Nov. 4 (Bloomberg) -- It’s too late, too timid, and comes with too many questions attached. Even so, the U.K. government deserves some credit for finally moving to break up a bloated, failed banking industry.

It has done two things that were urgently needed.

The banks that were bailed out at such huge cost to the taxpayer will be forced to become more competitive. And they will finally have to curb the bonuses they pay to senior staff.

The question now is whether the British break-up plan will provide a template for zombie banks in the U.S., and all the other countries where banking systems were rescued by taxpayers.

So far, U.S. President Barack Obama’s administration has dithered. But maybe the U.K.’s action will prompt the U.S. government to stop molly-coddling Wall Street and start protecting consumers and taxpayers instead.

Until this week, U.K. Prime Minister Gordon Brown’s government seemed willing to provide the country’s banking industry with an unlimited series of blank checks.

The banks got bailed out with billions.

And in return? They did precisely nothing.

They didn’t offer more choice to customers.

They didn’t bring bonuses under control.

In short, they didn’t think there was anything wrong with the way they had done business during the long boom -- apart from the small matter of having gone spectacularly bust.

Expensive Rescue

That is finally going to change.

The two big U.K. banks that ran into trouble -- Royal Bank of Scotland Group Plc and Lloyds Banking Group Plc -- required yet another round of money from the government. RBS will get 25.5 billion pounds ($41.8 billion) of capital. That takes the total it has received to more than 45 billion pounds, and wins the dubious honor of being the most expensive bank rescue in the world. Meanwhile, the government will finance about a quarter of Lloyds’s 21 billion-pound fundraising.

This time, though, it isn’t a free lunch for the bankers. The government has demanded two important changes.

Both will be forced to sell a chunk of their assets. Lloyds will have to get rid of its Cheltenham & Gloucester accounts, while RBS must dispose of its own branches in England and Wales, as well as the NatWest ones in Scotland. In effect, at least three new retail banks will be created in the U.K.

Bonus Cap

At the same time, there will be a cap on bonuses. Both banks have said they won’t pay cash bonuses to workers earning more than a relatively modest 39,000 pounds this year. If they get paid in shares instead, there will be a lot of RBS bankers taking home stock in their own bank this Christmas -- and no doubt wondering whether it will ever be worth anything.

True, the government should have been a lot tougher.

At RBS, it could have demanded a break-up of the bank into its retail and investment-banking units. The NatWest branch network could have been split into the old National Provincial and Westminster Bank chains, unwinding the 1968 merger.

And why not extend the ban on cash bonuses for as long as the government has a stake of more than 10 percent?

It should have been a lot bolder, both on the depth of the break-up, and the restrictions on bonus payments. Even so, it’s a start. And it is more radical than it looks at first sight.

There is no point in complaining that the banks have gone back to their old ways unless you have done something to change the structure and culture of the industry. If you leave sausages in the dog house, don’t be surprised if the dog eats them. Likewise, if you pump up a bank with free money, don’t be astonished if they start paying themselves big bonuses again.

More Is Better

And yet there are very few economic problems for which more choice, competition and diversity aren’t the answer. Break-ups and bonus controls do two things, both of them significant.

A series of new banks competing in the U.K. market will reverse decades of consolidation that made the financial- services industry less competitive. There were fewer and fewer mega-banks, all following the same strategies, and taking more and more risks to keep up with one another. The credit crunch accelerated that process, in the U.K., the U.S. and elsewhere.

We need more, smaller banks, following a genuinely diverse range of strategies -- as well as offering a wider range of products and prices to customers. If you want racy and risky, it should be there. If you want dull and safe, that should be on offer as well. But each bank should have a defined place in the market, and a set of competitors for every piece of business.

Held to Ransom

Most importantly, every bank should be labeled “just about the right size to fail.” The last thing the U.K. needs is another monster on the scale of RBS, which effectively holds the whole country to ransom. The same is true of Citigroup Inc. in the U.S.

Likewise, a cap on cash bonuses is a necessary first step to changing the way bankers get paid. Only by tying bankers into the long-term performance of the company they work for can the culture be changed. Banning cash bonuses is a crude way of doing that. Yet crude is often better than nothing.

Banking is an industry in which all the usual rules that make a free market work appeared to have been suspended. The U.K. government has made a start on restoring them.

It remains to be seen whether other governments around the world -- and the U.S. in particular -- can pick up that baton and start running with it. After all, if RBS can be broken up, why not Citigroup and Bank of America Corp.? That question just got a lot easier to answer.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

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To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net.

Last Updated: November 3, 2009 19:01 EST