By Olesya Dmitracova and Matt Falloon
LONDON, March 7 (Reuters) - The row over reforming Britain's banking sector is heating up as discussion of a drastic restructuring and increasingly assertive political rhetoric draw equally stern responses from the banks.
Britain has been at the forefront of a global push to strengthen the regulation of the banking sector, blamed for reckless lending which caused the credit crisis.
The country's banks are awaiting a preliminary report by the Independent Commission on Banking (ICB), due next month, for pointers on the next set of rules.
The report may include some radical suggestions, such as forcing banks to separately capitalise their retail and investment banking operations.
Although that may not mean a full break-up, it could still be hugely costly for the likes of Barclays, government-backed Royal Bank of Scotland and Lloyds, and others, and could prompt them to spin off their investment banking operations. Banks have been taking comfort from speculation the government may decide not to implement the final proposals, but a source at the Treasury said on Monday all options were on the table.
"If anyone thinks that the Treasury has had anything but an open mind on what the Commission might report, then they are indulging in wishful thinking," the source told Reuters.
Last month finance minister George Osborne warned against pre-judging what the ICB will recommend and how the government will respond to those suggestions, as he announced a deal with banks to curb bonuses and boost business lending, known as Project Merlin.
URGENT REFORM
Osborne's comments at the weekend shed further light on his combative stance. He defended Mervyn King -- governor of the Bank of England, which will become Britain's main banking supervisor from 2012 -- after he called for urgent reform of the industry and warned about the risk of a fresh financial crisis.
Banks responded by saying they had made their businesses safer since the crisis and that no bank should believe it can fall back on the taxpayer.
Some banks say that even existing regulations are taking the shine off Britain as a place to do business.
HSBC, Europe's biggest bank, may move its headquarters from London to Hong Kong because of what it sees as high levels of tax and red tape in Britain, according to a weekend report in the Sunday Telegraph.
A British tax on bank assets to be introduced this year would cost HSBC about $600 million based on its balance sheet at the end of December. That marks a cost for being based in the country, HSBC has said.
Separately the chief executive of Swiss bank UBS has said the British government was neglecting the City, London's financial sector, the Financial Times reported last week.
Oswald Gruebel said in an interview with the FT that tougher regulations would lead to Britain and the rest of Europe ceding investment banking business to Asia and the United States.
The row about the fate of Britain's banks is likely to simmer until at least September when the ICB is due to deliver its final proposals -- not least due to banks' failure to endear themselves to the public.
Banks continue to pay mega-bonuses to staff, while many Britons face falling living standards. Barclays' remuneration report showed on Monday one of its bankers was paid 10.9 million pounds ($17.8 million) for last year.
"The road to rehabilitating banks' image is likely to be long and arduous," IHS Global Insight analysts said in a recent note. (Additional reporting by Steve Slater and Huw Jones; Editing by David Holmes) ($1=.6124 Pound)