The Financial Services Authority (FSA), which issued a raft of proposals to reform the banking industry, said any banks whose living wills were deemed unsatisfactory could face the prospect of separating their retail and trading activities.

"Restructuring could include clear separation between retail deposit-taking business and businesses involved in proprietary trading activities, with the latter able to fail even if the former were supported in crisis conditions," the FSA said.

The concept of living wills has been backed by Prime Minister Gordon Brown and Chancellor Alistair Darling as one measure to help protect the public from propping up banks. But lawyers said bankers might have underestimated the force of regulatory scrutiny.

"It ain't going to be a cup of tea," said Tim Plews, co-head of the London finance and capital markets practice at law firm Clifford Chance. "It looks like a fairly continuous dialogue."

Britain's finance ministry said it welcomed the report and was working closely with the FSA as it prepares financial services legislation for later this year.

BRISTLING BANKS

The FSA has been galvanised into action after Britain used billions of taxpayer money to shore up banks such as Northern Rock, Bradford & Bingley, RBS and Lloyds .

"The industry won't like the sting-in-the tail, which is that FSA might make a bank sell or demerge bits of itself if the living will isn't up to scratch," said James Perry, a partner at law form Ashurst.

As a row brews between Brown's camp and Bank of England Governor Mervyn King, who has repeatedly called for big banks to be broken up to avert future crises, some investors applauded the FSA's proposal. Brown told parliament on Wednesday the financial crisis had not been caused by banks combining retail and investment activities but by a lack of global regulation.

The Association of British Insurers (ABI), whose members account for around one-fifth of investments in the London stock market, said it did not see a formal Glass-Steagall approach -- that erects legal barriers between commercial banking and investment banking -- as practicable.

But Peter Montagnon, the ABI's director of investment affairs, added: "It might be helpful if market pressures led to banks reorganising themselves into more manageable units, with either a utility or an investment banking focus."

FSA Chairman Adair Turner said it would be very difficult to write a law that splits up banks into risky and non-risky activities but there were other ways to obtain "internal Glass Steagall" at a bank.

"You can achieve the same thing through the capital requirements approach and resolution and recovery plans," Turner told reporters.

Bank of England deputy governor Paul Tucker said drawing up living wills for world's big cross-border banks will be "formidably difficult."

"Basically for the top roughly 25 banks and dealers, the authorities will work with them over the next 6-9 months to produce recovery and resolution plans," said Tucker, who also chairs the global Financial Stability Board's working group on resolution.

LEVY

The FSA is also keen to apply a form of capital and even liquidity surcharge internationally on banks deemed too big to fail without wider damage or too big for one country to rescue.

"If that means banks tend to stay a bit smaller than they are, that's fine," Turner said.

Turner said the FSA will respect European Union law on the free movement of capital regarding branches of banks from other countries in the bloc and cannot force them to become local subsidiaries with tougher capital and liquidity requirements.

The bulk of the proposals -- the second raft of recommendations following Turner's review of the financial crisis -- outline what the watchdog is seeking at international level.

Many are already being worked on in global bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board, but the FSA wants to shape the debate on dealing with large, cross-border firms, where there is still no consensus.

(Additional reporting by Kirstin Ridley and Matt Falloon; editing by Victoria Main/Ruth Pitchford)