Just how vulnerable are US banks?

A 'stress test' aims to assess which banks would need help if the economy worsened.

By , Staff writer of The Christian Science Monitor

It is a computer exercise only: On Wednesday, the US government will take the worst-case scenario for the economy and try to figure out what that might mean for each of the nation’s major banks.

Would banks from JPMorgan Chase in New York to Bank of America in Charlotte, N.C., have enough capital to survive? Or should the government be planning to inject more public money into the banking institutions considered critical to the nation?

Despite the Obama administration’s interest in greater transparency in government, economists doubt that the results of what is being termed “stress testing” of each of the major banks will be made public.

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After all, there’s no sense causing more angst to a financial system that is already under a high degree of stress by revealing which banks might not survive without more public aid. But, the results might help Treasury Secretary Timothy Geithner and other federal regulators have some kind of plan in place if the recently enacted fiscal stimulus package falls short, the recession drags on for another year, and the unemployment rate spirals to double-digit levels.

“Basically, what they are doing is planning for the worst and hoping for the best,” says Joel Naroff of Naroff Economic Advisors in Holland, Pa. “That does not mean the worst will actually occur.”

Bank stress already

The government exercise comes at a time when the stocks of many bank companies are under severe pressure on Wall Street. According to press reports, Citigroup, one of the nation’s largest banks, has asked the government to take a larger equity stake in the company – perhaps as much as 45 percent of the bank. So far, the US government has invested $45 billion in Citi, which is based in New York.

The Citigroup move follows a terrible week when the price of its stock dipped as low as $1.61 a share, indicating the entire company was worth $9.7 billion. By mid-afternoon Monday, the price had bounced back some, to above $2.20 a share.

“This is not a reflection of what the bank is worth,” says Sung Won Sohn, a professor of finance at California State University, Channel Islands and the former president of a bank. “If I had $10 billion, I’d like to buy Citigroup.”

Not spreading fear

In announcing the banking stress test, the nation’s financial regulators were quick to try to keep the public from jumping to conclusions about the current state of the banking industry. “Currently, the major U.S. banking institutions have capital in excess of the amounts required to be considered well capitalized,” the regulators said in a joint statement Monday.

The bank regulators include the US Department of the Treasury, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve Board.

However, the regulators added, any new capital provided by government will be to provide a cushion “against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers.”

A worst case

What would the worst economic scenario look like?

It is “conceivable” the economy could degenerate “into a cycle worse than what we have seen since ... World War II,” says economist Brian Bethune of IHS Global Insight in Lexington, Mass. “But it is not a Great Depression.”

Under the Global Insight worst-case scenario for the economy, the current recession continues into 2010 without much boost from the $789 billion fiscal stimulus package signed into law last week by President Obama. In the computer model, the stimulative monetary policy and the attempts to rescue the banks don’t work. “We would have a one year delay in the recovery,” says Mr. Bethune.

By this model, while the economy sputtered, the unemployment rate would spike to 10.5 percent, up from 7.6 percent in February. The federal budget deficit would be over $1 trillion for a second year in a row. And auto sales for Detroit would be at today’s depressed levels.

“When you put all this together, my sense is that only half the banks could survive that,” says Bethune. “But it’s a redundant exercise because the system is already under maximum stress.”

Losses at $1 trillion

Even without the economy getting worse, the banks may have as much as $1 trillion in losses, he estimates. They have raised additional capital to cover about half of those losses. “There is still a gap of $500 billion, so if you stress test it beyond [that], the whole banking system is insolvent.”

Bethune argues that the regulators should be doing a “due diligence” review for banks with assets over $100 billion. He would like regulators to assess the capability of each financial institution in terms of how dominant it is in its main markets, the strength of its brand, and the ability of the bank to manage risk.

“Then, they put 10 people in a room and ask is this entity worth saving from the point of view of putting in public capital?” says Bethune.

If nationalization happens

James Barth, a fellow at the Milken Institute in Santa Monica, Calif., worries about what might happen if the government decides it has to take over many of the banks. “Will the management of the bank be replaced with some delegate or government official?” asks Mr. Barth, a former banking official in the Reagan and George H.W. Bush administrations.

He also wonders if a better test for the regulators to use is whether the bank management is capable of running the bank despite the losses embedded in its books.

However, Mr. Naroff says the regulators are doing the prudent thing. If the unemployment rate jumps to between 10 to 12 percent, he says, regulators need to know what will happen to the banks.

“Will some of the large banks not make it?” he asks. “It’s hard to believe that would not be the case.”

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