Fed releases 'stress-test' criteria

Regulators delivered a simple but important message Friday: Some of the biggest US banks don't have enough of a capital cushion to fulfill their “critical role” in the economy.

The Federal Reserve laid out that general point in a public report, and in private the Fed began acting on its assessment. It called top bankers into meetings Friday to tell them whether their particular institutions need a balance-sheet boost.

Some big banks are being asked to raise more capital. This would serve two key purposes in the current recession: It acts as a cushion against losses and it provides seed money for new loans.

If the banks that need capital can’t raise it in the form of private equity, the investor will be the US Treasury.

In its public report, the Fed described the methods bank supervisors used in so-called “stress tests” to assess the health of the major banks.

The assessment is part of the Obama administration’s efforts to pull the economy out of recession. The Treasury’s Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp., worked alongside the Fed in conducting the tests.

“Given the heightened uncertainty around the future course of the US economy and potential losses in the banking system, supervisors believe it prudent for large bank holding companies to hold additional capital to provide a buffer,” the Fed’s report said.

Though the actual results of the tests won’t be released until May 4, bank stocks rose Friday.

The assessment, as outlined in the report, involved:

- Looking deep into banks’ books, evaluating both likely losses and the likely income that banks will have to offset those losses over the next two years.

- Considering outcomes in both a baseline economic scenario and a worse-than-expected case. The pessimistic case called for gross domestic product (GDP) to decline by 3.3 percent this year and to grow by 0.5 percent next year. It called for the unemployment rate to reach 10.3 percent, and for home prices to fall by another 29 percent, by 2010.

- Calling for enough capital so that banks can keep lending and cover the losses likely to materialize through 2011 in a worse-than-expected scenario.

- Emphasizing common stock as the most important form of capital. Bank capital can also come in other forms, but in times of stress a supply of common equity provides the safest cushion against losses.

- Evaluating a diverse set of banks using common benchmarks. Although banks may have their own individual models of forecasting loan performance, examiners tried to “apply a consistent and systematic approach across the group.”

The huge undertaking is sensitive politically as well as economically.

That’s because the resulting capital infusions could mean spending taxpayer dollars. Also, by taking a stake in the company alongside existing shareholders, an infusion of common stock could diminish the wealth of bank executives and others who own stock in these firms.

One central question, financial experts say, is whether the assessment is sufficiently tough, and thus whether the resulting capital boost will be sufficiently large.

Economists note, for example, that the “adverse” scenario in the Fed report is not all that different from mainstream forecasts. The International Monetary Fund, for example, this week projected a GDP decline of 2.8 percent for the US in 2009, and no growth at all in 2010. In a separate report, the IMF estimated that US banks may need $275 billion to $500 billion in new capital. The Treasury has not spelled out its own estimate of how undercapitalized the banking system is.

“I do think if you ran an honest stress test … a lot of banks would need more capital,” says Pete Kyle, a finance professor at the University of Maryland in College Park. “And some would have difficulty raising it.”

The stress tests focus especially on the 19 large institutions, which account for two-thirds of banking assets and half of bank loans in the US.

If banks do need more capital, some may opt to get it by converting preferred stock into common stock – using preferred shares already invested by the Treasury since last fall through the Troubled Asset Relief Program (TARP).

Some banks may be convincingly healthy enough to raise money from private investors.The Treasury also says that more than $100 billion of the $700 billion TARP funds remain untapped.

Yet another avenue for new capital would be if some banks repay their existing TARP funds, which could then go to other banks. For the biggest banks, however, that may pose a tricky test for the Treasury. It wants to make sure banks aren’t just healthy enough to survive, but also to keep up a strong flow of lending.

“We would like to repay it [TARP funds] as soon as possible,” said James Dimon, chief executive of JPMorgan Chase, earlier this month But, he added, “It may not be solely up to us.”

For President Obama and for Congress, trying to appropriate more “bailout” money for banks would be a politically unpopular move.

The risk on the other side is economic: If policymakers are asking banks to raise too little capital, the economic recovery might suffer as a result – an outcome with its own political fallout when elections roll around in 2010 and 2012.