UPDATE 5-UK prepares new law to break up errant banks

* New laws will make banks ring-fence retail operations

* Break-up threat in place if banks try to flout new laws

* Government would make final decision over break-ups

* Berlin considering jail for reckless bankers

* Will stick to Basel III rules on leverage ratios

By Laura Noonan and Matt Scuffham

BOURNEMOUTH, England, Feb 4 (Reuters) - British banks thatfail to shield their day-to-day banking from risky investmentactivities could be broken up, finance minister George Osbornesaid on Monday, bowing to political pressure to come down harderon reckless lenders.

European countries are retooling their financial systems toprevent a repeat of the 2008 financial crash, trying to strike abalance between popular calls for banks to be reined in andwarnings that too tight a leash will choke off recovery.

With Britain's banks buffeted by scandal andpart-nationalised Royal Bank of Scotland (RBS) set to befined up to 500 million pounds this week for interest raterigging, Osborne decided to "electrify" the ring-fence aroundbanks' core retail activities with the threat of break-up.

"Our country has paid a higher price than any other majoreconomy for what went so badly wrong in our banking system. Theanger people feel is very real," Osborne said in a speech aheadof the publication of the banking reform legislation.

"Let's turn that anger from a force of destruction into aforce for change," he said, speaking at the offices of U.S. bankJP Morgan in Bournemouth, southern England.

London's structural reforms go further than France andGermany, which, like the United States, are only demanding thatbanks separate out their proprietary trading, where they investthe banks' own funds, from the rest of their businesses.

Germany is however considering a new law that would seeexecutives jailed for up to five years if found guilty ofreckless behaviour that jeopardises their bank, a move describedby a senior government source in Berlin as a signal to Europe,which is seen as not moving fast enough on the issue.

Osborne said Britain could ban directors of failed banksfrom working in the industry.

FLICK THE SWITCH

In the absence of international agreement, nationalregulators are increasingly pursing their own banking rules, tothe dismay of industry insiders.

"We should not create unnecessary obstacles to pan-Europeanrules with a zig-zag approach. A crisis does not stop at thenational border. We need a coordinated approach in this area,"said Michael Kemmer, managing director of the German bankingassociation.

All the major British banks, including Barclays,HSBC and RBS, will be affected by the UK legislation,and the industry has warned it will put them at a disadvantageagainst continental rivals such as Deutsche Bank andBNP Paribas.

"This will create uncertainty for investors, making it moredifficult for banks to raise capital, which will ultimately meanthat banks will have less money to lend to businesses," theBritish Bankers' Association said in a statement.

But a source close to one of Britain's biggest lenders wasmore sanguine, saying that with banks already under intensescrutiny, Osborne's decision was a longer term move designed toprevent banks letting standards drop when attention is lessfocused on the industry.

Fitch ratings agency said the legislation could improve thecredit profile of Britain's retail banks.

Under the new rules, the Bank of England will monitorwhether banks' investment banking arms, which trade complexsecurities, are endangering their retail operations.

If the central bank finds a breach, the government willdecide whether to flick the switch on the electric fence,forcing the bank to sell one of the two arms.

"Banks require discouragement from gaming the rules. Theywill always try to do so unless strong disincentives are put inplace," said Andrew Tyrie, the chairman of the parliamentarycommission that had demanded the break-up threat.

Britain's finance ministry confirmed it would stick to ruleson limits to a bank's leverage that have been set at the globallevel. Leverage will be capped at 33 times a bank's capital,weaker than an original proposal for a maximum of 25 times.

In December, a cross-party group of lawmakers reviewing theplans said it was "not persuaded by the government's relaxation"of the leverage rule and added that the Bank of England shouldset the leverage cap.

ENORMOUS PUBLIC ANGER

RBS is expected to be fined this week for its role in aglobal interest-rate-fixing scandal, and Osborne repeated hiscall for the settlement with U.S. and UK regulators to be paidout of bankers' bonuses, saying it would cause "enormous publicanger" if the taxpayer footed the bill.

The UK has spent over $100 billion propping up itsover-leveraged banking system, much of it poured into RBS.

Asked whether there should be resignations at RBS as aresult of the bank's imminent fine, Osborne said it was "quitewell known that RBS are thinking about changes" amongst theinvestment bank's senior management.

"It is right that those who are responsible - not just thosewho are directly responsible, but also those who were dong thesupervising - must also bear a level of responsibility," hesaid.

RBS is expected to part company with the head of itsinvestment bank, John Hourican, when the settlement is announcedlater this week.