Whatever happens on equity markets this week, the government will have to take its most radical steps yet to save the Irish financial system from implosion. There must be a realisation at this stage that the guarantee scheme (which now comes with a theoretical price tag of €480bn) has failed to provide an effective buffer to the four listed Irish banks.

Other policy moves have proven equally ineffective (last week's interest rate cut for example) and some policy interventions have actually made things worse, such as the ban on short-selling, which is preventing investors from hedging their risk by going short.

The guarantee scheme was an astute move in some ways. It provided a short-term liquidity lifeline for the banks without the exchequer having to provide any upfront cash.

It would have dented Ireland's credit profile alright, but it might have at least given the four listed banks, and two building societies, a chance to trade their way out of their current predicament. Instead, it has left Irish bank shares in as much trouble as they were on 29 September, the afternoon when the government grew concerned all six institutions would tumble over the cliff together.

If the government guarantee is not working, the obvious question is, what will? Based on whats happening in the United States and Britain, there will have to nationalisation or part-nationalisation. The government will probably take preference shares and then underwrite rights issues, but who will pony up the money, even if the issue is set at a huge discount?

Nationalisation could occur as soon as this weekend, but surely the government will have to publish the budget first before it sends out another rescue party to save the banks.

The problem for Brian Lenihan is a simple one. If he does not indicate that the government would be prepared to nationalise or part-nationalise the banks, the markets will worry that some of them could collapse entirely. Equally if he does indicate nationalisation is on the table, shareholders will sell off because of concerns their stakes will be diluted.

Either way, it looks like it's time for a little bit of communism. Irish state-owned banks such as ACC and ICC never really impressed too many people. But it looks their bank models are now more relevant than the buccaneering instincts of Anglo Irish and co.

The appalling state of Ireland's balance sheet is the key problem here. A nationalisation or part-nationalisation will, in short order, lead to a recapitalisation of the banks. That is going to cost at least €14bn, according to NCB Stockbrokers, and possibly more. Does the government have the capacity to take on that additional level of debt? The previous consolation for the government – a very low debt-to-GDP ratio of 25% – is becoming less and less important as our fiscal position deteriorates at an alarming rate.

One way to sugar the debt pill is if the government orders a radical restructuring and virtual dismemberment of some of the institutions. For example, splitting up Irish Life & Permanent and parcelling out its two businesses to AIB and Bank of Ireland would hopefully strengthen those two banks. Folding Irish Nationwide and Anglo Irish Bank (minus their property-related bad debts) into the big two might also help the government to excavate some value from this nightmare.

The other approach would be for the government to set up a 'bad bank'-type structure and dump all the Irish property-related toxic loans in there. This would come at a cost too and would effectively just be another form of recapitalisation of the banks. But after last week's audacious decision by National Irish Bank (which has Danish owners) to aggressively write down its Irish property loan book, there is little point in the government relying on the estimates for bad debts from the Irish banks themselves because they are way below even what brokers are now estimating.

The political classes are taking huge flak for approving the bank guarantee scheme a fortnight ago and the bankers are not helping them sell the unpalatable medicine to the general public.

First there was the almost surreal decision by AIB chief executive Eugene Sheehy in July to push up AIB's interim dividend by 10%. The payment was made to long-suffering AIB shareholders on 26 September. Last week, brokers were telling the market that AIB will need to raise capital of €5.2bn in the period ahead. Squaring these two things is very difficult.

Unlike the Irish government, the Danish guarantee scheme for its banks came with an immediate halt to dividend payments over two years. It would be almost indefensible for the Irish government not to demand the same conditions when it outlines the terms of the guarantee scheme next week.

Even more curious was the decision by Anglo Irish chairman Seán Fitzpatrick to plunge into the budget debate at a conference in Wicklow last weekend and start talking about slaying sacred cows such as the right to universal child benefit just a few days after his bank was a key beneficiary of the government guarantee scheme. Irish bankers clearly know a lot about lending out money, but little about timing and good grace.

With the bankers scoring own goals, the government has no choice but to press ahead with part or whole nationalisation. It's deeply unpalatable, but there are even worse places to be. The US government is already going one step beyond this by getting into the commercial paper market and effectively lending directly to businesses itself.