George Osborne told parliamentarians on the banking standards commission there were "very considerable obstacles" to nationalising RBS and splitting the 82% taxpayer owned bank into "good" and "bad" parts. It would cost £8bn or £9bn to buy up the shares the government did not already own.
The idea was put him by former Conservative chancellor Lord Lawson who argued that such a move could bolster lending and eventually make it easier to privatise parts of the bank.
Ahead of full-year results from RBS on Thursday, Osborne insisted there would be "further progress this week" on focusing RBS on corporate and small business banking with an investment banking arm supporting this.
Part of the US bank Citizens is expected to be floated off while jobs are being axed in India.
The chancellor called on RBS to make "further significant reductions" in its investment bank in December 2011 and insisted his interventions were made through UK Financial Investments, the body which looks after the taxpayer stakes in the bailed out bank.
Osborne was criticised by the Archbishop of Canterbury, Justin Welby, for refusing to break up the UK's big banks which he was told was risking "a repetition of the disasters of the past years".
The chancellor has already agreed to the commission's demand that he "electrify" the ringfence between high street and investment banking arms by threatening a full breakup for any banks that flout the division recommended by Sir John Vickers' independent commission on banking.
He has refused, however, to threaten the entire industry with total breakup but said he was not against the idea of a review of whether the Vickers reforms are working. Osborne said he was "very happy to consider" the need for an independent review but stressed: "I would not want the essay question to be should we move to a full breakup".
The chancellor faced scepticism from peers and MPs on the banking standards commission about his requirement for RBS to pay the £300m of its fine by US regulators for rigging Libor out of staff bonuses but not the £80m levied by the Financial Services Authority in the UK. Andrew Tyrie, chairman of the commission, told Osborne there was "disquiet" about this among the members of the commission.
The stakes in RBS and Lloyds Banking Group are worth around £17bn less than the £65bn the taxpayer paid for them and Osborne said: "We paid a very high price, literally. The Americans struck a much tougher deal with their banking sector."
Osborne, who said the slow recovery of the banks was a "drag" on the economy, refused to intervene directly in bankers' pay in the City but said: "Their argument for why they should be paid so much was thin then [before the banking crash] and has remained so ever so since."
He also said he was against the idea of making bank accounts "portable" like phone numbers but would make it easier to move current accounts from September with a new switching system.
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