ANALYSIS:BRITAIN'S DECISION to rescue the UK banking system in a part-nationalisation of its eight biggest banks shows up the shortcoming in the Irish bank guarantee system and points to what the Government could soon be forced to do, writes Simon Carswell,Finance Correspondent

Following the lead of Minister for Finance Brian Lenihan last week, British chancellor Alistair Darling yesterday took an unprecedented step to encourage UK banks to start lending to one another in an effort to turn on the supply of short-term funding.

The UK is injecting £250 billion (€317 billion) into the system to keep banks lending to one another. Like Mr Lenihan, Mr Darling is offering a guarantee to banks, enabling them to secure medium-term borrowing. The credit crunch has forced banks to fund their long-term obligations with costly short-term money, so this will pump much-needed money into the system.

Yesterday's 0.5 per cent interest rate cut by the central banks around the world will also encourage banks to lend to each other as their borrowing rates fall.

However, Mr Darling has gone one step further than Mr Lenihan. He is making available £50 billion in fresh capital which the UK banks can use to protect against rising bad debts.

Mr Lenihan's guarantee, which allows the six guaranteed banks to use a State-backed IOU to borrow short-term money more cheaply and freely, solves the immediate funding problem amid the global liquidity famine, but mounting bad debts remain a big threat.

Capital is the money banks hold in reserve to protect against unforeseen losses. It is the armoury that will safeguard the six Irish institutions against loan losses, although this is becoming a more pressing issue as banks increase their bad debt forecasts.

Pressure will be particularly intense on Anglo Irish Bank and Irish Nationwide, where four out of every five loans are secured on commercial property, a sector that is going to see values fall up to 40 per cent over the coming years, according to Bank of Ireland estimates. As the massive drop in Irish bank shares this year has shown, investors do not believe Irish banks are being realistic about how much they are likely to lose on property loans.

Matters are complicated by the fact that Irish banks are delaying the collection of interest due on loans issued to some builders, property developers and investors, recognising that they cannot sell assets in a falling market and are unwilling to accept "fire-sale" prices.

Danish bank Danske, owner of National Irish Bank, surprised some on Monday when it said it had written down the value of its Irish commercial property loans by €80 million in one quarter (June-September). This compares with a writedown of €25 million in the first six months of the year.

All this points to the concerns that the Irish banks have not set aside enough to cover future losses on their loans.

The six guaranteed Irish-owned banks and building societies have set aside €32.5 billion in capital to protect themselves for the future. Bad debts at the four banks are estimated to total between €10 billion and €12 billion this year and over the next two years.

However, if the global credit crisis has taught us anything, it is to expect the unexpected and to put money aside not just for a rainy day but a prolonged flood.

The chief executives of AIB, Bank of Ireland and Anglo Irish Bank told a banking conference in London on Tuesday that they remain well capitalised and have no need to raise any more money.

Banking sources think otherwise. Analysts at JP Morgan said that the three Irish banks would need to raise €7.6 billion over the next two years.

NCB Stockbrokers said that the four Irish public banks (including Irish Life Permanent) may need €14.1 billion. The firm added that the State may be forced to take stakes in the banks as rising loan losses deplete capital and that the Government is "the only investor in town" for financial institutions.

Banks have four difficult options open to them to bolster their capital - they can curtail new lending, slash dividend pay-outs to shareholders, sell assets or turn to shareholders to raise cash.

All have carried out the first option, while the last two options would present huge hurdles in the current climate. AIB could reduce the capital it needs to hold in reserve by €1.2 billion if it sold its 25 per cent stake in US bank MT. Bank of Ireland is halving its dividend, while Irish Life Permanent has frozen its pay-out.

AIB's decision to raise its dividend by 10 per cent in July seems unusual given the pressures it is facing.

Mr Lenihan has said he did not think that the banks needed "recapitalisation" but he admitted that events were moving fast. He will need to respond swiftly if Irish bank shares suffer further sharp falls - and he will be following Mr Darling's lead this time.