Now that the State owns Anglo Irish Bank, what should be done with it? The Government has said that Anglo will continue to operate as a commercial bank, rejecting suggestions from several commentators, including myself, that the bank should be wound up.

The issues involved are complex, and the backdrop against which decisions about the future of the country's banking sector are being made is incredibly challenging and volatile.

But such decisions are crucial. Policy errors regarding the banks will undoubtedly damage prospects for recovery in the financial system, in the property market, in the public finances, and in the broader economy.

Language is important here. The Government has repeatedly said that it will not allow Anglo to fail. But to all intents and purposes, Anglo has already failed.

Otherwise, why did it have to be nationalised? You see, there are two ways a bank can fail. It can fail either because of capital insolvency (that is, when its liabilities are greater than its assets), or because it is liquidity insolvent (that is, the bank runs out of cash).

Outflows

Media reports suggest that Anglo was critically short of cash in late September. These reports are backed up by figures from Anglo itself showing large outflows of deposits that month.

Anglo has remained in operation since then only because the State's guarantee for banks' deposits and borrowings stemmed the tide. Reports also suggest that the pace of withdrawals accelerated over recent weeks, though the Government denies that there was a run on the bank.

In any event, it seems clear that even with the State guarantee in place, the ability of Anglo to maintain sufficient liquidity as a private institution was seriously in doubt.

There are also serious questions over the capital solvency of Anglo, given the prospective losses that the banks will suffer on property loans.

What the Government really means is that it will not put Anglo into liquidation. Instead, Anglo will operate as a going concern, albeit under State ownership.

"Business as usual" is how Taoiseach Brian Cowen described it. I certainly hope not, given the way Anglo conducted its business over the years, but I think I know what he means.

Arguments

The Government puts forward several arguments for not winding up Anglo. First, the Government argues that Anglo is systemically important to Ireland.

That is true only if the winding up of Anglo would significantly impair or even cause the failure of healthy banks or businesses in Ireland, or would severely disrupt the normal day-to-day functioning of the economy.

For sure, Anglo is a large bank, with a balance sheet in excess of €100bn. And size matters. But it is entirely possible for a bank to be large but not of systemic importance.

Consider how Anglo's customers and depositors would be affected if the bank were put into liquidation.

Customers

In his speech to the Dail on Tuesday, Finance Minister Brian Lenihan correctly pointed out that Anglo "lends to a wide range of customers providing funds for investment and employment in areas such as retail, office, leisure, healthcare, tourism and other services".

He added that "thousands of customers rely on Anglo for credit, while hundreds of thousands of depositors are involved". Moreover, the amounts involved are large. As of end-September, Anglo had about €52bn in customer deposits and loans to customers of €72bn.

If Anglo were wound up in a textbook manner, these deposits would be transferred to another Irish bank. These deposits are guaranteed by the State, so there is no question of depositors losing a single cent of their money.

It might work like this, for example. On a Friday evening, you have a State-guaranteed deposit with a bank with initials AIB, Anglo Irish Bank.

The following Monday morning, your state-guaranteed deposit is now at another bank with initials AIB, Allied Irish Banks. The terms and conditions attached to the deposits would not change.

How could such a transfer seriously disrupt depositors? Given that banks are desperately trying to increase their deposit base to reduce their loan-to-deposit ratio, it is hard to see that Allied Irish Banks (or Bank of Ireland, for that matter) would object. Bonds and other State-guaranteed debts of Anglo would also be transferred.

The liquidation of Anglo would also involve separating the bank's bad loans from the good loans and placing the bad loans in a special asset management company (AMC), sometimes referred to as a "bad bank".

The good loans would be transferred along with the deposits. In fact, the good loans would represent the lodgment corresponding to the new deposits. Any shortfall between the value of good loans and deposits transferred would be made up of cash or government bonds.

The accepting bank would presumably treat these new customers like existing customers.

As long as the borrowers are viable, there is presumably no question of the bank not providing funds for investment and employment.

The interest rates charged to the transferred customers would exceed those paid to the depositors, so the accepting bank can expect to make an ongoing profit from the transfer.

Realisation

In Tuesday's speech, the minister also said that there is "no question of moving the bank into a wind-up scenario which would create the potential for an under-priced realisation of the loans and other assets held by Anglo".

I take this to mean that the minister, rightly, does not want to take actions that would cause a fire sale of Anglo's assets, whereby the bank's loans and the collateral underlying those loans would be liquidated at prices far below their fair market value to achieve a quick sale.

But putting the bank's bad loans into a bad bank avoids such fire sales.

The objective of the bad bank would be to maximise the value of the distressed assets. It would do this by selling the assets back into the market in an orderly manner.

Transferring such loans to a specialist distressed asset company has advantages over retaining them at Anglo.

Bankers have little expertise and experience in managing distressed assets, and therefore are unlikely to extract the optimal value from these loans.

Incentives

In addition, bankers who made the bad loans often face perverse incentives in dealing with those loans.

This applies not only to senior management, but right down through various levels of management in the bank.

A third reason offered by the Government for not winding up Anglo is that such a move would damage the country's reputation abroad.

It is not clear how. Depositors and institutions providing wholesale funding covered under the State's guarantee would not incur any losses. Moreover, as Ben Bernanke, head of the US Federal Reserve once said, "policymakers earn credibility by doing good policy".

If liquidation is the right thing to do for economic reasons, then closing Anglo and winding it down in a manner consistent with international best practice would presumably enhance the country's reputation.

It would at the very least put a stop to rumours that the Government is keeping Anglo in operation solely for political reasons.

Moreover, it would allow the Government to concentrate on strengthening AIB and Bank of Ireland, two institutions that are without doubt of systemic importance.

The question of how best to support those banks, given that their shares are now trading in cents, is one I will return to at a later date.

One thing for sure, they have a very different future ahead of them compared to that of Anglo Irish Bank.

Alan Ahearne lectures in economics at NUI Galway and is a research fellow at Bruegel, the Brussels-based think tank. He is a former senior economist at the Federal Reserve Board in Washington DC

- Alan Ahearne