The UK's banks should ring-fence their retail operations from riskier investment banking and increase their capital requirements beyond what is required by the Basel III directives, a much-anticipated report by the Independent Commission on Banking (ICB) said Monday.
If carried out, the reforms will land Britain's banks with a pre-tax cost of between 4 billion pounds ($6.4 billion) and 7 billion pounds, according to the ICB.
"Structural separation should make it easier and less costly to resolve banks that get into trouble," the ICB wrote in its report.
The Commission believes that structural separation should help insulate retail banking from external financial shocks, such as the collapse of Lehman Brothers and Bear Stearns in the wake of the credit crunch.
The ICB members, who include Sir John Vickers, ex-chief economist at the Bank of England, and Bill Winters, former joint CEO of the JPMorgan Investment Bank, maintain that separating the two would "help sustain the UK’s position as a pre-eminent international financial centre."
UK Finance Minister George Osborne welcomed the report Monday morning, and said in a statement that it was an "important step" to reform.
There have been some concerns that making the demands at a time when banks are suffering from their exposure to broader economic troubles, such as the euro zone debt crisis, might weaken them.
"The ongoing strain on the economy and financial markets reinforces the importance of improving the resilience of the UK banking system," the ICB wrote in its final report.
"The fact that the economy is currently weak is no reason to be distracted from this goal. It is strongly in the national economic interest to have much sounder banks than before."
"Postponement of reform would be a mistake, as would failure to provide certainty about its path," the report continued.
However, the ICB concluded that ring-fencing was a better option than a total separation. That would mean that the retail arm of banks would have no greater relationship to their investment banking division than to the investment banking divisions of other banks.
The reforms should be enacted by 2019, the commission recommended.
“UK banks are well on the way to implementing the sweeping reforms already brought in and expected to be brought in by UK, EU and global authorities to make banks and the system safer and to ensure that banks can fail in the future with savers and taxpayers protected and the supply of finance to the economy maintained," the British Bankers' Association said in a statement.
"Any further reform measures adopted by the UK authorities need to be carefully analysed and compared with those agreed internationally. It is vital that the full impact any further reforms will have on the economy, the recovery and banks’ ability to support their customers in the UK is understood."
The UK relies on financial services for around 9 percent of its gross domestic product (GDP).
The ICB also argued that the Basel III directives, a new set of internationally recognized rules for banks, do not go far enough in their demands for capital requirements.
JP Morgan Chase chief executive Jamie Dimon said that the rules were "anti-American" in an interview with the Financial Times Monday.
Large UK retail banks such as Royal Bank of Scotland should have equity capital of at least 10 percent of risk-weighted assets, according to the ICB. The commission also called for primary loss-absorbing capacity of at least 17-20 percent across all banking divisions.
The commission also highlighted competition issues in the UK banking sector, where the largest four banks account for 77 percent of personal current accounts and 85 percent of SME current accounts.
It recommended that Lloyds Banking Group which was created when Lloyds took on HBOS following the credit crisis, should sell off more of its assets and liabilities than required for EU state aid approval.
"We are currently assessing the full implications of the report and may provide a further update to the market once we have had the opportunity to review the report in detail," Lloyds said in a statement Monday.