The Independent Commission on Banking (ICB) will consider breaking up the banks to improve competition for consumers as part of its year-long inquiry into the sector.
Chairman Sir John Vickers said "hard questions" needed to be asked in the aftermath of the worst financial crisis since the Second World War.
As expected, the ICB will now consider whether banks' investment operations should be split from their retail businesses. It will also look into the possibility of forcing some of the banks considered to be too big to fail to sell off some of their assets and discuss imposing higher capital requirements and taxes for larger banks.
"Most radically is the option of requiring the UK's largest banks to divest assets with a view to creating a more competitive market structure," the report said.
It also added that European Commission plans to force state-backed banks to offload some of their assets could "go further".
Royal Bank of Scotland (RBS) would be adversely affected by the break-up of retail and investment banking. It has already been ordered to sell 318 branches by the EU in return for receiving state aid.
Lloyds Banking Group has been recovering well after the fallout of its takeover of HBOS in October 2008, but its dominance in the UK retail banking sector could lead the Commission to recommend breaking up its operations.
Sir John said: "Experience shows that the risks from not asking hard questions about financial stability and competition are far greater than from doing so."
Graeme Leach, chief economist at the Institute of Directors, said: "We strongly support the Banking Commission's determination to ask hard questions and consider radical reform. Competition and competitiveness should be central to the Commission's deliberations. First, any reforms need to ensure that competition trumps regulation. Second, reforms need to consider the impact on the competitiveness of the City.
"There are a number of radical reform options, such as limited purpose banking, which have an intellectual appeal but may not be feasible to introduce unilaterally. The Commission will need to dig well below the surface in order to unearth the fact and fiction around any unilateral response by the UK."
However, there has already been a vehement reaction from the City, with Barclays and Standard Chartered threatening to move their headquarters outside of London if they consider the crackdown to be too harsh.
Angela Knight, chief executive of the British Bankers' Association, said: "We believe the UK industry has already taken significant steps to improve its financial position.
"We have just seen agreement on a new capital and liquidity accord - UK banks are already holding twice as much capital as previously and several times more liquidity. Work has also been undertaken on corporate governance, accounting and risk, and we are in discussion on recovery and resolution plans and other contingent measures recognised in the report."
The ICB will now report back with its recommendations in September 2011.