Lloyds, Royal Bank of Scotland and Northern Rock will be broken up and parts of their businesses sold off to create three new banks.

Government sources said ministers were "determined" to see more competition in the market, following the £1.2 trillion ($2.6 trillion) bailout of the sector which resulted in the loss of three independent banks and several building societies.

The European Union will today approve the split of Northern Rock into two sections, a "good", profitable, bank with no bad debt, and a "bad" bank.

Ministers will begin exploring sale options at the start of next year when the split happens and a deal could be finalised before the general election.

The remaining "bad" bank will remain in state hands for the time being, although sales of "tranches" of the more risky mortgages it holds will be explored in the longer term.

The Lloyds and RBS sell-offs will follow over the next three to five years and will be supervised by UK Financial Investments, the government body set up to oversee taxpayers' investment in the banks.

The Government is understood to have made clear that existing larger operators will be banned from participating in the sales.

Ministers want to drive competition in a sector they believe is too concentrated in the hands of the "Big Four" of Barclays, HSBC, Lloyds and RBS.

Virgin Money is known to be watching the situation closely and is in talks to add former Northern Rock chairman Bryan Sanderson to its board ahead of a possible bid for Northern Rock.

Tesco is another company that could be enticed into an auction as it seeks to grow its financial services business.

Spain's Banco Santander, which owns Abbey, Alliance & Leicester and part of Bradford & Bingley, may be allowed to get involved because it is significantly smaller than the big banking groups in Britain. But it could still be frustrated by the Government's determination to attract new entrants.

"We are keen to see greater competition in the banking sector as soon as possible," said a state source.

A deal to buy "good" Northern Rock would bring a new entrant around £20 billion of deposits together with a portfolio of low-risk mortgages and a platform to expand operations.

Lloyds is expected to face a forced reduction in its share of the retail banking market from 30 per cent to 25 per cent, with the disposal of more than a seventh of its 3000 branches.

It has been desperately seeking support in the City for a share issue of up to £15 billion to keep it out of the Government's asset protection scheme that will cover it against losses from up to £260 billion of risky loans.