The ring-fence between Britain's high street and investment banks is not effective and needs to be strengthened, say MPs in a highly critical report.
Britain's banks could face the threat of being broken up after a report warned the ring-fence to separate risky operations from savers' deposits needed "electrification".
The parliamentary commission on banking standards said plans included in the banking reform bill "fall well short of what is required".
Its initial recommendations could put it on a collision course with Chancellor George Osborne, who warned the commission last month against "unpicking the consensus" over reform proposals in the bill.
In its first report since being set up in the wake of the Libor-rigging scandal, the commission said legislation should include a reserve power for full separation if banks did not implement reforms. The report follows recommendations by the independent commission on banking, led by Sir John Vickers.
The report comes a day after Swiss banking giant UBS agreed a £940m settlement for "widespread and extensive" attempts to fix Libor rates after admitting fraud and bribery.
'More needs to be done'
Andrew Tyrie, chairman of the commission, said the latest revelations "beggar belief".
"It is the clearest illustration yet that a great deal more needs to be done to restore standards in banking," he added.
While the commission - whose membership includes the future Archbishop of Canterbury Justin Welby, former chancellor Lord Lawson and Treasury committee chair Andrew Tyrie - said it welcomed plans for a ring-fence, designed to make the system more secure and to protect deposits from so-called casino banking operations, it added that loopholes could easily develop.
The ring-fence would be "tested and challenged by the banks", while it said politicians could also succumb to lobbying from the industry.
"For the ring-fence to succeed, banks need to be discouraged from gaming the rules," said Mr Tyrie. "All history tells us they will do this unless incentivised not to. That's why we recommend electrification. The legislation needs to set out a reserve power for separation; the regulator needs to know he can use it."
Board members within banks should have a legal duty to preserve the integrity of the ring-fence, according to the report, while there also needs to be clear dividing lines.
The commission was also asked to look at whether retail banking operations should be able to offer simple derivative products, which have been thrust into the spotlight following the recent interest rate swap mis-selling scandal.
The commission said there was a case for allowing these products - which also include fixed rate mortgages - with retail banking operations, although it cautioned there needed to be a clear definition and strict controls.
But the commission said it had been "working in the dark" in the absence of secondary legislation for the bill, and that it would also look at measures to improve the culture in the banking system in the wake of this year's series of shocking scandals.
This could include changes in areas such as civil and criminal law, competition, corporate governance and regulation, according to the report.
Shadow chancellor Ed Balls said: "This is an important cross-party report which sets out real challenges for the banks, government and parliament. After repeated scandals, from Libor-fixing to mis-selling to small businesses, it is clear that we need radical reform of our banks.
"Having looked closely at the government's draft legislation to implement the Vickers proposals for a ringfence between retail and investment banking, the commission believes it 'falls well short of what is required' and is unpersuaded by the government's relaxation of the Vickers recommendations.
"As Ed Miliband and I said at the Labour conference this year, if the letter and spirit of the Vickers proposals are not delivered and we do not see cultural change in our banks, full separation will be necessary. The commission is clearly right to say the jury is still out and to demand a reserve power for full separation of the banks."