Bank stress tests yield good news and bad news

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For the last eight weeks, nearly 200 federal examiners have labored inside some of the nation’s biggest banks to determine how those institutions would hold up if the recession deepened.

What they are discovering may come as a relief to both the financial industry and the public: the banking industry, broadly speaking, seems to be in better shape than many people think, officials involved in the examinations say.

That is the good news. The bad news is that many of the largest American lenders, despite all those bailouts, probably need to be bailed out again, either by private investors or, more likely, the federal government. After receiving many millions, and in some cases, many billions of taxpayer dollars, banks still need more capital, these officials say.

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Industry insiders say that the government will use its findings to press certain banks to sell troubled assets. The hope is that by cleansing their balance sheets, banks will be able to lure private capital, stabilizing the entire industry.

In some cases, however, the investments of existing shareholders could be severely diluted by large sales of new stock.

Some of the banks could also face more stringent restrictions on employee compensation or be ordered to change their boards or management. In extreme instances, the government could wind up taking larger, perhaps even controlling, stakes.

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The stress tests are playing a pivotal role in the Obama administration’s sweeping plan to shore up the financial industry. Forcing many banks to raise capital might undermine the still-fragile confidence in the industry. But if only a few banks raise more money, the test might lose credibility with investors.

“Clearly there is a desire to put a seal of good bookkeeping on these banks,” said Lou Crandall, the chief economist at Wrightson ICAP. “Whether they will use this to select a couple of sacrificial lambs is unclear. It’s a big uncertainty hanging over the system right now.”

The tests, led by the Federal Reserve, rely on a series of computer-generated “what-if” projections in the event the economy deteriorates. Those include unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010.

Top regulators say the effort could signal a new approach to supervising the risks that banks take. While federal regulators routinely monitor the financial condition of banks, one goal of the tests is to devise a common set of standards for judging losses across all 19 institutions.

http://www.nytimes.com/2009/04/09/business/09bank.html