Anglo Irish Bank should have been allowed fail in September 2008 - the time of the bank guarantee, Central Bank chief Patrick Honohan has told the Banking Inquiry.
Anglo's failed business model was not credible at that time, it had run out of money, and it was clear that the bank was in danger of going bust.
But it should have been an orderly wind down to avoid contagion to the other banks, even though others were close enough to the edge, he said.
The governor also said that the decision of the last Government to guarantee subordinated debt was "clearly a mistake".
"With the benefit of hindsight - had the regulatory authorities had any notion that heavy losses could be involved - an alternative strategy of putting Anglo (and INBS) into liquidation on September 29, while standing behind the rest of the system, should have been more favourably considered," Mr Honohan said.
Prof Honohan did add that there was no guarantee that the European Central Bank would have stood by and allowed a wind down of Anglo.
He told members the net cost of the 2008 guarantee to the taxpayer has been around €40bn. Prof Honohan, who was not Central Bank governor at the time of the guarantee, thought this amount "could have been whittled down more" but "it would have been hard to avoid."
There were a lot of people working very hard to cut the costs and "a lot of very sophisticated work" had been done which helped to bring it down.
Prof Honohan said Anglo Irish Bank was a bank Ireland could have done without but said at the time of the guarantee it was of systemic importance.
But Prof Honohan said that the language of reports on financial stability was "too reassuring, a triumph of hope over reality," he said.
With the exception of Iceland no other countries had "allowed the scale of their banking systems to get so completely out of control as happened in Ireland".
He said that the Central Bank has now been granted powers by the Oireachtas on various regulatory and resolution issues.
There was also "greater use of on-site inspection of banks as well as a thoroughly overhauled organisational structure to further decentralise decision-making, cooperative working and career progression".
But he added a word of caution that no regulatory system "can or even should attempt to eliminate all possibility of failure".
"But I think the more assertive and risk-based system of prudential supervision that we now have in place has struck the right balance and will help ensure that the banking system helps the economic performance of Ireland."