Media playback is unsupported on your device Media caption Watch: Sir John Vickers calls for 'retail ring-fence'

UK banks' retail operations should be "ring-fenced" from their investment banking arms, the Independent Commission on Banking has recommended.

However, in its interim report the commission stopped short of recommending the two should operate as separate entities.

It said more competition was needed in retail banking, including the sell-off of more Lloyds branches.

The commission's final recommendations will be published in September.

The banking commission was set up by the government last June to review UK banks after the financial crisis.

However, the government is under no obligation to implement its recommendations.

Bank shares reacted positively to the report, with Barclays shares up 3.6% and Royal Bank of Scotland 3.2% higher by mid-afternoon trading.

Deputy Prime Minister Nick Clegg welcomed the report, telling BBC Radio 4's Today programme: "It is based on the insight that many people share, which is that it is not right to have very high-risk and very low-risk banking activities so intertwined that, when something goes wrong, it is the taxpayer that picks up the bill".

On its analysis, even if big banks such as HSBC or Barclays were to move their respective head offices abroad in protest at the reforms, the loss of tax revenue and the damage to the success of the City of London would be limited Read Robert's blog Q&A: Independent Commission on Banking

Shadow chancellor Ed Balls said he felt the report was "tough" on banks.

"The devil will be in the detail of the commission's final proposals, but we must get this right," he added.

But critics insisted that the commission had been too timid, an accusation that Sir John Vickers, the chairman of the commission, flatly denied.

"I absolutely reject any notion that we bottled it," he said at a press conference.

"In no sense at all are these half measures... these are absolutely far-reaching reforms."

Cash reserves

The report said that, in the build-up to the crisis, lenders and borrowers took on "excessive and ill-understood risks".

It added that implicit taxpayer support for the banks encouraged "too much risk taking".

Key recommendations Retail banks should be ring-fenced from investment banks

They should have their own capital reserves

Banks should hold more capital to withstand potential losses

Taxpayers should not be liable for future losses

Depositors should get their money back before creditors

Lloyds Banking Group should sell more branches to increase competition.

It should be much easier for customers to move their accounts.

The commission said that banks needed to hold more cash in reserve to protect against future crises, and that creditors, not taxpayers, should be liable for any losses.

It said it was looking at forms of "retail ring-fencing", under which retail banking would be carried out by a separate subsidiary within a wider banking group.

The report recommended that banks should have 10% of their capital set aside to cover potential losses, higher than the 7% set out in new European regulations.

However, the commission said it was not proposing that UK investment banks should hold higher capital ratios than their international rivals.

'Allowed to fail'

Sir John told the BBC that "total separation [of retail and investment banking] is not necessary".

"UK retail banking can be protected by its own capital cushion," he said. "Other parts of the bank should be allowed to fail."

This would lead to additional costs to the banks, some of which would fall on the wider economy, he said.

"The cost of capital is going to go up," Sir John said, but the costs to investment banks would be greater than those to retail banks.

Without an implicit government guarantee, which banks currently enjoy, lenders would view investment banks as more risky, and therefore charge more for their money.

Banks would also be less likely to take excessive risks without this implicit guarantee, the commission said.

These costs, however, would be more than offset by the benefits of "materially reducing the probability and impact of financial crises", the report said.

Analysts said that banks might have to increase retail charges to pay for the measures outlined in the report, should they be implemented.

"Rising financial capital cushions are likely to paid for by increased banking charges, whilst the rise of an army of new alternative banks still looks to be a lifetime away," said Keith Bowman at Hargreaves Lansdown.

Market power

See the full report Independent Commission on Banking interim report [2.3MB] Most computers will open PDF documents automatically, but you may need Adobe Reader Download the reader here

The report also recommended that Lloyds Banking Group, which has about 30% of current accounts in the UK, should sell more of its branches in order to increase competition on the High Street.

Lloyds is already in the process of selling about 600 branches, but Mr Vickers said competition in High Street banking would benefit from further branch sales.

The commission called for a radical improvement in the ability of bank customers to move their accounts, so that the threat of losing customers would put pressure on banks to improve their services.

To do this, it suggested that bank accounts could have unique numbers valid across the whole of the banking industry, like portable phone numbers.

Consumer groups questioned whether the commission's recommendations went far enough.

"The financial crisis has increased the market power of the largest banks, leading to a worse deal for consumers," said Peter Vicary-Smith, chief executive of Which?.

"We're pleased the commission recognised this, but need to consider whether the recommendations will go far enough to address the parlous state of competition in the UK."

Sir John said far-reaching reforms that would go beyond its focused recommendations had not been ruled out.

"Strict separation and much, much higher capital requirements - those options are not off the table," he said.