Britain's biggest banks will face complete separation if they flout new rules to ring-fence risky operations from savers' deposits, the Chancellor announced today.
The new legislation will give the Government and a new banking watchdog powers to "electrify the ring-fence" if banks fail to split high street branch operations from the dealing floor.
It comes after the Parliamentary Commission on Banking Standards, which was set up in the wake of the Libor rate rigging scandal, called for a reserve power for full separation if banks did not implement reforms.
Osborne had warned the Commission, against "unpicking the consensus" over reform proposals in the Bill in November, but appears to have heeded their warnings that loopholes could easily develop.
Sir John Vickers, who chaired the Independent Commission on Banking (ICB), has also said he "would not resist" a complete break up of banks if so-called ring-fencing fails to achieve its desired effect.
But the announcement puts the Chancellor on a collision course with the banks, which claim the legislation will damage London's attractiveness as a global financial centre.
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."
He said moving away from the universal model of banking undermined banks' ability to provide all the services businesses need.
He added: "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."
But Osborne said: "When the RBS failed, my predecessor Alastair Darling felt he had no option but to bail the entire thing out. Not just RBS on the high street, but the trading positions in Asia, the mortgage books in sub-prime America, the property punts in Dubai.
"I want to make sure that the next time a Chancellor faces that decision they have a choice. To keep the bank branches going, the cash machines operating, while letting the investment arm fail."
Under the Bill investment and high street banks will also have different bosses and a new watchdog will be set up.
Shadow Treasury minister Chris Leslie said: "If the Chancellor is now being dragged towards a partial climb down, this is a step in the right direction - but unless he legislates for a strong reserve power with the option for full separation of banks across the board, and not just for one or two banks, then this will be of little use."
He said: "The Government must implement both the letter and spirit of Vickers recommendations and we must see fundamental cultural change in our banks. If this does not happen then banks will need to be split up completely, as we made clear in the autumn."