Britain will get the go-ahead to force banks to shield their routine retail operations from riskier investment banking activities when lawmakers announce the conclusions of an inquiry into banking reform on Friday.
The Parliamentary Commission on Banking Standards will also recommend that the government can resort to a "nuclear option" of breaking up banks if they try to find ways around the new rules, commission sources said.
Britain is reforming its banks to avoid a repeat of the failures of 2008 when it was forced to pump 45 billion pounds ($73 billion) and 20 billion pounds into Royal Bank of Scotland and Lloyds Banking Group respectively to keep them afloat at the height of the global financial crisis.
The commission, initially set up to examine the conduct of banks following a series of scandals, was asked by Finance Minister George Osborne in October to conduct pre-legislative scrutiny of the government's Banking Reform Bill.
Commission members have expressed concerns over the lack of detail in the bill which they believe makes legislation vulnerable to being watered down if bank lobbyists put pressure on future governments.
The commission has considered ways to avoid that and will recommend the threat of full separation if banks don't comply - an idea supported by several witnesses, including John Vickers, who was the architect of the initial proposals as head of the Independent Commission on Banking.
"There is concern over the circumventing or undermining of the ring-fence by banks and that, over time, there will be an erosion of the effectiveness of it," one of the commission sources said.
Vickers' plans are designed to protect the taxpayer by putting a shield around deposits from individuals and small businesses so that they are not at risk in a bank failure and the government is therefore not required to step in to rescue an ailing institution.
However, some committee members, including former British Finance Minister Nigel Lawson, have argued that full separation offers a better remedy and would stop the more aggressive culture of investment banks infiltrating retail banks.
They believe that culture is partly to blame for the misselling of payment protection insurance by retail banks, which has cost the industry billions of pounds in compensation, and the misselling of unsuitable interest rate swaps to small businesses.
The cross-party commission, which is headed by Conservative Andrew Tyrie and also includes the next Archbishop of Canterbury, Justin Welby, has spent the last three months deliberating over reform of the industry.
It has taken evidence from the chief executives of all Britain's major banks as well as regulators, politicians and central bankers.
Influential voices from overseas also contributed to the debate. Paul Volcker, the former Federal Reserve Chairman at the forefront of regulatory thinking in the United States appeared as did Erkki Liikanen, the governor of the Bank of Finland, who has said European banks should separate deposit-taking businesses.
Banks reluctantly accepted the principle of ring-fencing after initial resistance although some remain unconvinced. RBS Chief Executive Stephen Hester told the commission the proposals carried a "huge risk of moral hazard".
"You are giving a charter in everyone's minds for the next time there is a problem inside the ring fence, (the bank) gets bailed out by one mechanism or another," he said.
Hester argued that the majority of the industry's problems had occurred within retail banking, rather than investment banking, and said authorities should aim for a system in which no part of a bank needs bailing out.
The commission has debated at length whether banks should be allowed to sell derivatives within the ring-fenced operations. Interest rate swaps are at the centre of a misselling scandal which could cost banks billions of pounds. Britain's financial regulator estimates 44,000 interest rate swaps have been wrongly sold to small businesses.
A commission source said it was likely to recommend simple derivatives will be allowed within the ring-fence if they are relevant to the businesses acquiring them.
The commission will intensify its examination of banking standards in the new year.
($1 = 0.6173 British pounds)
(Reporting by Matt Scuffham; Editing by Erica Billingham)