AIB was the first bank to formally respond last Tuesday to the Financial Regulator's new demand for banks to hold significantly higher levels of capital to absorb ongoing and future losses associated with bad lending policies of the last decade. In a statement to the markets, Ireland's biggest bank confirmed for the first time that it would sell its UK business, including First Trust in Northern Ireland, its stake in US regional lender M&T Bank and, most significantly, its majority shareholding in the market-leading Polish bank BZWBK.

Stockbroker NCB estimates these disposals could yield the bank about €4bn, a sum sufficient to cover what analysts originally thought AIB would need to rebuild its capital base. But new head of financial regulation Matthew Elderfield has determined, after putting AIB's balance sheet through a stress test, that by the end of this year the bank needs €7.4bn to meet minimum equity levels plus another €4.9bn to satisfy core capital requirements.

Selling the family jewels, therefore, will only get AIB so far. Worse, some commentators think that by essentially selling the best parts of the business under pressure from the regulator and the Department of Finance, which wants to minimise the cost to the state of further recapitalisations, AIB will only undermine its ability to generate profits and capital in the future. With a majority state-ownership likely for AIB at this point, this would leave the taxpayer with a weaker bank less capable of sustaining itself in the coming years.

"It's like a doctor looking at a gangrenous leg and saying, 'To save the leg we'll have to chop off a healthy arm'," said Brian Lucey, associate professor of finance at Trinity College, Dublin, a prominent opponent of Nama who argued last year that the government should nationalise AIB and Bank of Ireland. "We're feeding almost €23bn into the Anglo carcass but forcing AIB to sell its moneymaking businesses to become a carcass itself. I don't understand it."

The problem is not the sales per se. In fact, most observers expect AIB will be able to offload its foreign businesses without too much trouble. BZWBK, which AIB managing director Colm Doherty has called the bank's "jewel in the crown", is said to be attracting interest from a number of major European banks. Santander is reportedly considering AIB UK as part of its strategy to build out its business banking capacity in Britain. M&T chief executive Robert Wilmers said he has been "hounded" by investors interested in buying AIB's stake in the bank.

The problem is that after the amputations of these businesses, AIB will still be in a major capital hole, but will have a weaker investment case. That will make it harder to raise money from a rights issue, leaving the taxpayer picking up the slack.

This was always the concern with Doherty's capital generation plan, first announced with AIB's 2009 results last month. The strategy was to whittle down the core franchise to its worst-performing business – the Irish business (plus capital markets) – and then ask shareholders to reinvest. If shareholders baulk and no fresh funds roll in from private sources, the state will be called on once again to inject capital beyond the €3.5bn in preference shares "invested" last year.

As Ciaran Callaghan from NCB explained in a briefing note last week: "In the scenario of no new private capital coming into the bank, we believe that a full conversion by the state of its preference shares may not be feasible this year if AIB sticks to the regulator's requirements of maintaining a Core Tier 1 ratio at 8%. This is due to the fact that it has no other debt securities allowable for Core Tier 1 purposes apart from the government preference shares."

AIB would have to keep about €800m of the €3.5bn preference shares to meet new capital regulations and continue paying an annual coupon of €60m while trying at the same time to boost its equity ratios through retained earnings. These are clearly contradictory imperatives.

Yet there has been some positive reaction to the news on AIB, notwithstanding the shock and surprise of the capital mountain the bank will have to climb. Ratings agency Moody's upgraded AIB's bank financial strength outlook to 'positive' in anticipation of a stronger capital position and the support of the government. Stock investors have been more cautious, as have stock analysts, as Bank of Ireland has taken up all the running due to its comparatively stronger position.

Doherty now has 30 days to submit a capital plan to Elderfield for approval. Then it is a race to get the money in the door by the end of the year. If he can pull it off with private investment, so much the better for the taxpayer. If AIB has to call on the state once again, we are on the hook for yet another badly damaged banking franchise.