Senior bosses at Lloyds Banking Group has told the government they knew about the black hole in the accounts of the Co-operative Bank, four months before the deal to transfer more than 600 Lloyds branches over.
The Co-operative cited the poor economic climate as the reason for the deal falling through.
Lloyds was ordered to sell the branches by the European Commission as part of the government's bail-out of the bank, which is currently 38 per cent owned by the taxpayer.
The Co-op Bank became the preferred bidder to buy the Lloyds branches in December 2011.
Antonio Horta-Osorio, the chief executive of the Lloyds Banking Group, said the company had asked the Co-operative's about its financial problems in December 2012 but was told the bank was handling the situation.
The full extent of the Co-operative's problems only became public this week when it announced its plan to raise £1.5 billion in capital.
By Tony Aynsley