Fed releases 'stress-test' criteria

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.

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