The Government and the Troika have agreed to split up the performing and non-performing loans in Permanent TSB.
The measure will allow the institution to continue to operate as a smaller bank with a healthier loan book.
The plan forms part of the latest review of the Government's bailout programme.
Finance Minister Michael Noonan said that the Government has met all its targets and will continue to draw down emergency loans from the EU, the ECB and the IMF.
He said the restructuring of Permanent TSB is another step along the road to improving the health of the Irish banks.
"The PTSB will continue as a small retail bank providing personal loans and mortgages to the kind of customer core that it has had in the past," said Minister Noonan.
"It has a mortgage department in the UK, and that will continue as a separate department in that market, and will probably be run down over time."
Permanent tsb bank has welcomed today’s announcement.
"The plan will create a viable, customer focused and competitive retail bank capable of resuming normal lending into the Irish market," said a company statement.
"This will be achieved by carving out a viable bank from the current permanent tsb business.
"At the same time the Group will create a separate Asset Management Unit [AMU] to manage those businesses and assets which are not core to the new bank. A wide range of assets and loans will be included in this Unit which will allow the bank to manage them in a more concentrated and professional manner than currently.
"Finally the plan will see the UK business [CHL] continue as a standalone business unit within the group."
In a joint statement, the chairman Alan Cook and chief executive Jeremy Masding said that they welcomed the progress made today.
"This decision follows the most intensive and detailed review ever undertaken of the options for permanent tsb bank," their statement read.
"No option was excluded from consideration including the outright closure of the bank.
"However, we believe that there is a compelling case that a viable, competitive bank can be created from the current permanent tsb by separating out the different elements of that bank into distinct business units and that permanent tsb itself is the most suitable vehicle for managing that process in the short to medium term."