SAN FRANCISCO (MarketWatch) -- The U.S. government has tried several different ways to pump capital into the nation's ailing banks, revive lending and ease the recession. Now some analysts say it may be time for the solution everyone's been trying to avoid: nationalization.

Treasury Secretary Timothy Geithner unveiled a Financial Stability Plan Tuesday that aims to strengthen banks, buy up to $1 trillion of their toxic assets and revitalize moribund securitization markets. See full story.

The plan includes a so-called "stress test" that all U.S. banks with at least $100 billion in assets will be required to take. If lenders are found to need more capital after the test, the government said it will invest more money via preferred securities that could convert into common shares if needed.

The broad plan was criticized, partly for being too small to tackle the size of the banking sector's problems, while a lack of details on the stress test increased uncertainty among investors. See full story.

"The Treasury plan is a step in the right direction, but it does not go far enough in addressing banks' tangible common equity or the problem assets on their balance sheets," Paul Miller, an analyst at Friedman, Billings, Ramsey, told investors this week.

The U.S. financial system needs at least $1 trillion in tangible common equity to be sufficiently capitalized, he noted. Common shareholders are the true owners of businesses. In banking, when loan losses happen, they're the most exposed. Without more common equity, banks will likely remain reluctant to increase lending.

"We would prefer to see the government take bold steps now, either putting the much-needed capital into financials or providing a closed-back solution, in which the government briefly takes over the weakest financials (regardless of size), strips out the bad assets, and sells the good back to public markets," Miller said.

Gerard Cassidy, a banking analyst at RBC Capital Markets, suggested a similar "tuff love" approach.

"U.S. regulators need to move in and close down insolvent banks (regardless of size)," Cassidy wrote in a note to clients this week. "The banks are seized, the deposits are sold along with any good assets, and bad assets are transferred over to an 'RTC II,' which liquidates the troubled assets."

The original Resolution Trust Corp., or RTC, was a government-owned investment fund that bought bad assets after the savings and loan crisis at the end of the 1980s and early 1990s. The fund helped get lending going again by buying soured debt from failed institutions and liquidating the assets.

During that crisis, regulators seized banks if losses ate into their equity capital positions and profitability didn't return, Cassidy recalled. That left common stock holders with nothing.

"After the shareholders were wiped out and bond holders took their losses, taxpayers had to step in and fill the hole," the analyst explained.

"In this cycle, taxpayers are being asked to share the burden of the losses with common shareholders," Cassidy added. "Taxpayers and Congress will probably revolt against any kind of additional bailout that does not include shareholders being nearly wiped out should they require meaningful government assistance."

Effective nationalization

Treasury may end up effectively nationalizing many weaker institutions, if its stress tests conclude some firms need more capital.

Treasury is expected to allocate at least $100 billion of the remaining $350 billion from the Troubled Asset Relief Program to a bank bailout fund to buy preferred shares in banks that can be converted into voting common equity "if needed." According to Treasury, banks can convert securities into common shares in a "worse than expected economic environment."

Many banks have such low stock market valuations that if the government converts its stakes into common stock, it would end up owning at least half of the equity of the bank and leave existing common shareholders heavily diluted.

"Depending on how much capital an institution needs under this program, you could see a high percentage of its common equity, more than half, be issued to Treasury," said David Brown, partner at Alston & Bird LLP in Washington.

If needed, the convertible securities will be converted into common shares at a "modest discount" to banks' stock prices on Feb. 9.

Robert Klingler, attorney at Bryan Cave LLP in Atlanta, points out that most financial institutions were trading at historic low valuations on that date, which means the government stakes could be converted into massive controlling interests.

"Because of the low stock market valuations of these banks, the government is expected to get more of the company than they would have once the shares are converted into common shares," Klinger said.

Klinger contends that only banks that have significant loan quality concerns but aren't in great risk of going into receivership this year will be eligible to receive capital injections.

Most vulnerable banks

The KBW Bank Index BKX, -1.53% , which tracks shares of the largest U.S. lenders, dropped 14% this week on concern about such dilution.

There are 17 institutions, representing roughly three-quarters of the assets in the banking system, which may be required to take the stress test.

These are: J.P. Morgan Chase JPM, -0.84% , Citigroup, Bank of America, Wells Fargo, Goldman Sachs, American Express, Morgan Stanley, State Street STT, -1.00% , Bank of New York Mellon BK, -1.22% , U.S. Bancorp, SunTrust Banks, Capital One COF, -1.23% , PNC Financial PNC, -1.11% , Regions Financial RF, -1.21% , BB&T BBT, , Fifth Third and KeyCorp.

Goldman GS, -1.14% , Morgan Stanley MS, -2.35% and American Express AXP, -1.08% aren't traditional banks, but the companies became either bank holding companies or financial holding companies last year, partly to get better access to government support.

There are few details about the stress test, but Goldman Sachs analysts expect it to focus on banks' tangible common equity and the reserves firms have set aside to cover future loan losses. Non-performing assets and delinquency trends may also be gauged, they said in a note to clients on Wednesday.

Based on these criteria, Citi C, -2.12% , SunTrust STI, -0.20% and Fifth Third FITB, -1.64% may be the most likely to need extra government support after a stress test, according to data compiled by the Goldman analysts.

Citi's tangible common equity and reserves are relatively low compared to the bank's tangible assets. Meanwhile its non-performing assets and loans that are at least 90 days overdue are relatively high compared to the bank's total loans, according to Goldman data.

With SunTrust and Fifth Third, non-performing assets and loans at least 90 days delinquent are higher than at Citi, however, the two banks have more tangible common equity and reserves compared to their tangible assets, Goldman data show.

Bank of America BAC, -1.32% , Wells Fargo WFC, -2.35% and US Bancorp USB, -1.06% have relatively low capital levels based on such criteria, but these banks have fewer credit problems than Citi, the Goldman data show.