The government should split its bailed out Royal Bank of Scotland and create a business bank dedicated to boosting lending to companies and supporting exports, Business Secretary Vince Cable said in an internal government letter.
Britain owns 82 percent of the loss-making RBS after rescuing it along with Lloyds Banking Group during the 2008 financial crisis.
Cable, a Liberal Democrat, is a long-time critic of the banking system for failing to lend enough to business and who had previously pushed for deposit-taking banks to be separated from their investment divisions.
My suggestion is that we recognize that RBS will not return to the market in its current shape and use its time as ward of state to carve out of it a British Business Bank with a clean balance sheet and a mandate to expand lending rapidly to sound business, he wrote in the letter published by the BBC and confirmed by Cable's department as genuine.
We should be willing to use such an institution to support our other industrial objectives, such as supporting exports and sectors identified as of strategic importance, he added.
The letter, dated February 8, was addressed to Prime Minister David Cameron and his Deputy Nick Clegg.
Cable's proposals are not government policy but the leak casts a light on the internal debate within government on how best to utilise its investment in RBS.
Britain used about 45 billion pounds of taxpayers' money to rescue RBS, and eventually aims to sell it back to the private sector.
Cable said the government badly needed an initiative that would give confidence to businesses that expansion would not be choked off by the banks.
Britain's economy is still limping along after recovering from a steep recession following the banking crisis and the coalition is under pressure to find ways to boost growth without breaking a strict austerity program.
In the letter, Cable said the government lacked a compelling vision of where the country was headed beyond sorting out the fiscal mess.
A lack of lending to smaller and medium-sized businesses remains a political hot topic in Britain after the government's Merlin agreement with the country's large banks failed to funnel enough credit to smaller firms.
Banks have blamed low levels of lending on a lack of demand, but smaller firms frequently complain about tough lending conditions.
In a BBC radio interview after the letter was published Cable said he was floating one of a number of options that could be used to improve the flow of lending to small-scale companies.
But he stressed that the key emphasis of current government policy was to get its scheme of credit easing up and running, with the details due in this month's budget statement.
Britain's finance minister George Osborne said Tuesday the credit easing scheme was ready to be launched as soon as the European Union gave its green light as a way of unlocking a lending bottleneck.
Bank of England policymakers have also said the lack of lending is an issue. Bank governor Mervyn King as well as external policymaker member Adam Posen have both suggested using the banks partly owned by the government as a way to fix the problem.
RBS reported a full-year loss of 2 billion pounds for 2011, the fourth straight year in which it has made an annual loss..
(Editing by Elaine Hardcastle)