OPINION:DING! DING! Irish bank recapitalisation; round two. The jumping off point to any analysis of what to do next about AIB and Bank of Ireland is to accept that there is no happy ending, writes JOHN McMANUS.

We are very much in “the best of a bad lot” territory. In that vein, the best way to approach it is probably on the basis of what will put the smallest burden on the taxpayer – or more accurately, the taxpayer’s children. And in coming to such a determination, it is also necessary to take into account the upfront cost and the longer-term consequences.

There are two options on the table. One is to recapitalise the banks, and the other is to nationalise them. There really is not much point dwelling on the third option – letting either of them go bust – as the Government has made it clear it will not let that happen.

Recapitalisation combined with some sort of measure to limit the banks’ exposure to their bad debts seems to be the favoured option. The twin attractions of it are that the banks remain independent commercial entities, and the upfront cost is known.

It is generally estimated that something in the region of €8 billion will have to be put into the two banks to raise their capital to the level required to meet the threshold now demanded by the market.

Combining this with some sort of measure to limit the banks’ exposure to bad debts is attractive because it ensures that the new capital will not be decimated by bad loans, thus requiring more capital. It also makes the deal attractive to third-party investors such as Malabraca if they feel that their potential losses are capped.

The two options being considered in this regard are either some sort of insurance policy underwritten by the Government, or the use of Anglo Irish Bank as a bad bank.

In both cases, the two banks would have to pay some sort of fee, but the State is exposed to an unknown level of risk. This will manifest either as the cost of honouring the insurance policy it has written, or else through having to meet the losses on the loans transferred to Anglo Irish Bank as they arise.

If the Government was to nationalise the two banks, the situation would not really be very different. The Government would still be on the hook for losses at AIB and Bank of Ireland, but this time directly rather than via an insurance policy or indirectly through the transfer of bad loans to Anglo.

Either way, the taxpayer is going to take a real bath if the banks’ bad loans live up to people’s worst expectations.

Indeed, this outcome was inevitable from the moment the State agreed to guarantee the banks last September. Absorbing their losses was always going to be preferable to a situation where the Government has to honour a €400 billion guarantee.

The only difference between the two options is that upfront costs of nationalisation would be low, as demonstrated in the case of Anglo, and taking the banks into State ownership negates the need for an immediate injection of capital.

On this basis, it could be argued that we might as well nationalise the banks, because the upfront cost is less and not having to borrow an extra €8 billion this year would be a very good thing, given that our tab for 2009 is looking like €26 billion.

But recapitalisation wins out on a number of what might be termed softer issues. The first one is the message that goes forth when a country nationalises its banking system. It would be the equivalent of running up a white flag, and would destroy what is left of our financial credibility.

Amongst the knock-on effects of this could be a loss of our triple- A-credit rating, and higher borrowing costs. Thus we arrive at one of those non-sequiturs that only the world of high finance can produce. We must borrow more money this year to recapitalise the banks to save on the cost of borrowing in future years. Confused? You should be.

The other great drawback with nationalisation is that once done, it cannot be easily undone.

Returning the banks to private ownership once the current economic storm has passed could take years. That in itself would not be an issue if there was reason to believe a State-owned banking system would be advantageous in the current situation, but there is no basis for that.

Private-sector banking may not have covered itself in glory, but the nature of the business – both good and bad – lends itself to private ownership.

The solution may well be to split the difference – to nationalise Bank of Ireland and recapitalise AIB.