The government also injected billions of pounds more of taxpayer funds into Royal Bank of Scotland PLC and Lloyds Group PLC, underscoring worries the banking sector is not out of trouble yet.
The change effectively pump almost 40 billion pounds ($65 billion) more into the two banks and could result in the creation of as many as three new commercial banks.
The move to make the banks sell off some of their businesses approach comes at the insistence of European regulators to ensure competition in the banking industry after the government's initial 37 billion pound rescue package last October.
The British government also extracted promises from RBS and Lloyds for new restrictions on bonuses to align pay with long-term performance, reflecting demands from disgruntled taxpayers that the previous culture of big payouts based on short-term gains - and excessive risk taking - not be allowed to continue.
"These changes are better for the taxpayer, better for the banks, and better for the economy," Treasury chief Alastair Darling told lawmakers. "They will mean stronger and safer banks better able to support the recovery."
But the reform plan raised eyebrows by more than doubling the funds that the government has invested in the British banking system, one of those hit hardest by the global credit squeeze. The RBS bailout now exceeds the $45 billion given by the U.S. government to each of Citibank and Bank of America.
The plans to reduce the size of the banks come amid an international debate about whether large banks should be broken up to prevent so-called "too big to fail" syndrome.
The government has already announced it will split Northern Rock PLC, the victim of Britain's first bank in more than a century, into two but it has rejected suggestions by the Bank of England that banks' retail functions be hived off from their more speculative ventures.
In the United States, the Obama administration has also shied away from suggestions that all large lenders be broken up for safety, maintaining that strong, large banks play an important role in the economy.
The government will buy 25.5 billion pounds of "B" shares in RBS to strengthen its capital, taking its current 70 percent stake closer to full nationalization at 84 percent. It also granted tax changes worth up to 11 billion pounds and set aside a further 8 billion pounds to support the bank if its position deteriorates badly.
The government will spend another 5.7 billion pounds exercising its right to buy new stock issued by Lloyds in a planned record-breaking 13.5 billion pound rights issue, holding its stake at 43 percent.
The extra funding injection is a reminder that even though world economies and markets have improved since the first bailout a year ago, Britain remains in recession and economists have warned that the road ahead remains rocky.
Danny Gabay, the director of Fathom Consulting in London and a former economist with the Bank of England, said the new recapitalization was "a real jolt" to the economy.
"We keep being told that the recession is over," he said. But he said the infusion of extra cash into the banking sector "clearly demonstrates that it's not healed. Far from it."
"If there really was a robust recovery on the way, why would these banks be in such trouble?"
Jonathan Jackson, head of equities at Killik & Co noted that the government's efforts are all geared at restarting lending to support economic growth.
"We have not seen that happening," he said, adding it remained to be seen who would buy the assets up for sale.
RBS will sell 318 branches, or 14 percent of its British network, while Lloyds will dispose of more than 600 branches, or 4.6 percent of its total, over the next four years to appease EU competition regulators.
The government has decreed that the buyers must be a smaller competitor or a new entrant to the market, potentially creating three new banks over the next five years. The Unite union, Britain's largest, called on the government to secure jobs, rather than the best price for the banks' assets.
"If you're going to invest in a bank, you've got to have a positive view about global economic growth," said Jackson. "If you're worried about recovery, banks are not the place to be."
The reforms also highlight the diverging paths taken by RBS, one of the world's largest banks before the bailout, and Lloyds, with Lloyds striking out toward future independence while RBS succumbs to greater public ownership.
Lloyds's decision to hold a rights issues means it can drop out of a government-run insurance plan for toxic assets, leaving RBS as the sole participant. Lloyds is paying 2.5 billion pounds to the government in recognition it benefited from earlier signing up to the plan and to reimburse the state's costs.
The differing directions were reflected in the share price of each, with RBS stock dropping 11 percent to 34.41 pence, while Lloyds shares rose 1.6 percent to 86.39 pence.
Keith Bowman, an equity analyst at Hargreaves Lansdown Stockbrokers in London, said the news cast "a further shadow of uncertainty" over RBS.
"And if there's one thing investors hate, it's uncertainty," Bowman said.
Gabay said Lloyds's Chief Executive Eric Daniels "seems to be fighting harder" to maintain his company's independence.
"Whether he'll ultimately succeed is another question."
Both banks agreed to curbs on bonuses, saying they would not pay cash bonuses for 2009 to employees earning more than 39,000 pounds ($63,500) and defer 2009 bonuses for executive directors until 2012. RBS had faced a public outcry over the 16 million pound pension pot bestowed on its former chief executive Fred Goodwin, who led the overly aggressive expansion drive of recent years that resulted in the bank's downfall.
Stephen Hester, the current chief executive of RBS, said the bonus requirements made it more difficult for the bank - which has a large investment banking division - to recruit the right staff.
"It's one of the additional obstacles that makes our job of recovering money for the taxpayer more difficult... although I completely understand the rationale for it," he said.
AP reporters Raphael G. Satter and Jill Lawless in London contributed to this report.
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