* UK banks face "ring-fencing" of retail operations
* Extra capital for retail units could be costly -analysts
* Barclays may use contingent convertibles to pay bonuses
* RBS, Barclays, Lloyds shares slide 1-3 percent
(Adds details on ICB report, link to Dec. 3 story on CoCos)
By Steve Slater and Sudip Kar-Gupta
LONDON, Jan 24 (Reuters) - The prospect of Britain's banks needing to hold more capital to protect retail banking operations pressured their share prices on Monday, even though the threat of a radical overhaul eased.
The head of a special commission tasked with reviewing the structure and operation of Britain's banks said at the weekend the banks might need extra capital for their retail operations, but that possible reforms to the sector were unlikely to include a complete break-up of the big integrated banks.
John Vickers, the head of Britain's Independent Commission on Banking (ICB), said he favoured "ring-fencing" retail banking operations, so that depositors' funds aren't used to subsidise more risky investment banking activities.
Analysts say radical changes could be expensive for Barclays , Royal Bank of Scotland and other universal banks, which combine retail and investment banking but the ICB is not due to make recommendations to the government until September.
By 1140 GMT shares in RBS, which is largely in the hands of the government, were down 3.4 percent at 43.4 pence while Barclays was off 1.2 percent at 297.35p and part-nationalised group Lloyds Banking was down 2.7 percent at 65.56p, all underperforming a flat UK FTSE 100 share index.
Only HSBC edged higher, up 0.2 percent at 696.9p.
"Investors remain concerned that the ICB will continue to increase pressure for higher capital ratios," said James Chappell at brokerage Olivetree Securities.
"Splitting up the banks would be a draconian approach but there are other ways to reduce the scale of the capital markets operations or find ways of changing the protection (of retail banking)," said Colin McLean, managing director at SVM Asset Management in Edinburgh.
Bankers' pay also remains a hot topic in Britain and the government remains in talks with banks to get them to curb bonus and commit to business lending targets.
The talks, dubbed "Project Merlin", have been expected to see banks commit to a lending target of about 180 billion pounds ($286.9 billion) for 2011, according to media reports.
Barclays is considering paying top staff their bonuses in contingent capital securities, as reported by Reuters Breakingviews on Dec. 3.
The bank is still considering paying staff a chunk of their 2010 deferred bonuses in the so-called CoCos, people familiar with the matter said on Monday.
CoCos are bonds that turn into equity when a bank hits trouble, bolstering its capital position and are playing a pivotal role in plans by the Basel Committee of global bank regulators to make banks' capital more robust.
Credit Suisse is also considering using them for pay, like its peer in Switzerland, UBS. But these instruments are largely untested in practice and investors have yet to give them a wholehearted backing.
Barclays's new chief executive Bob Diamond is taking a hard look at the bank's operations, in particular the returns on capital achieved by all the business units, industry sources have said. He is expected to unveil his shake-up alongside 2010 results on Feb. 15.
Monday's Financial Times said that could see the bank cut 3,000 jobs in its Barclays Capital division. Diamond also plans to reshuffle senior roles, the paper said. ($1=.6274 pounds) (Additional reporting by Karolina Tagaris and Saeed Azhar; Editing by Greg Mahlich)