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Five things the bank stress tests will and will not do

The tests will be the first clear look at which banks are doing better than others, for example, but they won't be the last word.

By Staff writer / May 6, 2009

People enter the Bank of New York building on April 20. The Associated Press reported Wednesday that New York Mellon will not be asked to raise more capital as a result of the federal stress tests. The findings will be released Thursday afternoon.

Richard Drew/AP

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The mood surrounding the vital banking industry has actually been getting less stressful, even as federal regulators prepare to unveil the results of “stress tests” on major banks.

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Investors have been sending positive signals about banks. Financial stocks have risen by double digits since Treasury Secretary Timothy Geithner announced the stress tests on Feb. 10. It’s an indication that fears of an ongoing economic meltdown are receding.

Yet the stress tests remain important. Banks still face big losses on their loans, and most experts say that fixing banks is fundamental to an economic recovery. The stress test is one of the most important federal policies to set banks right.

So here’s a cheat sheet for the stress tests – five things to expect, and five things that won’t happen as the results are released.

What the stress test will do:

1. The results will provide a tangible report card on specific banks.

Analysts will debate how reliable the assessment is, but for the first time in this financial crisis, federal regulators will be saying publicly where the 19 biggest bank holding companies stand.

The word tangible is important. One key measure of each bank’s health is whether it has enough “tangible common equity,” essentially common stock, on its balance sheet. That stock is a vital cushion – a reserve that can be tapped if need be to cover losses.

In the test, regulators are looking at the likely losses on bad loans for each bank and seeing if banks have enough capital on hand to cover them. Tangible stock is one key way to measure capital, and the regulators may ask banks to raise more of it to ensure their health in the next couple of years.

2. No bank will 'fail,' but the results will divide apparent winners from losers in the industry.

Already, investors have formed their own opinions on how healthy the various banks are, but the official view of regulators could have an impact if they differ from the prevailing views.

On Wednesday, the Associated Press cited sources briefed on the results, who said that American Express, JPMorgan Chase, and Bank of New York Mellon will not be asked to raise more capital. By contrast, Citigroup, Bank of America, and Wells Fargo all will be asked to raise money to fill potential gaps in their capital.

3. The test results are expected to help keep credit flowing for consumers and businesses.

“The main purpose is to make sure that the banks have a more than sufficient capital buffer,” so they can make new loans, says Brian Bethune, an economist for IHS Global Insight, who tracks the financial sector.

“Banks might say, ‘We’re fine, thank you very much,’ ” Mr. Bethune says. Raising new capital is a costly process that many banks would rather avoid right now. But regulators are trying to ensure that banks not only can survive the current storm of mortgage and other defaults but also continue to lend as loan losses devour banks' capital.

4. The government's ownership stake at some banks might expand.

Banks deemed to need more capital will have the opportunity to raise it from private investors. But a key alternative is to draw more capital from the Treasury’s Troubled Assets Relief Program (TARP) in the form of preferred shares.