Chancellor George Osborne has launched an independent inquiry into embattled Co-operative Bank as it is engulfed in controversy.

It follows months of troubles emanating from the ethical lender, from announcing a £1.5bn capital hole on its balance sheet to the arrest of former chairman Reverend Paul Flowers amid a drugs and orgies scandal.

"The investigation has been jointly agreed with the two regulators - the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) - who agree there is a public interest in a statutory investigation," said the Treasury statement.

"It will be led by an independent person appointed by the regulators, with the approval of the Treasury. Separately, the FCA and PRA have today announced they are both considering whether they should also launch formal enforcement investigations.

"The independent investigation under the Financial Services Act will therefore not start until it is clear it will not prejudice any actions the relevant authorities may take, including the potential FCA and PRA enforcement investigations."

Labour cautions on political Trojan horse

Labour, which has close political and financial ties with the Co-op, has warned not to let an investigation become a "Trojan horse for a party political attack" after days of Conservative-led attacks.

Shadow Cabinet Office Minister Michael Dugher wrote to Cabinet Secretary Sir Jeremy Heywood over the issue.

"We fully back an independent inquiry to ensure such events cannot be repeated," said the letter.

"We believe, however, that as cabinet secretary it is your responsibility to ensure that any such inquiry must be genuinely independent and robust.

"It must not become some sort of Trojan horse for a party political attack. We would therefore be grateful if you could provide a public and written assurance that this will be the case."

Co-op engulfed

On the same day as the Treasury announcement, accountancy watchdog the Financial Reporting Authority confirmed it is "making enquiries" into the institution over its 2012 accounts with the potential for a full investigation.

Police have also arrested the former chairman Flowers, who was allegedly found to be embroiled in crack cocaine, crystal meth and ketamine-fuelled sex orgies, as part of an investigation into the supply of illegal drugs.

According to a police statement, authorities confirmed that "Flowers has been taken to a police station in West Yorkshire where detectives will continue their enquiries."

Flowers was paid £132,000 a year as chairman of the Co-op Bank from 2010 until May 2013, when he stepped down.

He faced embarrassment in front of the Treasury Select Committee earlier this month after telling MPs that Co-op's assets stood at £3bn when, in fact, they were around £47bn.

Meanwhile, the Co-operative Group has launched a "root and branch" investigation into how it is run. The group pledged to review its "democratic structure" and stressed the need to "modernise" itself.

In November, Co-op Bank revealed it is closing 15% of its branches and cutting jobs as part of a five-year turnaround plan. In the first six months of 2013, the bank made a pre-tax loss of £709.4m.

The bank racked up huge losses on commercial property during the financial downturn, much stemming from is disastrous takeover of the Britannia Building Society, and is currently undergoing major restructuring.

Part of its plan to fill the £1.5bn capital hole on its balance sheet, stemming from regulatory requirements to build up sufficient buffers against future crises and negate any need for bailouts, is to convert junior bondholders into shareholders.