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Understanding the banking ‘stress tests’

Big banks are taking turns on the treadmill to see how well they can take a pounding.
/ Source: The Associated Press

Big banks are taking turns on the treadmill to see how well they can take a pounding.

The government began to conduct financial “stress tests” Wednesday to determine how well the biggest U.S. banks could hold up if the recession gripping the country got worse.

What are these stress tests, and what will the federal examiners be looking for? Will the banks, which have received billions in aid under the government rescue program, get a “passing” or “failing” grade on them? What will the results be used for?

Here are some questions and answers about the Obama administration’s newest step in addressing the most severe financial crisis since the 1930s.

Q: As if we don’t already have enough stress from the economic meltdown: What are these “stress tests,” anyway?

A: Just as doctors put patients on a treadmill to check for possible heart disease, the government is looking at the financial conditions of the biggest banks — Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc., JPMorgan Chase & Co., about 20 in all — to help decide whether they have sufficient capital to withstand fresh shocks to the economy over the next two years.

People with blockages near the heart may have normal test results and no symptoms while they’re at rest. So patients are put on a treadmill: Up goes the speed, and the additional stress on the heart can reveal signs of problems.

Economic scenarios used in the bank stress tests are the equivalent of jacking up the treadmill, to unmask financial weaknesses. Stress testing is widely used in the financial industry; federal regulators use it in their periodic “safety and soundness” reviews of banks, and banks run their own stress tests.

Q: How do they work?

A: The tests use computer-generated models to gauge the effect of various “stressors” on the bank’s financial condition, trying out several hypothetical settings of factors like interest rates, unemployment and business conditions.

As a banker, “you run a variety of future scenarios and what it means for your bank,” said Wayne Abernathy, an executive vice president of the American Bankers Association.

Q: What scenarios will the Treasury Department use in this new stress testing?

A: The tests are expected to take into account a broader-than-usual range of economic indicators. Also, looking two years ahead pushes the tests well beyond the usual time frame of six months.

The banks will be tested under two economic scenarios: what the government calls a “baseline” and “a more adverse scenario,” reflecting a deeper and longer recession.

The scarier scenario includes a 3.3 percent decline in gross domestic product this year; unemployment rising to 8.9 percent this year and 10.3 percent in 2010, from the current 7.6 percent (already the highest in more than 16 years); and home prices plunging 22 percent this year and 7 percent next year.

Q: That sounds dire. Should we be worried about this worse-case scenario?

A: Government officials say — stress, even — that the worse-case “adverse” scenario is unlikely to occur. But they also say it can’t be ruled out.

Q: Will regulators be getting their hands on more information from the banks than they usually have access to, in order to conduct these stress tests?

A: No, they won’t get any more information than usual — they just plan to scrutinize it in a more intensive way.

Q: How long will the stress tests take, and will banks be graded on them? What will the government do with the results?

A: They’re expected to be completed by the end of April. And there won’t be any grades.

“The outcome of the stress test is not going to be fail or pass,” Federal Reserve Chairman Ben Bernanke told Congress on Tuesday

“The outcome of the stress test is, how much capital does this bank need in order to meet the ... credit needs” of American borrowers to get the credit system flowing again.

“We’re going to do an honest evaluation,” Bernanke said. “We’re going to do a tough evaluation, try to figure out how much hole there is, if there is a hole. In many cases, there’s not a hole.”

The tests will help regulators decide whether individual banks need additional government money so they can meet the mission of boosting lending — a crucial component to turning around the economy.

Bernanke said Wednesday that if a stress test reveals that a bank needs more capital, it will have up to six months to raise it from private sources. If it fails to do that, then the government would come in with additional aid to shore up the bank’s capital cushion against potential losses.

One option, laid out by the administration this week, would allow the government to sharply increase its stake in banks.

That would be done by converting the government’s stock in banks from preferred to common shares. The strategy, which could be applied retroactively to banks that received money in the first incarnation of the bailout, would give the government voting shares and more say in a bank’s operations. This could help the banks by making it easier for them to fulfill the mix of capital — bolstered by common shares — that regulators take into account when gauging their financial condition.

Q: Will results of the stress tests be released to the public?

A: The government says it won’t announce the results, though it expects the banks themselves to do so. Either way, the public could get an indication indirectly — from the actions Treasury takes, such as the injection of additional government money into certain banks.