Royal Bank of Scotland may be radically shrunk and overseas operations and major assets such as Direct Line could be sold as part of the agreement with the Government over the use of the insurance scheme for toxic assets.

RBS, which is 70 per cent taxpayer-owned, was engaged in intense negotiations with the Treasury last night over what it might be forced to sell. No decisions have been made and the bank hopes to keep Citizens, its US business.

The Government wants a dramatic reduction in RBS’s overseas businesses and its risky investment banking operations — the price the bank must pay for its use of the Asset Protection Scheme (APS).

The European Commission has also drawn up a list of divestments it will impose on RBS in return for the billions of pounds of state aid it has received. The Commission has been pushing RBS to offload its insurance arm, which comprises Churchill, Direct Line and Green Flag.

Brussels and the Government are keen to see the Edinburgh-based bank sell swaths of its foreign operations, such as its French operations and Citizens. RBS is confident that it has won the battle to keep Citizens.

RBS may also have to sell parts of its riskier investment banking business, such as debt syndication. A government source said: “The taxpayer cannot be expected to be on the hook for exotic instruments and overseas deals that did much to bring the bank down.”

RBS is fighting hard to retain some of these operations. Some believe that it will get a far harsher deal from Brussels than the one handed to Lloyds Banking Group because the Government has been keen to protect Lloyds, whose emergency takeover of HBOS it brokered last year. The Government wants to make a final statement about both banks early next week.

There is some brighter news for RBS: it may be allowed to leave the APS early. It will also avoid having to pay a £16 billion insurance premium upfront. Instead it has agreed a pay-as-you-go arrangement whereby a premium could be paid each year depending on the size of the toxic assets needing to be insured. The original plan had been for the APS to run for about five years.

RBS is also cutting the amount of toxic debt it will put into the APS, from £325 billion to about £280 billion.

These concessions come in the light of the near-certainty that the Treasury will allow Lloyds to avoid the APS altogether as long as it can raise more than £20 billion from investors. Officials had considered scrapping the scheme, but decided RBS still needed to use it because of the volatile nature of the assets, including derivatives.

The Treasury has yet to give a final sign-off to the changes, which must also be agreed with the Commission. RBS would not comment.

Lloyds is canvassing its shareholders to assess support for its rights issue. The bank has been forced to increase the issue from £11 billion to £13.5 billion to pay between £2 billion and £2.5 billion to the Government for the benefit it has received from the APS since it was announced in February, even though the bank has not actually entered the scheme.

Lloyds plans to top up the issue by turning debt into “contingent capital”, which converts into loss-absorbing core tier 1 equity if the bank’s finances worsen. It has had to abandon plans to raise £2 billion through hybrid instruments known as mandatory convertible notes. That money will now be raised as part of the rights issue because Lloyds needs the money upfront to pay the fee to the Government.

Lloyds must launch its rights issue next week if it wants to ensure it will be completed by the end of the year.

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