Britain to Break Up Lloyds (LON: LLOY) and Royal Bank of Scotland (LON: RBS)

In hopes of adding competition to the banking sector, Britain’s Labour government is set to propose the breaking up of Lloyds Banking Group (LON: RBS) and the Royal Bank of Scotland (LON: RBS) and will sell pieces of Lloyds and RBS to new entrants into the market place.

Chancellor Alistair Darling will likely unveil his proposed overhaul of the UK banking system to the House of Commons which will include breaking up the Royal Bank of Scotland and Lloyds Banking Group and bring at least 3 new major banking competitors into Britain’s financial sector.

The Labour Government hasn’t made an official announcement about its plans yet because it’s still in negotiations with both banks over their participation in the government’s asset protection scheme, which provided insurance to billions worth of bad loans.

In a statement that the Chancellor made yesterday, Darling said that the banking sector would look very different in the next four years. He continued, “What I want to do now is begin the process of reform and reconstruction so we have got a safer, more competitive banking system with more high street banks than we have at the moment, with new entrants coming in”.

RBS is currently 70% owned by the British government and Lloyds is currently 43% state owned, which will be forced to sell its assets to new entrants into the market. According to Darling, both banks “will be divesting some of the holdings they have at the moment. What you really want to do is have substantial divestment of branches, or particular institutions they own, made available to other people.”

The plan to break up to of the UK’s largest banks follows pressure from the European competition commissioner, Neelie Kroes, that has demanded that RBS and Lloyds sell operations under the EU’s state aid rules.

Darling added, “I would hope that you would have perhaps three new entrants over the next few years. You know, some are already in banking, others may decide it’s something they want to get into.”

What banks will bid for Lloyds’ and RBS’ assets? Business Week has reported that Virgin Money and Tesco are both looking to boost their financial service operations with assets from the two companies that are to be broken up. Other banking giants, including Barclays, HSBC and possibly Spain’s Banco Santander, will likely be blocked from bidding as the government is hoping for more competitors in the market place so that customers receive better services.