George Osborne's planned banking reforms "fall well short of what is required", the parliamentary commission on banking standards has warned.
In a report published today the Commission, led by the chair of the Commons Treasury committee Andrew Tyrie, said banks should face the threat of being broken up in order to prevent savers' deposits being put at risk.
The Commission, whose membership includes the future Archbishop of Canterbury Justin Welby, former chancellor Lord Lawson and Tyrie, was set up in the wake of the Libor-rigging scandal.
In its first report, published today, the Commission said legislation should include a reserve power for full separation if banks did not implement reforms.
The Commission will also take evidence in the new year on whether separation of proprietary trading would be more appropriate.
Its initial recommendations could put it on a collision course with Chancellor George Osborne, who warned the Commission last month against "unpicking the consensus" over reform proposals in the Bill.
The report comes a day after Swiss banking giant UBS agreed a £940 million settlement for "widespread and extensive" attempts to fix Libor rates after admitting fraud and bribery.
Tyrie said the latest revelations "beggar belief".
"It is the clearest illustration yet that a great deal more needs to be done to restore standards in banking," he added.
While the Commission said it welcomed plans for a ring-fence, designed to make the system more secure and to protect deposits from so-called casino banking operations, it added that loopholes could easily develop.
The ring-fence would be "tested and challenged by the banks", while it said politicians could also succumb to lobbying from the industry.
Tyrie said: "For the ring-fence to succeed, banks need to be discouraged from gaming the rules.
"All history tells us they will do this unless incentivised not to. That's why we recommend electrification.
"The legislation needs to set out a reserve power for separation; the regulator needs to know he can use it."
Board members within banks should have a legal duty to preserve the integrity of the ring-fence, according to the report, while there also needs to be clear dividing lines.
It was also asked to look at whether retail banking operations should be able to offer simple derivative products, which have been thrust into the spotlight following the recent interest rate swap mis-selling scandal.
The Commission said there was a case for allowing these products - which also include fixed rate mortgages - with retail banking operations, although it cautioned there needed to be a clear definition and strict controls.
But the Commission said it had been "working in the dark" in the absence of secondary legislation for the Bill.
The Commission said it would also look at measures to improve the culture in the banking system in the wake of this year's series of shocking scandals.
This could include changes in areas such as civil and criminal law, competition, corporate governance and regulation, according to the report.
The Commission is also carrying out a separate inquiry into the collapse of HBOS and yesterday announced it would take evidence on the UBS Libor scandal, blasting it as a "manifest failure of regulation" and standards in the sector.
Shadow chancellor Ed Balls said: "This is an important cross-party report which sets out real challenges for the banks, government and Parliament. After repeated scandals, from Libor-fixing to mis-selling to small businesses, it is clear that we need radical reform of our banks.
"Having looked closely at the Government's draft legislation to implement the Vickers proposals for a ringfence between retail and investment banking, the Commission believes it 'falls well short of what is required' and is unpersuaded by the Government's relaxation of the Vickers recommendations.
"As Ed Miliband and I said at the Labour conference this year, if the letter and spirit of the Vickers proposals are not delivered and we do not see cultural change in our banks, full separation will be necessary. The Commission is clearly right to say the jury is still out and to demand a reserve power for full separation of the banks.
"We need serious cultural change in our banks and the Commission's next report on the culture and practices of the banks will be just as important as these vital structural changes. Only then will we get the banking system our businesses and economy needs."
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