Britain on Monday approved wide-ranging proposals to shake up the country's banks, forcing lenders to form barriers between their retail operations and riskier investment arms to protect ordinary customers better in any future crisis.

The government will separate retail and investment banking through a ring-fence, Finance Minister George Osborne told parliament.

It's important to know that this ringfence will not prevent banks from failing, but it does mean, if banks get into trouble, those elements of the banking system that are vital for families, businesses and for the whole economy can continue without resort to the taxpayer, he added.

Osborne was giving his formal approval to plans laid out in September by the government-appointed Independent Commission on Banking (ICB), which had proposed this ring-fencing model.

The government set up the ICB after the 2007-08 credit crisis saw Britain nationalise Northern Rock and pump 66 billion pounds ($102 billion) into Lloyds and Royal Bank of Scotland.

The ICB, headed by Oxford University academic Sir John Vickers, also said banks should hold core capital of 10 percent, plus a further 7-10 percent capital in the form of bail-in bonds.

There would also be limits to the extent to which a bank could use money in its retail arm for its investment bank, a move that will increase funding costs for British lenders.

Osborne said the Conservative-led coalition government backed the plans to make banks hold more loss-absorbing capital.

However, he added this would only apply to the UK operations of British banks - removing a potential disadvantage to HSBC and Standard Chartered, which make much of their profits outside of Britain in Asia.

Large, ringfenced retail banks will be required to hold equity capital of at least 10 percent, but there will also be a minimum requirement for the loss-absorbing capacity of big banks of at least 17 percent, said Osborne.

This requirement will apply to the UK operations of British banks; it will also be applied to the non-UK operations of UK-headquartered banks, except where they can demonstrate that they do not pose a threat to the UK taxpayer.

RBS TO SHRINK INVESTMENT BANKING ARM

Osborne also called on RBS to cut its investment banking arm further.

RBS itself has made significant changes since 2008, including reducing the size of its investment bank by half. But I believe RBS needs to go further and the management agrees.

RBS will make further significant reductions in the investment bank, scaling back riskier activities that are heavy users of capital or funding, he added.

Osborne said the government estimated the costs of the ICB's proposals to stand between 3.5 billion and 8 billion pounds, although the banks say it could be greater than this.

The proposal on bail-in debt has been attacked by HSBC and Standard Chartered, who have threatened to quit their London headquarters for Asia.

While the government says taxpayers should not have to bail out lenders in the future, Prime Minister David Cameron also wants to ensure the regulations do not harm London's standing as a leading financial centre. He vetoed changes to the European Union treaty this month to protect the City.

The ICB has said banks should have until 2019 to implement the proposals -- in line with plans by the Basel committee of global banking regulators to impose tougher capital requirements on banks also by 2019.

The proposals would see Britain follow Sweden and Switzerland in setting a benchmark in capital rules on banks, since the size of each of those countries' bank sectors is greater than their national GDP, creating a greater risk for taxpayers.

The issue of banking reform has caused tension between the Conservatives, who lead the coalition, and Liberal Democrats, with Cable and LibDem Deputy Prime Minister Nick Clegg fiercer critics of the banks than Cameron or Osborne.

($1 = 0.6440 pound)

(Additional reporting by Michael Holden, Fiona Shaikh and Steve Slater; Editing by Jon Loades-Carter and Dan Lalor)