Britain's top banks are set to need more capital and ring-fence retail banking to shield taxpayers from another crisis in the most radical industry shake-up for decades, which may prompt some banks to leave.
Proposals due to be unveiled on Monday by a powerful independent panel could force lenders like HSBC and Barclays to hold billions of pounds more capital and squeeze profits, prompting them to follow through with threats to quit London for New York or Hong Kong.
The Independent Commission on Banking (ICB) will outline several options to make sure retail deposits are protected if a bank hits trouble and reduce the threat taxpayers will be forced to again step in to save a big bank.
Proposals are expected to include "ring-fencing" their retail operations so they would be unharmed if investment banking operations hit trouble. That would require them to hold more capital for separate businesses and would raise funding and other costs and put them at a disadvantage to overseas rivals, banks claim.
Government officials received over the weekend an embargoed copy of Monday's interim ICB report.
The ICB, headed by Oxford academic and former Bank of England interest rate setter John Vickers, has a twin task to consider structural reforms to reduce risk and promote competition.
Vickers and his team may propose Lloyds Banking Group needs to offload more than the 600 branches it is already in the process of selling, but they are not expected to go as far as recommend the reversal of its takeover of HBOS.
The ICB's interim report marks the half-way stage of its year-long probe. Its final report is due in September, and it will be up to the government to choose how many of its proposals to implement, and banks are already lobbying hard to limit the scale of reform.
"We set up this commission because we have a serious problem which has caused enormous damage to our economy," government minister Danny Alexander said on Sunday.
"These banks ... their balance sheets are five times the size of the British economy. We have to act on that and we certainly intend to."
Barclays Seen as Most at Risk
The credit crisis battered Britain's banking industry, which is one of the main contributors to the UK economy. Britain had to bail out and part-nationalize Royal Bank of Scotland and Lloyds and nationalize Northern Rock.
The "ring-fencing" model could take different forms, such as "functional subsidiarization" to make banks capitalize retail and investment banking separately.
Less draconian would be "operational subsidiarization", aimed at ensuring functions like the payments system, getting cash from ATMs or lending to businesses would still operate if bank is on the brink of collapse, as RBS was three years ago.
"This commission is looking at separation issues within the banking system to make sure that the bits that are valuable to us as an economy, retail banking and so on, could be protected whereas those people who engage in that sort of casino banking take responsibility for themselves," said Alexander.
Barclays is considered most at risk from a radical change to structure, as its investment bank has earned over 7 billion pounds ($11.47 billion) in the last two years, or two-thirds of group profits.
The cost of holding separate capital, liquidity and funding would also hit HSBC, RBS and Standard Chartered hard, with the total cost running to several billion pounds, analysts said.
Lloyds would be most impacted by a clampdown on competition, given its strong retail market share following the HBOS deal.
HSBC, Barclays and Standard Chartered have said onerous regulations could see them leave London, and rival cities such as New York, Hong Kong and Paris are already courting them.