THE planned sale by UK state-backed Lloyds of hundreds of bank branches to the Co-op fell through on Wednesday, setting back British government plans to boost competition in the industry.
The Co-Op said it pulled out of the deal 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 hoped the combination of Co-Op's existing banking business with the Lloyds branches would have created 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.
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.
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".
Industry sources had expressed doubts for several months about the viability of the deal, citing supposed concerns held by the financial regulator about Co-op's capital strength. There had also been worries about the complexities of breaking out the business and merging it with the Co-op.
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 £20.5bn into the bank leaving taxpayers holding a 39pc 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 is unlikely to be possible until the second half of 2014, sources have said.
Amid doubts over the Co-op transaction, Lloyds had operated a "dual track" approach, preparing for both a sale and a share offer. It has prepared to operate the branches as a standalone business from August, under the TSB brand which had disappeared from the high street in 1995 when TSB merged with Lloyds.
The Verde business - the name given to the branches for sale - has around 5 million customers and represents about 6 percent of all bank branches in Britain.
Co-Op agreed in 2012 to buy the branches, which would have created Britain's seventh-biggest bank.
Britain's "Big Five" lenders - Lloyds, HSBC, Barclays, Royal Bank of Scotland and Santander UK hold 83pc of current accounts.
A source close to the Co-op said there was no truth in speculation that it could now pull out of banking altogether. Co-op's insurance business remains on the market having been put up for sale last month.
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 where he was chief operating officer and has a predominantly retail background.
Shares in Lloyds showed little reaction and were down 0.2pc in morning trade, reflecting doubt the deal would succeed.
Industry sources say that Lloyds has been hit with about £1bn in costs associated with the deal. The Verde business has been making around £200m a year in profit, according to analysts.