George Osborne's reluctance to push through a full split of banks' investment and retail arms has collapsed, prompting anger and recrimination from the City.
The chancellor was rebuked by MPs before Christmas for his half-hearted approach to proposals to split up the banks, after the full scale of the interbank lending scandal emerged last year.
But Osborne has now heeded their calls to "electrify the ring-fence", pledging to force high street banks to have different bosses from their investment banks and manage their own risks separately from those of their investment banks.
The investment bank will be banned from using savers' money to fund their investments, and - most significantly - the regulator and the Treasury will have the option to break up the bank altogether if it is judged to be breaking the rules.
The chancellor used a speech at JP Morgan in Bournemouth later to pledge "full separation, not just a ring fence", insisting: "We're not going to repeat the mistakes of the past."
His announcement, which comes as the Treasury publishes its banking reform bill, has been met with outrage in the City. One banker told the Financial Times newspaper Osborne was "playing politics with the economy".
Anthony Browne, chief executive of the British Bankers' Association, said: "This will create uncertainty for investors, making it more difficult for banks to raise capital, which will ultimately mean that banks will have less money to lend to businesses.
"Above all, what banks and business need is regulatory certainty so that banks can get on with what they want to do, which is help the economy grow."
The chancellor is now implementing the reforms proposed by the Vickers commission in full, despite fears the City could lose its position as a pre-eminent global trading centre as a result.
"In America and elsewhere, banks found ways to undermine and get around the rules.Greed overcame good governance," Osborne added.
"We could see that again – so we are going to arm ourselves in advance. In the jargon, we will 'electrify the ring fence'."
He will pledge that "2013 is the year when we reset our banking system".
His position raises question-marks about the views of business secretary Vince Cable, who argued before Christmas that a complete separation of the banks could be achieved "in a less disruptive way" by the Vickers commission's proposals.
"It would create further massive uncertainty to reopen the whole bank reform agenda at this stage," he said.
Even Labour has conceded the chancellor has conducted a "partial climbdown".
Shadow chancellor Ed Balls said: “For all the rhetoric and the partial climbdown he has been forced into, George Osborne is still failing to deliver the radical banking reform we need.
“He is refusing to legislate for a backstop power to allow for across the board separation of the banks, as Andrew Tyrie’s commission and Labour called for last year. He has refused to repeat Labour’s tax on bank bonuses or implement our legislation on pay transparency. And he has failed to get the banks to lend to businesses with net lending to small firms falling month by month."