Bank Test May Expand U.S. Regulators’ Role

Nearly 100 federal banking regulators descended on Citigroup in New York on Wednesday morning. Dozens more fanned out through Bank of America , JPMorgan Chase and other big banks across the nation.

It was just another workday. For years, regulators have embedded themselves inside the nation’s major banks to monitor their financial health.

But now these regulators could become the arbiters of American finance. Treasury Secretary Timothy F. Geithner is empowering them to decide which banks are strong enough to survive on their own — and which must be compelled to accept new bailouts from Washington, along with any strings that might be attached to them.

At the center of this effort, part of the Obama administration’s plan to shore up the nation’s financial industry, is a new stress test for banks that federal officials are devising.

Details are scant. But exams for 18 or so of the biggest banks are set to begin immediately, and the first results could arrive within weeks. They are not expected to be made public for every institution. Regulators were also discussing whether to apply the stress test to small and midsize banks, according to an administration official.

The new test is likely to be more stringent than the standards used to determine which banks would receive money under the first round of the federal rescue. And unlike in the government’s initial investments, the amount of capital that banks receive will be based on the depth of their problems.

Regulators plan to assess the potential losses a bank could face over the next two years, rather than the typical one year, according to government officials close to the situation. They are also expected to look at banks’ exposure to derivatives and other assets normally carried off their balance sheets, and make sure that banks also carry an additional capital cushion. Their assumptions will be guided on a “worst case” basis.

The exams could be used not only to determine which large banks would receive additional aid but also to help weed out small, unhealthy banks, hastening consolidation in the industry.

Analysts said the program hints at a creeping nationalization of the banking industry. “There is no way you can survive the failure of the stress test without having the government inject large amounts of taxpayer money,” said Jaret Seiberg, a policy analyst at the Stanford Group in Washington. “That means the government will own a majority of the bank.”

Paul J. Miller, a longtime banking analyst with Friedman Billings Ramsey, said the test might provide the government with political cover to take a more heavy-handed approach. “It gives them the mechanism they need to take giant steps with capital infusions,” he said.

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“Maybe the thought is that we will put in so much capital that even under these stringent circumstances, this bank will not fail,” added Martin Lowy, a banking lawyer who advised the Federal Deposit Insurance Corporation on troubled banks during the savings and loan crisis of 20 years ago.

“That will take a huge amount of capital if they are going to do it honestly,” he said. “Why that is different from nationalizing, I don’t know.”

If a bank fails the test, its regulators will demand that it raise additional capital. But with few investors willing to put in fresh funds, the bank may be forced to return to the government.

The government could inject capital into the bank without declaring it insolvent, since it may meet other industry standards. It might also require that the bank have enough common equity to start lending again, something investors increasingly demand.

According to a government official close to the situation, regulators will continue to require that banks maintain a minimum 6 percent Tier 1 capital ratio, a common measure of financial health. Regulators are also expected to insist that at least half of that figure, or 3 percent, come from common stock.

As part of the new program, firms that receive new preferred equity investments from the government can convert them into common shares. Senior administration officials are also considering allowing the Treasury’s original investments under the Troubled Asset Relief Program, or TARP, to be converted into common equity, but no final decision has been made.

The government’s new investments will carry several additional restrictions. They will bar banks from paying quarterly dividends in excess of a penny, repurchasing their shares or pursuing acquisitions. Senior executives will be subject to a $500,000 cap on annual cash compensation until the government is repaid.

It also means the government could become the largest shareholder of many of those banks, setting the stage for it to play an even more powerful role.

Some analysts questioned whether the approach would work.

“What you are left with is that we are going to nationalize banks that fail the stress test,” Mr. Seiberg said. “How many big companies are going to want to do business with government-run banks?”

This story originally appeared in the The New York Times