ANALYSIS: THE WAVE started in Ireland, rippled around Europe and looks set to wash back even bigger over Irish shores. It could force the Government to build even higher levees to protect the Irish banks.

The Government's €485 billion bank guarantee two weeks ago led to economic nationalism spreading across Europe as other countries followed Ireland's lead by introducing guarantees to protect their own banking systems.

The ripple effect encouraged a broader EU plan to be devised so countries would not "go it alone".

On Sunday, the night before bank shares were in for another pummelling when the markets opened, the EU-wide initiative was agreed to rescue the entire system. In a co-ordinated bailout plan, countries in the euro zone have pledged to guarantee loans between banks until the end of 2009 and to take stakes in troubled banks in what will amounts to part-nationalisation of the banks.

This means the Irish Government will come under increased pressure to keep pace with the faster runner in the field, particularly Britain where some banks have large Irish businesses.

They could be forced to inject money into the banks, taking stakes in return, and increasing the capital held in their reserve to protect them against future losses.

The guarantee, a type of insurance policy for banks, means the Government will not have to put its hand in the taxpayer's pocket as it was charging for the cover. But now it may have to.

The guarantee solved the initial liquidity shortage, injecting cash flow into a suffocated banking system. Now the problem is capital. Yesterday's decision by the British government to inject new capital of £37 billion (€47 billion) into its banks in a massive bailout has trumped the Irish guarantee, providing much stronger protection to the British banking system.

Two major British banks with significant Irish businesses are benefiting from the equity injection. RBS, which owns Ulster Bank and First Active, is taking £5 billion with the British government underwriting a further £15 billion.

HBOS, owner of Bank of Scotland (Ireland) and Halifax, is raising £17 billion in capital.

Germany and France followed, pledging to inject fresh capital totalling €140 billion in their banks, in addition to a combined €720 billion in bank guarantees.

Investors are evidently noticing the differences emerging between Ireland and other countries, and expect the Government to follow suit. European stocks surged but Irish share increases trailed them.

While British shares climbed 8.3 per cent in their second best one-day percentage rise ever and Europe's leading share index gained more than 9 per cent, Irish shares closed up just 2.5 per cent.

AIB fell 18.8 per cent and Bank of Ireland dropped 14 per cent in a large sell-off as investors grew concerned that the Government may be forced, like other European countries, to inject fresh capital in the banks, diluting their stakes.

Irish Life & Permanent rose 3.2 per cent as investors appear buoyed that funding problems at the company, which relies heavily on the wholesale money markets, have been resolved by the bank guarantee. ILP also has no exposure to commercial property or builders.

The EU bank rescue plan has set the bar higher for the Irish Government, leading to fears that fresh capital will be needed. The Government and the Irish banks themselves have been at pains to explain that the banks have plenty of capital in reserve.

Taoiseach Brian Cowen was keen to stress after the EU scheme was announced that the Government would not need to use all the measures outlined in the plan but could use it on an a la carte basis. He climbed up on the fence on the issue of recapitalising (essentially part-nationalising), saying he never ruled anything in or out, but said the EU plan was "a toolbox for future instruments that various members states will use to deal with the present situation".

Stockbrokers Merrion Capital say the State capital injections in the British banks brings their core tier one capital ratio - a key measure of a bank's financial strength to absorb any future loan loss shocks - up to between 8.5 and 9 per cent.

AIB, Bank of Ireland and Anglo Irish Bank sit well below this level, making them more vulnerable.

To catch up, the banks, including ILP, will need to raise a combined €11.2 billion. To put this in context, the four banks made combined profits of €6 billion in their most recent financial year, which cover most or all of 2007, a highly profitable year at the tail end of the decade-long boom.

Bad debts at the banks will reach €12.7 billion between now and the end of 2010, according to Merrion, and the four banks have total capital of almost €30 billion to absorb these loan losses. But uncertainty lingers about the scale of loan losses, as property values are expected to fall up to 40 per cent from peak levels. Yesterday the courts recorded a large number of new commercial cases relating to property, reflecting an increasing pattern.

A glimmer of hope for banks are proposals to change international accounting rules, meaning that auditors would not have to mark down the true value of property assets, reducing the pressure of rising bad debts on the banks.

However, capital issues remain and the Government may be forced to raise cash for the banks through the State's money manager, National Treasury Management Agency, which could have to sell more Government bonds.

At a time when the State is facing a deficit of almost €15 billion next year, having to raise an additional €11 billion for the banks would be a nightmare for the Government. Shotgun mergers between the Irish banks would certainly ease the burden somewhat.

It's no surprise that Mr Cowen is eager to keep the State out of bank ownership.