Lloyds, Royal Bank of Scotland and Northern Rock will be broken up and parts of their businesses sold off to create three new banks, it emerged last night.

Government sources said ministers were "determined" to see more competition in the market, following the £1.2 trillion bailout of the sector which resulted in the loss of three independent banks and several building societies.

The European Union will today approve the split of Northern Rock into two sections, a "good", profitable, bank with no bad debt, and a "bad" bank. Ministers will begin exploring sale options at the start of next year when the split happens and a deal could be finalised before the general election. The remaining "bad" bank will remain in state hands for the time being although sales of "tranches" of the more risky mortgages it holds will be explored in the longer term.

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The Lloyds and RBS sell-offs will follow over the next three to five years and will be supervised by UK Financial Investments, the government body set up to oversee taxpayers' investment in the banks.

The Government is understood to have made clear that existing larger operators will be banned from participating in the sales.

Ministers want to drive competition in a sector they believe is too concentrated in the hands of the "Big Four" of Barclays, HSBC, Lloyds and RBS. Virgin Money is known to be watching the situation closely and is in talks to add former Northern Rock chairman Bryan Sanderson to its board ahead of a possible bid for Northern Rock.

Tesco is another company that could be enticed into an auction as it seeks to grow its financial services business.

Spain's Banco Santander, which owns Abbey, Alliance & Leicester and part of Bradford & Bingley, may be allowed to get involved because it is significantly smaller than the big banking groups in Britain. But it could still be frustrated by the Government's determination to attract new entrants.

"We are keen to see greater competition in the banking sector as soon as possible," said a government source.

A deal to buy "good" Northern Rock would bring a new entrant around £20bn of deposits together with a portfolio of low-risk mortgages and a platform to expand operations that remain concentrated in the North-east nationwide.

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Lloyds is expected to face a forced reduction in its share of the retail banking market from 30 per cent to 25 per cent, with the disposal of more than a seventh of its 3,000 branches expected.

It has been desperately seeking support in the City for a share issue of up to £15bn to keep it out of the Government's asset protection scheme that will cover it against losses from up to £260bn of risky loans.

But even if Lloyds can achieve this, it will be forced to sell parts of itself as a consequence of the Government's injection of nearly £15bn to recapitalise the bank at the height of the financial crisis. That will be seen as a blow to Eric Daniels, chief executive, who indicated at the bank's recent results that he did not expect to make significant disposals. A spokesman said: "We continue to work with European regulators."

Royal Bank of Scotland, meanwhile, is working on plans to sell off a "couple of hundred" branches, including RBS branded outlets in the UK and NatWest's Scottish branches. It is certain to join the government scheme although how much will be protected is not yet certain.

Final details on the Lloyds and RBS disposals are set to be announced alongside details of the asset protection scheme.

But an indication of the EU's "get tough" approach came on Monday when ING, which owns the ING Direct savings bank in Britain, said it would split itself in two to satisfy watchdogs unhappy at its bailout by the Dutch government.

Britain's banking sector was further consolidated on Monday with the announcement by Barclays of a deal to buy Standard Life Bank.

Government sources said that while the new banks would be relatively small compared with the big four, they hoped they would prove fast moving and innovative.

The effect Standard Life Bank had on the market when it was launched has been noted, although its activities were constrained by the credit crunch.

The Government currently has a stake of 70.34 per cent in Royal Bank of Scotland and 43.44 per cent in Lloyds. That gives ministers the whip hand over both banks. They are expected to take up the taxpayers' "rights" when Lloyds launches its share issue to maintain the size of its investment.