Britain's top banks should shield retail operations from riskier investment banking activities and boost capital levels to protect taxpayers from future crises, a government-commissioned report said.

Proposals outlined on Monday appear harshest for Lloyds Banking Group , which may have to sell hundreds more branches, but stopped short of measures to break up Britain's big banks or risk putting them at a competitive disadvantage to U.S. and Swiss peers.

Ring-fencing retail units may force the likes of HSBC and Barclays to hold more capital, potentially increasing funding costs and squeezing profits. But the commission said it expected the industry-wide cost of its proposals to be well below 12 billion pounds ($20 billion).

They've got away with it, apart from Lloyds which might have to sell off more assets, but it could have been harsher and it wasn't, John Smith, senior fund manager at Brown Shipley, said following publication of the 208 page interim report.

There's relief that it's been in line with expectations.

Analysts noted the banks already hold close to the recommended core Tier 1 capital level of 10 percent having bolstered balance sheets in anticipation of new global rules.

As always, the devil is in the detail and there will be a cost, but it will be seen as manageable, said Christopher Wheeler, banking analyst at Mediobanca, noting that Standard Chartered , HSBC and Barclays are already expected to have capital ratios of between 9.9 and 12.4 percent by 2012.

The costs to the banking sector of ring-fencing retail operations may be material but are likely to be much smaller than the 12-15 billion pounds calculated last month by management consultants Oliver Wyman, the commission said.

Cost estimates submitted privately by the most affected lenders fell well short of the bottom of the range, it added.

HSBC alone recorded an operating income of over $80 billion last year and a pretax profit of $19 billion.

NO EXODUS

British finance minister George Osborne said he welcomed the excellent analysis and findings of the commission led by former Bank of England interest rate setter John Vickers.

Speaking at a news conference in London, Vickers said he believed the proposed reforms could be transformative and denied the report had been soft on the banks: I absolutely reject any notion that we've bottled it.

The aim had been to make banks less risky and better able to absorb losses, thus ensuring that vital operations like payments systems and cash for ATMs are kept running if a lender nears collapse as RBS did three years ago.

Barclays had been seen as most at risk if the panel proposed more formal separation of businesses, due to its reliance on investment banking. Along with HSBC it had threatened to quit London for New York or Hong Kong if regulation was too onerous.

One needs to cast a very skeptical eye on remarks of that kind, Vickers said. There will be a whole host of practical obstacles, legal obstacles and reputational obstacles.

The commission said it did not expect London to become a less attractive place to do business and that continued prosperity was not dependent on British banks staying put.

Most of the historical evidence suggests that the City's growth was not driven by UK-headquartered banks' success but by its openness to foreign firms, it said

Shares in Barclays were up 3.1 percent by 1217 GMT while RBS gained 2.6 percent. Lloyds and Barclays were broadly flat and HSBC was 0.9 percent weaker.

Big banks in Britain and elsewhere have already boosted their capital levels in preparation for new rules. Global watchdogs have signaled that extra safeguards for big banks are likely to include a capital buffer of about 3 percent on top of the new global minimum of 7 percent for all banks from 2013.

However the ICB took a hard line by requiring the extra 3 percent of capital to be in the form of pure equity as it doubts the effectiveness of hybrid debt known as contingent capital which is also being considered by global regulators.

Underscoring the need for reform, the commission noted the balance sheets of Britain's banks are more than four times the country's annual gross domestic product -- way ahead of the United States where the economy and its banks are roughly the same size.

The UK is also ahead of other countries heavily reliant on the financial services sector such as Switzerland and the Netherlands.

The banks are expected to lobby heavily to lighten the regulatory burden before the final IBC report is handed to Osborne and Business Secretary Vince Cable in September.

BRANCHES SALE

The panel said more needed to be done to combat a lack of competition on the high street as Lloyds' takeover of HBOS -- a rescue deal engineered by the government -- left it with a 30 percent share of the current account market.

Signaling hundreds more branches need to go, its report said Lloyds' sale of 600 branches would have a limited impact on competition unless it is substantially enhanced.

Deutsche Bank analysts estimated that a 50 percent increase in the size of the disposals previously asked of Lloyds could shave around 6 percent off group earnings.

Vickers and his team stopped short of the nuclear option of unwinding Lloyds' takeover of HBOS, but said: There is cause for regret that the government in 2008 amended competition law to facilitate the Lloyds TSB/HBOS merger.

Lloyds, however, said further disposals may paradoxically potentially delay a new competitor coming into the UK market.

The board and I ... share the management team's surprise at the prescriptive nature of the interim report's recommendation, Lloyds Chairman Win Bischoff said.

(Additional reporting by Paul Hoskins, Huw Jones and Sarah White; editing by Sophie Walker and Jodie Ginsberg)