity," Bailey said.

"I’m still waiting to hear whether a trade occurred."

MR NICE GUY?

During more than two hours of questions, lawmakers did not ask Bailey, 60, if he had applied for the role of central bank governor.

However, they did press him on other issues, including the collapse of investment firm London Capital & Finance, which led to an independent review being opened into the regulator's handling of events.

One lawmaker asked Bailey if he was being too nice to top financiers.

"I don't get up in the morning hoping that people will love me. Don't become chief executive of the FCA if you want to be loved. I don’t agree with that conclusion," Bailey said.

SHRINKING FUND

The Woodford fund was worth around 10 billion pounds ($12.8 billion) at its peak in 2017, but has fallen in value to about 3.5 billion pounds, mainly due to redemptions, Bailey said.

He did not object to the decision to close it for now.

"Suspension is an important tool, it should not be demonised," Bailey said.

The FCA will also look at the role of Northern Trust , the Woodford fund's depositary, which shares some responsibility for oversight of the fund with Link. Northern Trust declined to comment.

While Woodford picked the stocks, Link Fund Solutions, as the authorised corporate director and legal owner, has responsibility for the management of the suspended Woodford fund.

"It would be wrong to think Link are any different from the other firms that are in that space," Bailey said.

"We have investigations going on, but I don't think it's right to suggest that they, at this stage, are particularly worse than others."

(Reporting by Huw Jones, David Milliken and Carolyn Cohn; Editing by Alexander Smith)