Misbehaving banks could be forcibly broken up, George Osborne is expected to warn the industry, in a move that will pave the way for a further fundamental shake-up of Britain's banking sector.
I understand that the Chancellor is preparing to back a call by the Parliamentary Commission on Banking Standards for regulators to have powers to split so-called universal banks such as Barclays (LSE: BARC.L - news) and Royal Bank of Scotland (LSE: RBS.L - news) (RBS) into their separate retail and investment banking components.
An announcement by Mr Osborne, which could come as soon as next week, will lay the foundations for arguably the most radical overhaul ever of British banking.
It would potentially go much further than a plan currently passing through legislation for a ring-fence to artificially separate retail and investment banks but allow both to exist within the same corporate entity.
A senior Treasury source has told me that Mr Osborne and Vince Cable, the Business Secretary, agreed in recent weeks that the Government should back the Parliamentary Commission's blueprint for 'electrifying' the ring-fence. Mr Cable is also expected to publicly support the move next week.
The news will delight Andrew Tyrie, Chairman of the Parliamentary Commission, which was set up last summer by Mr Osborne and David Cameron in the wake of Barclays' £290m fine for rigging Libor benchmark interest rates.
The Chancellor is expected to outline his views in the same week that RBS settles with regulators for its role in the Libor scandal.
RBS, which is 82%-owned by the taxpayer, is likely to pay more than £400m in fines and is fighting to avoid a criminal prosecution by the US Department of Justice.
In the last few days, the industry's reputation has again been dragged through the mire with the City regulator ruling there had been widespread mis-selling of products designed to help small businesses manage the financial impact of sharp rises in interest rates.
"The Coalition is totally joined-up on this," one source said.
The precise detail of how Mr Osborne would want the new reserve powers to operate was unclear on Saturday.
However, he is likely to back the judgement of Mr Tyrie and his colleagues on the commission that the industry regulator should have the ability to identify individual banks which are abusing the ring-fencing framework and pursue – subject to a veto from the Treasury - full separation of that banking group's high street and investment (or "casino", as Mr Cable has dubbed it) divisions.
The Chancellor is also expected to endorse the idea put forward by Mr Tyrie that there should be periodic reviews of the effectiveness of the ring-fence across the banking industry, with the first independent review taking place four years after the new structure is in operation.
Mr Osborne has already set in process far-reaching reforms of bank regulation. The Financial Services Authority, which was created by Gordon Brown in 1997, is to be abolished, and its powers are to be divided between two new bodies: The Financial Conduct Authority and the Prudential Regulatory Authority, which will sit within the Bank of England.
In its interim report last month, the Parliamentary Commission warned that banks were likely to attempt to manipulate the ring-fencing system for their own benefit. Mr Tyrie said the current banking reform proposals "fall well short of what is required".
"Over time, the ring-fence will be tested and challenged by the banks. Politicians, too, could succumb to lobbying from banks and others, adding to pressure to put holes in the ring-fence," he said when the report was published in December.
"For the ring-fence to succeed, banks need to be discouraged from gaming the rules. All history tells us they will do this unless incentivised not to. That's why we recommend electrification. The legislation needs to set out a reserve power for separation — the regulator needs to know he can use it. Furthermore, we need periodic reviews of the sector to reassure us that the ring-fence as a whole is working."
The banking industry has lobbied furiously against the electrification move, claiming that the existence of such reserve powers to break them up will deter big City investors from buying their equity and debt.
A powerful City lobbying group, the Association of British Insurers, recently published a report on the investment case for the major UK banks, in which it argued that regulatory uncertainty was among a number of factors preventing investors from being able to commit their money to the industry confident that they would secure a commercial return.
If the investor groups are correct, and the electrification proposal exacerbates that uncertainty, it risks permanently impairing the value of those shareholdings and denting the chances of ever recovering the money injected during the 2008 financial crisis.
Whitehall insiders said that the endorsement of the Parliamentary Commission's report by Sir John Vickers, whose Independent Commission on Banking (ICB) came up with the ring-fencing proposals in 2011, had “tipped the argument in favour of backing Tyrie”.
Mr Osborne's move will contain a silver lining for the big banks in that he will not be endorsing the most draconian approach to policing the industry, which would have meant implementing full and immediate separation of each group's retail and investment banking operations.
The Treasury declined to comment on Saturday.