The Government is girding itself for a battle royal with the EU over threats that Lloyds Banking Group and RBS ( (RBS.L)
) will be forced to spin off or sell parts of their businesses.
City sources said: "The Government is terrified that the EU is getting ready to issue an ultimatum over Lloyds and RBS, forcing them to break up following the massive state injections of capital last autumn. This row is heating up and is likely to come to a head quite soon."
Urgent negotiations are taking place between the Treasury, UKFI, the agency which controls the Government's shareholding in Lloyds, and the EU. Treasury sources said they hoped that some sort of deal could be thrashed out ahead of the August deadline set by the EU.
Lloyds has already conceded that it may have "to divest or exit core businesses" and has a plan to sell-off or stop some activities. But analysts are worried about selling in such a depressed market.
Meanwhile, a two-horse race has emerged over who should take over as the new chairman of Lloyds ( (LLOY.L)
) to replace Sir Victor Blank when he steps down next year. UKFI is backing Sir Win Bischoff, the former chairman of Citigroup, while Eric Daniels, the chief executive of Lloyds, is keener on Chris Gibson-Smith, the current chairman of the London Stock Exchange.
EU competition commissioner, Neelie Kroes made it quite clear last week at the British Banker's Association conference in London, that she would push through the restructuring: "The massive aid received by banks such as Lloyds and RBS allows these banks to remain leaders in markets which are concentrated. The likelihood of significant divestments by RBS and Lloyds is strong."
The Government pumped more than £37bn into the banks, leaving it with 70 per cent of RBS and 43 per cent of Lloyds.
Ms Kroes, who is renowned for her tough stance on EU companies taking state aid, said: "[RBS] is not a bank with a sustainable business approach. This bank was not merely too big to fail. It was too big to supervise, too big to operate, too complex to understand, and highly dangerous to the European single market."
After the HBOS rescue, Lloyds has more than 30 per cent of the retail banking market, and a 28 per cent chunk of mortgage lending, while RBS's concentration is in the UK small- and medium-sized enterprise and corporate-banking markets.
But Ms Kroes restated that the state aid approval process—which the UK has to have from the EU—means that the banks will have to be restructured.