Leaks in the media indicate that the banks are about to inhale another helping of taxpayer dollars. This round is likely to be considerably larger than the $350bn they swallowed in the bail-out last October.

The leaks from Obama administration officials without names suggest that the money will provide a further subsidy to bank executives and shareholders and may not even resolve the banks' financial crisis. In other words, the banks may yet come back for more.

The rumoured plan is for the government to buy up hundreds of billions of dollars of bad debt from banks and place it in a "bad bank". The bad bank would then resell these assets for whatever price it could get from private buyers.

The basic problem with this sort of plan is that it requires that the government overpay for the bad assets. If we just pay Citigroup, Bank of America and the rest what their assets are worth, then they would be bankrupt. They have taken enormous losses on these assets. If they had to own up to their losses, it would wipe out the capital of many, if not most, of the banks in the country.

Recent estimates from Goldman Sachs and Nouriel Roubini put the cumulative losses to the banking system at around $2tn. There is a lot of room for guesswork in such estimates, but there can be little doubt that this number is in the right neighbourhood.

We are in the process of losing $8tn in housing bubble wealth. Most of this will be absorbed by homeowners, but if just 10% of this loss accrues to banks, that would be $800bn. In addition, banks have lent $3tn to support a bubble in commercial real estate. If one third of these more speculative loans go bad, and half of that loss is incurred by banks, that gets us another $500bn. Add in $200bn each in losses on credit card debt, car loans and small business loans, all of which are now far shakier because borrowers no longer have home equity as a backdrop, and you get to the $2tn neighbourhood.

This $2tn loss compares with bank capital of just $1.4tn, a large portion of which is rapidly disappearing "goodwill". In other words, the losses to the banking system will almost certainly vastly exceed its capital. This is why the banks need to tap our wallets.

If we go the bad bank route and pay too much for bad assets, then taxpayers are effectively subsidising bank shareholders, who would otherwise be wiped out, and bank executives, who would otherwise be looking at big pay cuts or unemployment.

But it gets even worse. There is no reason to think that the bad bank route will be sufficient for resolving the banks' problems, at least not in round one, because they may not come clean with all their bad assets.

It is important to remember that these banks are run by people who could not see an $8tn housing bubble. It is likely that they still don't know the full seriousness of their problems. (The same can be said of Treasury secretary Tim Geithner and national economic adviser Larry Summers, the bad bank's designers.)

Many of their loans have not yet gone bad – for example, underwater mortgages that are still current. The bad news on these loans will come when homeowners have to make short sales, which could leave banks with losses of $100,000 or more per loan. This means that the bad bank created under this plan will have to be an ongoing business, handing out more taxpayer dollars for the banks' junk over the next several years.

There is a simple alternative, which can be called "bank rationalisation" in order to avoid the "n" word. Under this scenario, the government would take possession of insolvent banks. This is not interference with the market. It is the market. Bankrupt banks go out of business, but due to their importance to the economy, we can't let them be tied up in bankruptcy proceedings for years.

Dealing with the matter all at once can both allow for a quicker fix to the financial system and also ensure fairer treatment of bank creditors. First, the shareholders of bankrupt institutions must be forced to eat their losses. However, we may not want to honour all the debts of the banks at 100 cents on the dollar, which has been current practice.

While the government has guaranteed most deposits, it has not guaranteed the bonds and commercial paper of the banks, nor their commitments on credit default swaps (CDS) and other derivative instruments. If it takes possession of all the bankrupt banks at once, it can apply a uniform policy. For example, it could honour bonds at 90 cents on the dollar or only pay off full CDS obligations to those who actually own the bond that was being insured against default.

To force banks to own up to insolvency, bank rationalisation can apply punitive terms to banks that fail subsequently and allow their creditors to hold bank executives personally liable for their losses. Such rules would lead to more truth telling from our bankers.

In short, bank rationalisation is both much fairer and better for the economy than the bad bank plan. If only the people who missed the housing bubble can be forced to recognise this fact.