The planned sale by state-backed Lloyds of hundreds of UK bank branches to the Co-op fell through yesterday, setting back government plans to boost competition in the industry.

The Co-Op said it pulled out of the deal due to toughening regulations and the worsening outlook for UK economic growth.

Lloyds, which is Britain’s biggest retail bank and has over 2,900 branches in total, plans instead to spin-off the 630 branches under the TSB name and sell shares in the new company.

Parliamentarians hoped the combination of Co-Op’s existing banking business with the Lloyds branches would have created a viable competitor to Britain’s established but unpopular lenders, which have been plagued by scandals including the mis-selling of insurance on loans and mortgages.

Co-op chief executive Peter Marks said in a statement that the deal would not currently deliver a suitable return in a reasonable timeframe and with an acceptable level of risk.

“This should serve as yet another warning to (chancellor) George Osborne that his economic plan is failing and he must urgently act to kick-start our flat-lining economy,” said Chris Leslie, a lawmaker from the opposition Labour party.

Britain’s finance ministry said the government remained “determined to promote greater competition in the banking sector to provide consumers with more choice”.

Industry sources had expressed doubts for several months about the viability of the deal, citing supposed concerns held by the financial regulator about Co-op’s capital strength. There had also been worries about the complexities of breaking out the business and merging it with the Co-op.

Lloyds was ordered to sell the branches by European regulators as a condition of receiving state aid during the 2008 financial crisis when Britain pumped £20.5 billion into the bank leaving taxpayers holding a 39 per cent stake.

Industry sources said Lloyds will almost certainly need to request that EU regulators extend the November 2013 deadline they have set for a sale, which analysts expect to be granted. A flotation is unlikely to be possible until the second half of 2014, sources have said.

Amid doubts over the Co-op transaction, Lloyds had operated a “dual track” approach, preparing for both a sale and a share offer. It has prepared to operate the branches as a standalone business from August, under the TSB brand which had disappeared from the high street in 1995 when TSB merged with Lloyds.

The Verde business – the name given to the branches for sale – has around five million customers and represents about six per cent of all bank branches in Britain.

Co-Op agreed in 2012 to buy the branches, which would have created Britain’s seventh-biggest bank. Britain’s “Big Five” lenders – Lloyds, HSBC, Barclays, Royal Bank of Scotland and Santander UK – hold 83 per cent of current accounts.

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