The sale of the Co-operative Bank has been scrapped as bailout talks with the troubled lender’s backers intensify.

The hedge funds that own 80 per cent of the bank are in talks with the Co-operative Group, the minority shareholder, over splitting the Co-op Group’s pension scheme, which had proved an obstacle for the bank’s sale. The loss-making bank said that a deal had been “substantially agreed”.

The £700 million rescue comes after the bank put itself up for sale in February, admitting that it would miss the capital threshold required by the Bank of England. At the same time, it entered talks with shareholders and bondholders about a new debt-for-equity swap.

The hedge funds took control of the bank after it almost collapsed in 2013 amid a £1.5 billion funding shortfall. The Co-operative Group owns 20 per cent of the bank, but the latest rescue could wipe out its holding.

The continuing liability of the group pension fund, which manages the retirement funds of about 90,000 members, is one of the key issues. Co-op Bank staff are part of the group scheme and the Co-op Group wants any agreement to cover it for the costs of providing the bank workers’ pensions.

The last-man-standing clause means that Co-op Group and Co-op Bank are jointly liable for the pension liabilities of the scheme if one or the other were to fail. The hedge fund backers want to end this arrangement.

The Co-op Bank said: “A majority of the key commercial aspects of the proposal have been substantially agreed between the bank and the investors. Discussions with respect to the separation of the Co-operative Pension Scheme into sections for which Co-operative Group and Bank have respective responsibility are advanced.”

This year the bank reported its fifth annual loss in a row. It put its failure to meet capital threshold rules down to low interest rates and the cost of its turnaround plan.

John Ralfe, a pensions expert, said that splitting the pension fund into different sections to apportion liabilities was not uncommon. The difficulty would come in hammering out where to draw the line.

“Under the existing structure the Co-op Group is on the hook for all the £8 billion liabilities, including those for Co-op Bank members, if the bank went bust,” he said.

“The Co-op Group wants to split the scheme into two separate sections, with the bank entirely responsible for its 20 per cent share. But to make sure the bank members have the same support as they have now requires a big chunk of cash to go into the new bank section. This cash can only come from existing investors and the more money needed to sort the pension, the less attractive the deal becomes for them.”

The 89,000 pension fund members include about 37,000 pensioners, nearly 11,000 present staff and 41,000 deferred members.

The hedge funds Blue Mountain Capital Management, Cyrus Capital Partners, Golden Tree Asset Management and Silver Point Capital, were said to be offering about £200 million to cover the future liabilities of 90,000 pension scheme members, including a little over £60 million in cash and more than £100 million in security over high-quality assets of the lender.