Bank Stress Tests Will Enter Critical Phase on Friday

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Bank Stress Tests Will Enter Critical Phase on Friday
By: Reuters | 23 Apr 2009 | 07:33 PM ET

US officials testing the health of the nation's top banks must walk a tightrope when they disclose the exams' results: The scrutiny must be tough enough to be credible, but not so harsh as to rattle an already shaken system.

"The challenging thing here is presumably they're going to be talking about some information that is not going to be at all flattering for some institutions," said Kevin Petrasic, a banking lawyer at Paul, Hastings, Janofsky & Walker in Washington.

"How do you make sure that the information that is relevant about certain institutions is not damaging to those institutions?" asked Petrasic, a former assistant chief counsel at the Office of Thrift Supervision.

U.S. regulators are conducting "stress tests" of the 19 largest U.S. banks, including Citigroup [C  3.20 ▼ -0.05  (-1.54%) ], JPMorgan Chase [JPM  33.21 ▲ 1.31  (+4.11%) ] and Wells Fargo [WFC  20.09 ▲ 1.91  (+10.51%) ], to try to determine how much capital any big bank might need to weather the storm, should the already recession-bound economy turn down further.

The process enters a critical final phase on Friday, when regulators begin discussing their findings with the banks. U.S. officials also will outline publicly the process they followed in an attempt to show how rigorous the testing was.

The final results will be announced on May 4.

Assumptions Outlined

Those results—expected to reveal which banks are on the path to recovery and which ones will need further government assistance—could prove a critical moment for financial markets still jittery about the banking sector's health.

Banks that are unable to attract capital from private markets and that must lean on taxpayers for more support could be pushed by the government to oust senior managers.

"Where we provide exceptional assistance ... it will come with conditions to make sure there's restructuring, accountability to make sure these firms emerge stronger," Treasury Secretary Timothy Geithner said on Tuesday.

Vikram Pandit, the chief executive of Citigroup, the third-largest U.S. bank and a recipient of $45 billion in emergency government funds, pledged on Tuesday to repay "every dollar" of government capital. He sought to counter speculation he would be replaced if Citi needs another bailout with a vow to shareholders to see the bank through its troubles.

In February, the Treasury Department said that regulators would see how banks would fare if the nation's output shrank by as much as 3.3 percent this year and unemployment were to average as much as 10.3 percent next year.

The document will "add some meat" to those worst-case scenarios, according to a source who has seen a draft version, and regulators hope it will be a useful guide when the time comes to interpret the public test results.

Analysts expect the underlying assumptions to be published on Friday to contain more detail about how a steeper downturn might impact specific asset classes. They may use fluctuations in spreads between benchmark interest rates as a gauge.

The document on Friday may explore some of the unanticipated discoveries that came out of the stress tests, such as differences in underwriting standards, Petrasic said.

"A big difference could be underwriting standards and how different institutions did their originations," he said.
The assumptions may also factor in risks from regional concentrations of debts held by banks.

"Institutions that perhaps have heavier concentrations in different areas of the country where the economy is particularly challenging, those institutions will need to be stress tested to take in some regional differences," Petrasic said.

Managing Expectations

When the results are made public, officials hope to present them in a way that does not compound difficulties for weaker banks, but they could set tough requirements for how banks should rebuild.

While regulators may have held out hope the tests would show the top banks were largely healthy and strong, analysts says a positive outcome is far from assured.

"It's like the old lawyers' tale: Don't ask a witness a question you don't know the answer to," said Alex Pollock, resident fellow with the American Enterprise Institute and former president of the Federal Home Loan Bank of Chicago.

To keep financial markets from panicking, the government will need to get capital quickly to institutions that need it.

Converting the preferred shares the government holds in banks to common stock could be one way weak banks could increase their capital strength by some measures. Banks also may be encouraged to sell toxic debts to cleanse their balance sheets and make themselves more attractive to investors.