A £3.5 billion merger is being proposed involving the Co-operative Bank and one of Britain’s biggest lenders to small businesses.

Shawbrook Group has been working on a deal with the Co-operative Bank’s owners in recent weeks ahead of an expected auction of the business next month.

The potential deal would see Co-operative Bank’s shareholders hold 29% of the combined new group, according to Sky News, which says Shawbrook has hired investment bankers at Barclays as advisers.

Rivals could gatecrash the deal, with OneSavings Bank considered one of the Co-op’s likeliest suitors. Aldermore, Nationwide and Paragon Bank have all also been named as prospective bidders.

Barclays’ role as an adviser to Shawbrook is likely to rule out the major high street bank as a bidder for the Co-operative Bank in its own right.

Shawbrook itself has been the subject of speculation about a transaction that would realise value for its owners, the private equity firms BC Partners and Pollen Street Capital.

Two years ago the Co-operative Bank, owned mostly by a syndicate of hedge funds, approached Sabadell-owned TSB about a merger.

Until 2013 the Co-operative Bank was 100% owned by The Co-operative Group. This is the cooperative that runs 80% of the Co-op shops.

In 2013, the bank got itself into deep financial trouble and the Co-operative Group’s shareholding fell to 30% as a group of private equity and hedge funds took ownership of most of the rest.

In 2017 the bank went through a second restructuring, during which the private investors were asked to put in more capital. As a result of this the Co-op Group sold all its remaining shares, leaving the bank 100% owned by private equity, including hedge funds.