Prime Minister Malcolm Turnbull said the commission - Australia's highest form of public inquiry - would help restore confidence in the sector.
Australian banks have been embroiled in scandals in recent times.
The announcement came soon after the four biggest banks called for an inquiry in a joint letter, reversing their previous opposition.
"The only way we can give all Australians a greater degree of assurance is a royal commission into misconduct into the financial services industry," Mr Turnbull said.
He said the "regrettable but necessary" decision would also help the nation's economy by restoring confidence.
Mr Turnbull had previously ruled out an inquiry amid pressure from opposition parties.
The royal commission will cover every Australian financial institution, run for 12 months and cost A$75m (£42m; $56m), the government said. Its findings have been scheduled for 1 February, 2019.
Australian banks have faced various allegations of misconduct in recent years, including over financial planning, rate-rigging and insurance fraud.
In August, the nation's largest lender, Commonwealth Bank, was accused of massive breaches of anti-money laundering laws.
Earlier on Thursday, the heads of the four largest banks - Commonwealth Bank, NAB, ANZ and Westpac - co-signed a letter in which they reversed their long-held opposition to an inquiry.
"Our banks have consistently argued the view that further inquiries into the sector, including a royal commission, are unwarranted," the letter said.
"However, it is now in the national interest for the political uncertainty to end."
Mr Turnbull said the inquiry would examine responses to misconduct scandals and whether institutions had governance or culture problems.
He described banks as the "bedrock of the economy", representing more than a third of Australia's stock market value.
The government had already forced bank chiefs to appear regularly before parliamentary committees to increase accountability, Mr Turnbull said.
In a description aimed at international markets, the government stressed that Australia's banks remained "unquestionably strong".
The inquiry has the approval of the central Reserve Bank of Australia and industry regulators.
Photo copyright: REUTERS. Caption: Australia's four biggest banks have reversed their opposition to an inquiry