By Sudip Kar-Gupta

LONDON (Reuters) - Britain's banks should shield their retail operations from riskier investment banking units and boost capital levels to protect taxpayers from future crises, according to far-reaching proposals that could cost the industry 7 billion pounds ($11 billion) a year.

The Independent Commission on Banking (ICB) also said on Monday banks must hold core capital of at least 10 percent in their British retail banking operations and have primary loss-absorbing capital of between 17 and 20 percent.

It estimated the annual pretax cost of its proposals for Britain's banks at between 4 billion pounds and 7 billion.

The British government backed the proposals, saying they would help boost the economy and protect taxpayers.

"The Chancellor (finance minister) considers it to be an impressive report and an important step toward a new banking system that supports lending to businesses and families, supports the economy and jobs, but does not cost the taxpayers billions of pounds when it goes wrong," a government spokesman said.

However the British Chambers of Commerce (BCC), a business lobby group, warned before the plan was published that the broader economy could suffer from the ICB's proposed reforms.

"There are real concerns that ring-fencing may limit banks' ability to lend to small businesses," BCC Director General John Longworth said in a statement early on Monday.

As foreshadowed, the ICB wants banks to put a "ring-fence" around their core retail banking operations. Consumer deposits and small business lending must be inside the cordon, but banks will have some flexibility on what else should be included.

The ICB said "an extended implementation period would be appropriate" for the reforms, but they should be completed by 2019.

"It's no worse than expected. They've gone for ring-fencing rather than full separation which is not good news, but it's certainly not the worst outcome," said Neil Smith, analyst at WestLB.

Britain set up the ICB last year to examine ways to ensure taxpayers do not bear the brunt of future banking crises.

The credit crisis resulted in Britain fully nationalizing Northern Rock and part-nationalizing Royal Bank of Scotland <RBS.L> and Lloyds <LLOY.L>. The government now has stakes of 83 percent and 41 percent in RBS and Lloyds, respectively.

Britain's "Big Four" banks -- Barclays <BARC.L> and HSBC <HSBA.L> <0005.HK> as well as Lloyds and RBS -- have fought hard against excessively tough new regulation and are expected to continue lobbying now the ICB's report is out.

The government has the final say in deciding what to implement into law. Britain's banks form a powerful lobbying group since financial services are estimated to contribute some 10 percent to the UK economy.

($1 = 0.629 pound)

(Additional reporting by Steve Slater and Sarah White; Writing by Sophie Walker; Editing by Dan Lalor and David Holmes)