Just how vulnerable are US banks?

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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