The planned sale by state-backed Lloyds (LLOY.L) of hundreds of UK bank branches to the Co-op fell through on Wednesday, setting back government plans to boost competition in the industry.
The Co-op CWSGR.UL said it pulled out of the deal, worth up to 750 million pounds ($1.15 billion), due to toughening regulations and the worsening outlook for UK economic growth.
Lloyds, which is Britain's biggest retail bank and has over 2,900 branches in total, plans instead to spin-off the 630 branches under the TSB name and sell shares in the new company.
UK lawmakers had hoped the deal would create a viable competitor to Britain's established but unpopular lenders, which have been plagued by scandals including the mis-selling of insurance on loans and mortgages.
Britain's finance ministry said the government remained "determined to promote greater competition in the banking sector in order to provide consumers with more choice".
There was political support for the Co-op to play a bigger role in UK banking because of the firm's ethical credentials. The Co-operative is Britain's biggest mutual business, owned not by private shareholders, but by over 6 million individuals.
However, industry sources had expressed doubts for several months about the viability of the deal, mainly citing concerns about how the Co-op would meet regulatory capital requirements.
Co-op chief executive Peter Marks said in a statement that the deal would not currently deliver a suitable return in a reasonable timeframe and with an acceptable level of risk.
"This should serve as yet another warning to (finance minister) George Osborne that his economic plan is failing and he must urgently act to kickstart our flatlining economy," said Chris Leslie, a lawmaker from the opposition Labour party.
LLOYDS MUST SELL BRANCHES
Lloyds was ordered to sell the branches by European regulators as a condition of receiving state aid during the 2008 financial crisis when Britain pumped 20.5 billion pounds into the bank leaving taxpayers holding a 39 percent stake.
Industry sources said Lloyds will almost certainty need to request that EU regulators extend the November 2013 deadline they have set for a sale, which analysts expect to be granted.
A flotation of the branches is unlikely to be possible until the second half of 2014, sources have said.
Industry sources also said Lloyds has been hit with about 1 billion pounds in costs associated with the failed deal. The bank made underlying pretax profit of 2.6 billion pounds in 2012 and the Verde business, which comprises the branches for sale, has been making around 200 million pounds a year in profit, according to analysts.
Lloyds had prepared to operate the branches as a separate business from August, using the TSB brand which disappeared from the high street in 1995 when TSB and Lloyds merged.
Verde has around 5 million customers and represents about 6 percent of all bank branches in Britain.
Britain's "Big Five" lenders - Lloyds, HSBC (HSBA.L), Barclays (BARC.L), Royal Bank of Scotland (RBS.L) and Santander UK (SAN.MC) hold 83 percent of current accounts. Co-op's 150 year old banking business has only 2 percent.
A source close to the Co-op said there was no truth in speculation that it would now pull out of banking. Its other businesses include supermarkets, funeral services, travel and pharmacy.
Co-op's general insurance business was put up for sale last month in a move to bolster its capital but it has so far failed to find a buyer.
Co-op's future strategy will be shaped by incoming chief executive Euan Sutherland who takes the helm on May 1. Sutherland joins Co-op from European home improvement retailer Kingfisher (KGF.L).
"The challenge they've got is how can they grow the banking operation because it is fairly clear to me that it is a bit short on capital," said Shore Capital analyst Gary Greenwood.
With banks facing increasingly burdensome regulation and with low interest rates constraining profitability, Sutherland, who has spent his career in retail, might want to focus on that side of the business rather than banking, said analysts.
Co-op Bank made a loss of 674 million pounds last year. The other businesses in the group also struggled as the UK recession continue to bite.
Lloyds shares closed up 1.7 percent at 51.9 pence a share after a rise of 71 percent in the last 12 months.
($1 = 0.6542 British pounds)