Lloyds Banking Group has struck a deal to sell 632 branches to the Co-operative.
This will transform the group into a powerful new rival to Britain's dominant high-street banks.
Mutually-owned Co-op said the sale would lift its share of Britain's bank branch network to 10% from less than 4%, equipping it to take on the country's "Big Four" lenders - HSBC, Barclays Royal Bank of Scotland and Lloyds itself.
"People have lost trust in the financial services sector. Now we can provide a big bank, a challenger bank, that people can really trust," Co-op Group CEO Peter Marks told reporters on a conference call.
It is estimated around 4.8 million Lloyds customers will transfer to the Co-op along with up to 7,000 staff.
The Co-op's high street presence will expand to around 1,000 branches.
Lloyds, ordered by European regulators to offload the branches as payback for a state bailout it received in 2008, will transfer £24 billion of loans to Co-op under the deal, well below the original target of about £70 billion.
Lloyds will likely make an overall loss of up to £700m on the sale, while the scaled-back loan disposal means it will need regulatory approval for the deal, a source familiar with the matter said.
The bank said any loss would be counterbalanced by a lower capital requirement, and there would be no lasting hit to group profits.
"Today's agreement is an important step in meeting our obligations under the mandated sale of our branches," Lloyds CEO Antonio Horta-Osorio said.
"We believe the cooperative will be a good owner for our business, customers and colleagues, and the combined banking business will be a significant competitor on the high street.
Lloyds, which had been expected to raise as much as £1.5 billion from the branch sale, will receive just £350 million upfront.
It also stands to collect further payments spread out until 2027 with a present value of £400m, depending on how the newly-created business performs.
Lloyd's opted to sell to Co-op even though it received a higher offer for rival bidder NBNK, an acquisition vehicle created in 2008 to create a new retail bank out of assets being sold off by distressed incumbents, an industry source said.
NBNK offered about £800m in cash upfront for a comparable package of assets, plus slightly higher deferred payments spread over a shorter time period, the source said.
A Lloyd's spokeswoman declined to comment on the size of NBNK's offer, but said the bank had decided selling to Co-op offered greater certainty to customers and employees and had a better chance of success.
Co-op's Marks said Britain's financial regulator was "very pleased" the new bank would use Lloyds' IT system, reducing the risk of computer glitches of the kind that disrupted payments at Royal Bank of Scotland's NatWest unit last month.
But he denied press reports that the Financial Services Authority had raised concerns that the Co-op's board lacked banking experience.
"Never once in all of my meetings with the FSA, and there have been plenty, have the FSA raised any questions about our banking board or our group board," he said.
The new bank will be led by Lloyds executive Paul Pester, who was appointed in May 2011 to run the branches earmarked for sale in case the lender opted to list them as a separate business instead.
Lloyd's shares were up 1.5% 1120 GMT, outperforming a flat FTSE 100 share index.
News of the deal was welcomed by the UK government which has championed a shake-up in UK banking and the promotion of mutually-owned financial businesses.
Chancellor of the Exchequer George Osborne said: "This is another step towards creating a new banking system for Britain that gives real choice to customers and supports the economy."
The banking sector's public image, tarnished by the 2008 crisis, has taken a further knock this year due to scandals including the widespread mis-selling of loan insurance, NatWest's IT problems, and news that Barclays traders rigged a key interbank lending rate.
