Government to Stress Test Big Banks

US banking regulators reveal the details of the much anticipated "stress test" to be applied to large financial institutions. This process is intended to sort banks by their ability, strength to endure even deeper recession.

Results from these tests will provide the government with data to determine which banks may need additional capital and how much. Some also believe it will identify winners and losers in the event of future economic decline.

The stress tests will be mandatory for nineteen major financial institutions worth more than $100 billion. The testing will be completed by the end of April by the Federal Reserve, the Federal Deposit Insurance Corp. (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS).

Results of the stress test will guide the use of the new Capital Assistance Program, run by the US Treasury. This fund, along with the already $200 billion that has already been injected into the banks, will pull from the Treasury's $700 billion TARP fund.

Stress testing is not uncommon for large bank portfolios and financial assets. They are consistently used to test capital reserves by "shocking" certain economic variables or assumptions within asset performance models. These tests are routinely used by bank regulators to set capital reserve requirements.

Unlike standard stress tests, the current economic environment and unprecedented asset classes is yielding radically unexpected performance on these assets--massive default and failure. This is particularly relevant to mortgage portfolios and so called toxic assets.

As a result, the government has continually been surprised by unflagged surprises in loss levels and bank performance. These surprises and the seemingly unfettered need for more taxpayer capital is driving this new more standardized and radical stress test program.

The stress test will use three "shock" variables to test the banks capital reserves: real gross domestic product, unemployment rates, and home prices. The testing will use two scenarios.

The first, will be a "baseline" that utilizes consensus economic forecasts: real gross domestic product falling to 2.0 percent in 2009 and rising to 2.1 percent in 2010; unemployment rising from 7.9 percent to 8.9 percent in 2009 and dropping to 8.8 percent in 2010; and home prices dropping another 14 percent in 2009.

The second, "severe" scenario will assume: real gross domestic product descending 3.3 percent in 2009 and only recovering 0.5 percent in 2010; unemployment rising to 8.9 in 2009 and 10.3 in 2010; and home prices dropping 22 percent in 2009.

The bank stress tests will not be made public, but will drive additional government capital injections and possible conversion of preferred shares into common stock, increasing Federal control of weaker financial institutions.