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Bank Stress Tests: Where Do Banks Stand?

Posted by Wendell Brock on Fri, May 01, 2009

Late last week, executives from the 19 largest domestic banks were briefed on the results of TARP-related stress test, officially called the SCAP. The stress tests are intended to predict bank capital levels under deteriorating economic conditions in 2009 and 2010. Equivalent to a government-imposed pop quiz, the tests were incorporated into TARP after the Obama administration was handed the U.S. political reins in January.

The exact details of the test results are supposed to be kept under wraps until an official announcement can be made on May 4. Bloomberg has reported, however, that six banks failed the tests and will be asked by the Fed to raise additional capital. Analysts believe Bank of America, Citigroup and possibly Fifth Third Bancorp of Cincinnati are among the six.

Test assumptions

The stress tests used two scenarios to project the banks’ losses, revenues and reserve needs for 2009 and 2010. The more adverse set of assumptions included:

•    Negative 3.3 percent GDP growth in 2009 and 0.5 percent GDP growth in 2010
•    Unemployment of 8.9 percent this year, rising to 10.3 percent next year
•    Housing price declines of 22 percent this year and 7 percent next year

The value of testing the banks’ capital levels under these particular assumptions has drawn both criticism and praise—some say the assumptions aren’t extreme enough, while others argue that these scenarios will produce results that make banks look worse off than they really are.

Setting aside that argument, the Treasury intends to use the results to determine which institutions need to shore up their capital reserves—to ensure they remain well capitalized in a sharp economic downturn. The exercise is also intended to bolster the public’s confidence that the banking system has the capital to withstand further economic deterioration.   

The consequences of failure

Banks that fail the stress tests will be required by the Fed to raise more capital, preferably from private sources. It has also been suggested that a quick fix might be to convert the government’s preferred stock into common shares—but that scenario raises questions about how the government should appropriately manage its role as an investor.  

There has been no official word on the government’s intention to become a common shareholder in the banking system. Treasury Secretary Timothy Geithner has only said that the Treasury would be able to provide additional convertible preferred shares as “a backstop until private capital becomes available.”

Banks that end up needing additional taxpayer cash will undoubtedly be subject to greater government scrutiny and involvement. It’s a possibility that some industry executives and board members could even suffer the fate of GM Chief Rick Wagoner.

Topics: stress tests, test results, domestic banks

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