The Independent Commission on Banking, led by Sir John Vickers, said it would “make it easier and less costly to resolve banks that get into trouble”.
The ICB called for the changes to be implemented by the start of 2019.
Chancellor George Osborne said the report would mean UK banks could remain competitive.
“The government wants Britain and the City of London to be the pre-eminent global centre for banking and finance. We want universal banks headquartered here with all the advantages that brings,” he told Parliament.
“The global investment banking operations of UK banks can continue to be as competitive as any in the world.”
He also said that he planned to stick to the report’s timetable.
There was some criticism from employers’ group the CBI, which said some aspects of the report would damage the competitiveness of UK banks.
The head of the union umbrella body the TUC said that the report did not go far enough.
Brendan Barber said it was “merely tinkering around the edges of what is one of our absolutely central economic problems”, which was how to make banks useful and “get responsible credit flowing again”.
The shadow chancellor, Ed Balls, said he was “deeply sorry” for the part the last government played in the regulatory failures that led to the banking crisis.
He described the report as “important and authoritative”, while the ring-fence proposal was “tough and radical”. But he said it should be “the start, not the end point for reform”.
“To help get the economy growing again, we urgently need to increase net lending to small businesses, which the government’s deal with the banks has failed to do, and we need action on issues like pay and bonus transparency.”
Sir John Vickers said the report was “fundamental and far-reaching”.
The report recommends that ring-fenced banks should be the only operations granted permission by the UK regulator to provide “mandated services”, which include taking deposits from and making loans to individuals and small businesses.
It says that the different arms of banks should be separate legal entities with independent boards.
Another of the ICB’s recommendations is that banks must have a buffer to absorb the impact of potential losses or future financial crises – of at least 10% of domestic retail assets in top-quality form, such as shares or retained earnings.
That is a stiffer target than the 7% recommended by the international Basel Committee on Banking Supervision.
It also says the biggest banks should go further than this and have a safety cushion of between 17% and 20% of assets, made up of highest-quality assets topped up with bonds that can be easily converted to equity.
The business lobby group, the CBI said this would not help business.
The CBI’s deputy director-general, Dr Neil Bentley, said: “The proposals on capital requirements are out of step with internationally agreed measures underway so will increase the cost of lending for UK businesses, putting them at a disadvantage to their overseas competitors.”
The commission also recommends that steps should be taken to make it simpler to switch bank accounts, something that was welcomed by the CBI.
The ICB wants a free current account redirection service to be formed by September 2013, with an improved system to catch all credits and debits going to a customer’s old, closed account, including automated payments on debit cards and direct debits.
Costs and benefits
The BBC’s business editor, Robert Peston, called it the most radical reform of British banks in a generation, and possibly ever.
He said it would be hated by the biggest UK banks, Royal Bank of Scotland (RBS) and Barclays.
He pointed to the report’s analysis of the costs and benefits of the reforms, which estimates the social costs of its proposed reforms – the costs for everyone in the UK, rather than just for banks’ creditors and investors – as between £1bn and £3bn a year.
That compares with the annual £40bn cost of lost output that follows periodic financial crises, he said, adding: “If the commission’s calculations are even vaguely in the right ballpark, it will be very hard for banks to resist the changes.”
The British Bankers’ Association (BBA) said banks had already begun the process of making themselves safer.
“UK banks are well on the way to implementing the sweeping reforms already brought in and expected to be brought in by UK, EU and global authorities to make banks and the system safer and to ensure that banks can fail in the future with savers and taxpayers protected and the supply of finance to the economy maintained,” the BBA said.
‘Into the unknown’
Michael Symonds, an analyst at Daiwa Capital Markets, said there was a danger that the changes would damage UK banking’s international competitiveness.
“Into the unknown we go, in terms of the recommendations,” Mr Symonds said. “The main issue really is the fact that the UK is going it alone on their structural reforms and the potential damage it will do to the competitiveness of the UK banking sector and economy as a whole.”
Bank shares all fell sharply in early tradewith Barclays, Lloyds and RBS all down about 4% and HSBC down 1.6%, although by mid-morning they had recovered of the ground lost. Bank shares globally were lower on Monday on continued concerns over the eurozone and its debt crisis.
There is a view that regulating UK banks could push some to leave the country in search of a place where regulation is lighter.
Sir John said he thought this was unlikely, at least as far as High Street banking was concerned.
The ICB was set up last year to look at how taxpayers could be protected from future banking crises.
The credit crisis ultimately led to the government nationalising Northern Rock and part-nationalising Royal Bank of Scotland and Lloyds.
The government now has stakes of 83% and 41% in RBS and Lloyds, respectively.
The ICB said its proposed reforms could result in a pre-tax cost of between £4bn ($6.4bn) and £7bn for Britain’s banks, something Sir John said would be unlikely to be felt by individuals.
He said the cost would be about one-tenth of 1% to customers, with the banks themselves absorbing some of the costs.
“How much of this passes through to the customer? It’s not going to be a large amount whatever. We believe that most of the cost increase will be felt outside the UK retail ring-fence, rather than within the arena of UK economic activity. We also believe that a portion of the cost increase will be absorbed by the banks, so it won’t all get passed through.”