GEORGE Osborne has promised to "reset" Britain's banking system with a threat to break up the banks if they do not follow strict rules to ring-fence risky investment operations from savers' deposits.

The Chancellor also made clear that the forthcoming fine for Royal Bank of Scotland as part of the Libor-rigging scandal – expected to be up to £500 million – will be paid out of the bonuses of investment banking staff and not come from the taxpayer.

Outlining the UK Government's Banking Reform Bill, which went to Parliament yesterday, Mr Osborne told bankers in Bournemouth there would be no more "too big to fail" institutions and unveiled payment reforms to speed up the banking system.

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His comments look likely to incur the wrath of the City after he pledged to introduce powers to "electrify the ring-fence", if lenders failed to split high street branch operations from the dealing floor.

The bill has reignited fears that Britain's biggest banks could move abroad, with the British Bankers' Association (BBA) warning the plans will damage London's attractiveness as a global financial centre. However, Lloyds Banking Group, which is part-taxpayer owned, distanced itself from the BBA's criticism of electrification.

Antonio Horta-Osorio, its chief executive, told the Parliamentary Commission on Banking Standards at Westminster that Lloyds had not been notified about the BBA's comments. "I do support electrification," he said.

In his speech, Mr Osborne said it was time the banks worked for their customers, and not the other way round, "so that when mistakes are made, it's the banks and not the taxpayer that picks up the bill".

The Chancellor explained he wanted to open up the payment system to ensure new players could access it in a fair and transparent way and so that customers and businesses would be able to move money around the system more quickly.

The new bill follows recommendations by the Independent Commission on Banking, led by Sir John Vickers in 2011, which came up with ways to make the sector safer and give greater protection to depositors in the wake of the financial crisis.

The Parliamentary Commission on Banking Standards, set up in the wake of the Libor scandal, also called for reserve powers to break up the banks if they do not adhere to rules to separate investment and high street operations.

Anthony Browne, the BBA chief executive, said this would make it more difficult for banks to raise capital to lend to businesses and would also create uncertainty for investors.

However, Mr Osborne said: "When the RBS failed, my predecessor Alistair Darling felt he had no option but to bail the entire thing out. Not just RBS on the high street but the trading positions in Asia, the mortgage books in sub-prime America, the property punts in Dubai. I want to make sure that the next time a chancellor faces that decision, they have a choice – to keep the bank branches going, the cash machines operating, while letting the investment arm fail."

On RBS – 82% owned by the public – and Libor, he stressed: "Any UK fine will benefit the public. When it comes to RBS, I am clear that the bill for any US fine related to this investigation should on this occasion be paid for by the bankers and not the taxpayer."

Last night Labour Shadow Chancellor Ed Balls said: "He is refusing to legislate for a backstop power to allow for across-the-board separation of the banks." He made clear Labour would put down amendments to the bill to this effect.