Let me declare an interest.

I have a bank account with the Co-operative and I chaired an event sponsored by the Co-op at the Tartan Heart music festival at Belladrum last year. What was the Co-op doing at a music festival? Quite good business as it turned out because the original mutual non-profit company has a very different image to most commercial companies and fitted rather well with the festival ethos. It takes things like climate change and fair trade so seriously it hurts. The Co-op even has a bumble bee welfare initiative called "Plan Bee".

It's hard to imagine Tesco Bank pitching a tent at a music festival and promoting debates on wind farms and social housing. Or sharing its profits with the suppliers in developing countries. Or turning down more than a billion pounds in business because its ethical policy prevents it lending money to countries or companies that fall down on human rights. The Co-operative does all that, and a lot more. But more importantly, it has been in my experience a rather good bank which treats its customers pretty well and offers good interest rates because it doesn't have to pay its executives huge bonuses.

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Which is why, like many people, I was disappointed that the deal for the Co-op to take over the 632 TSB branches of Lloyds/HBOS bank has fallen through. Confidence needs to be restored in the British financial sector, and the Co-operative could perhaps have shown the way by introducing an ethical dimension to banking – a real choice for once. It may be naive to think any commercial bank can have a social conscience, but if you take a step back in history it's not as ridiculous as it sounds.

The Lloyds division the Co-operative would have taken over is called TSB. The original Trustee Savings Bank was founded by Reverend Henry Duncan in Dumfriesshire in 1810. It was a non-profit, philanthropic enterprise intended to encourage thrifty habits among Scottish working people who had been ignored by the banking sector. Their deposits, with interest, were guaranteed by the voluntary trustees who ran the bank. It was very successful too, in a very hard-nosed commercial Victorian era. By the end of the 19th century there were more than 600 similar institutions in Britain.

What a long way we have come since the days of the real TSB. Banks today have no trust, they don't seem very interested in savers and don't pay them much interest. Banking has become too big, too greedy and has lost any sense of social obligation. It is very unfortunate that the Co-operative, which grew out of the same Scottish self-help movement as the TSB, has been unable to restore some meaning to the mutual ideal.

The proposed Co-operative/TSB bank would at the very least have broken the oligopoly of the big four: RBS, Barclays, Lloyds, HSBC, all of whom have behaved appallingly over the last four years. The Government was keen for the Co-op deal to go ahead, not least because there is still a large public stake in Lloyds. But most of us would just like to see real competition against the Libor-fixing, sub-prime lending, money-laundering, bonus-driven shysters who run high street banking today.

I'm not entirely surprised the deal failed. The Co-op would have become a very big bank almost overnight, with 1000 branches and a fair chunk of the market. Members of its board were concerned that the organisation might lose its integrity if it joined the world of high finance, and found itself having to do, well, what banks do. All those extra branches look good value just now, but how many will survive in future with banking increasingly migrating from the high street to the computer screen?

The Co-operative lost £559 million last year, and its banking division has a billion-pound so-called "black hole" which, under new banking regulations, it has to fill to match its capital requirements. In short, the Co-op is a bit short of cash right now, and with the economy going down it was probably worried about doing an ABN AMRO. That was the Dutch bank that RBS rashly took over on the eve of the 2008 crash and led to its collapse into the arms of the taxpayer.

That concern is understandable. But I have to say that as a taxpayer I would rather see the Co-op falling into state hands than the rest of them. We have now in Britain four commercial banks, at least two of which are only in business because the Government has given them, effectively, a guarantee of more taxpayer's support in future. That is profoundly unhealthy. The other big player is Nationwide, which is a mutual society and very much the better for it.

Earlier this month the Parliamentary Commission on Banking Standards issued a report on HBOS – part of Lloyds – saying its executives behaved in an "incompetent and reckless manner" and that James Crosby, Andy Hornby and Lord Stevenson – the top three – should be banned from holding senior posts in financial institutions in the future. They may have gone to other jobs – Andy Hornby is now boss of the bookmakers Coral, presumably because he knows all about bad bets. The culture they created in these huge banks, each with assets of around one trillion pounds, lives on.

There is now a very serious issue facing society. Do we continue to finance these deviant institutions with public money just because we are afraid of the consequences of not doing so? What other business can rely on effectively unlimited help from the state? What kind of moral hazard does that embed in our banking system? How do we wind down the immense debts of the banking sector without bankrupting the state?

Either the banks should be taken fully into public ownership and run in the public interest, or the banks must be broken up. The aborted Lloyds sale was demanded by the European Competition Commission as part of the deal under which Lloyds was recapitalised with public money. Lloyds will now try to float off the TSB branches, which have to be sold by November.

But here's a thought. Why not make TSB a standalone mutual society, like Nationwide, to live up to its original mission, perhaps in partnership with the Co-operative? It's not too late to save banking from itself.