WASHINGTON — The Federal Reserve on Friday said the government is prepared to rescue any of the banks that underwent “stress tests” and were deemed vulnerable if the recession worsened sharply.
Outlining the tests’ methodology, the Fed said the 19 companies that hold one-half of the loans in the U.S. banking system won’t be allowed to fail — even if they fared poorly on the stress tests.
The announcement reinforced the Fed’s view that major financial firms are “too big to fail,” and that the government must do whatever is necessary to save them, said former Fed examiner Mark Williams.
“It appears ’too big to fail’ is a fundamental philosophy — it’s a philosophical principle,” said Williams, a finance professor at Boston University.
In extreme cases, a rescue could include a government-backed merger, similar to what regulators did in helping Bank of America to buy Merrill Lynch and JPMorgan Chase & Co. to buy Bear Stearns.
Critics say that policy has put taxpayer money at risk to give banks billions in government bailouts and guarantees.
Separately Friday, bank executives were being briefed on their test results in meetings across the country. By law, the banks cannot publicize the results without the government’s permission, but Wall Street buzzed with anticipation and most financial stocks rose. The Dow Jones industrial average added more than 119 points to 8,076.29.
Friday’s Fed release contained little new or concrete information. But Fed officials said in a conference call with reporters that banks will be required to keep an extra capital buffer beyond current requirements in case losses continue to mount.
The stress tests, a centerpiece of the Obama administration’s financial rescue plan, were intended to boost market confidence by giving investors clarity about the relative strength of the largest financial firms.
But critics have said the effect was just the opposite: creating uncertainty that fed market instability.
“I really don’t think this is going to add transparency to the system,” said Linda Allen, a finance professor at Baruch College.
Allen said the stress tests wouldn’t make much difference. She said they are similar to bank examinations that are done regularly to ensure banks have enough money to absorb further losses.
In the stress tests, regulators are putting banks through two scenarios.
One scenario reflects forecasters’ expectations about the recession. It assumes unemployment will reach 8.8 percent in 2010 and house prices will decline by 14 percent.
The second imagines a worse-than-expected downturn: Unemployment would hit 10.3 percent in 2010 and house prices would drop 22 percent this year.
Some experts fear the hypotheticals aren’t tough enough.
“The question is, will the market accept the stress test as a realistic case?” said Paul Miller, an analyst with Friedman, Billings, Ramsey & Co.
Recent economic indicators show the economy is approaching the more severe of the government’s two scenarios, Miller said.
The Fed emphasized that banks needing more capital to offset possible future loan losses should not be considered insolvent — a point that quelled fears that some weak banks would be allowed to fail.
Even if the tests showed a bank needs more capital, that “is not a measure of the current solvency or viability of the firm,” the Fed said in Friday’s announcement about the test methodology.
The Fed has several tools for shoring up banks’ finances. One is converting the Treasury Department’s loans to the banks into common-stock shares. Another is forcing the banks to raise money in private markets or receive more money from Treasury’s bailout fund.
Battling the worst financial crisis since the 1930s, the government has committed more than $11 trillion in loans, investments and other measures to prop up troubled institutions and stabilize the banking system.
For months, officials have put off questions about the banking system by saying they’re awaiting the stress-test results.
The delays have led investors to fret: If the tests show every bank to be strong, they will look like a whitewash and won’t be taken seriously. Yet once investors can distinguish stronger from weaker banks, they could start selling off weaker banks that remain stable but might falter if the recession got much worse.
News reports, including a confidential outline of the tests first reported by The Associated Press this week, led analysts to start handicapping which banks could fail.
Friday’s announcement put some of those fears to rest. It became clear that — at least for now — the Fed won’t be saying any bank now lacks the capital it needs to survive.
The Fed announcement downplayed the decisions, due to be announced May 4, by calling the stress tests “a ’what if’ exercise.”
Banks are barred by law from revealing results of regulators’ examinations without permission. The law was designed to keep fearful investors from making runs on banks perceived to be weak.
Regulators have specifically asked the banks not to disclose what they learn in meetings today at the various Federal Reserve banks, according to a regulatory official who requested anonymity because he was not authorized to discuss the process.
One reason is the results could still change.
The banks will have a few days to review the government’s stress tests results and appeal any findings they disagree with. Regulators will give them the final results next Friday, according to two people familiar with the matter who spoke on condition of anonymity because they were not authorized to discuss it publicly.
In a conference call with journalists, senior Fed officials said regulators will be keeping a close eye on banks to make sure they have adequate capital to withstand likely losses on mortgages and other assets as the recession drags on.
Separately Friday, a report from bank regulators concluded that under Treasury’s financial rescue package, the government could end up acquiring a “substantial” ownership stake of a participating financial institution. The report, released Friday, says Treasury’s goal is to keep the period of government ownership “as temporary as possible.”
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