George Osborne has stepped back from an enforced break-up of Britain’s biggest banks in the Conservative blueprint for financial regulation, which is being unveiled today.

Instead, the Shadow Chancellor will say that banks that insist on combining retail and riskier investment divisions will be forced to hold additional capital.

In what would be the biggest shake-up of banking regulation for more than a decade, an incoming Conservative administration would scrap the Financial Services Authority. In its place, Mr Osborne would introduce a new body dedicated to protecting consumers and armed with powers to open lenders to more scrutiny.

In a further step to encourage competition, a Tory government would initiate a full inquiry into Lloyds Banking Group in the light of its acquisition of HBOS last year.

Depending on the findings of a competition investigation by the Office of Fair Trading (OFT), the Conservatives might orchestrate a partial break-up of Lloyds and, to a lesser extent, Royal Bank of Scotland (RBS) through legislation. Alternatively, they could use the State’s influence as a large shareholder to force the banks to sell businesses to new entrants to the market, a move that could lead to clashes with big institutional shareholders in the banks.

Mr Osborne will say: “The findings of the OFT and the Competition Commission will help to inform a Conservative government’s strategy for disposing of its banking shares.”

A Conservative government would be likely to sell Northern Rock to a newcomer if the bank is still publicly owned after the next general election. The Government is rushing to sell Rock and can claim kudos from its multibillion-pound bailout of banks.

Vince Cable, the Liberal Democrat Treasury spokesman, will also call today for break-ups of Lloyds and RBS before their return to the private sector.

The European Commission is moving closer to a full-scale investigation of both Lloyds and RBS with the publication this week of guidelines that reassert its tough rules on state aid. The guidelines on how the Commission will interpret the state aid rules in relation to the banks are expected on Thursday. They are likely to assert the principle that there must be a reduction in activity by banks that have received state aid to offset the impact of that support on the market.

Although Lloyds would be the subject of an investigation by British competition authorities because of its dominance in the UK, some believe that Brussels’s priority would be to clamp down on RBS, which has a network of businesses in continental Europe.

A Conservative government would end the tripartite system of financial regulation set up by Gordon Brown while he was chancellor and pass the powers for regulating banks to the Bank of England. Reflecting the dramatic increase in powers flowing to the Bank, a new financial policy committee would be set up, mirroring the Bank’s Monetary Policy Committee. It would have external members and the Bank would have a third deputy governor to oversee the task of monitoring financial stability in the system.

After criticism from the City, Mr Osborne has retreated from earlier signals that the Conservatives would impose a split between retail and investment banks. He will say that the divide should still take place but can be implemented only internationally. In the meantime, banks such as Barclays, with large retail and investment banking operations, would be forced to hold a high level of capital to reflect the riskiness of their investment bank.

The Government and the FSA have outlined similar approaches on capital allocation.

Mr Cable will say that the FSA should remain the day-to-day regulator of banks and building societies because it would be too disruptive to return this power to the Bank.

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