Handicapping the Bank 'Stress Test'

Federal Reserve Chairman Ben Bernanke Tuesday went before the Senate Banking Committee to talk about the state of the economy and wound up taking a stress test.

“The stress test has introduced stress,” the committee’s chairman Christopher Dodd (D-Conn) said, in referring to the uncertainty surrounding the banking industry tests the Obama administration is expected to begin undertaking at major financial institutions Wednesday.

Joking aside, Bernanke was repeatedly asked about how the tests would work and what they would achieve, offering some detail about a concept that appears bound to be a key component of the government's latest financial stability plan.

“The outcome of the stress test is not going to be fail or pass [for banks],” Benrnake told legislators, but to “get a clear estimate of their capital needs.”

Thus far, the Treasury has only said that: a) the tests would be applied to banks with assets over a $100 billion, which is essentially the top 20; b) banks found lacking would be told they needed to raise private capital; c) if they were unable to do so, they could apply for government funds under the newly created Capital Access Program, CAP, which is replacing the Capital Purchase Program, of CPP, first administered under then-Treasury Secretary Henry Paulson; d) funding would come from the second tranche of TARP.

In responding to several lawmakers on the subject, Bernanke, however, was not very specific and appeared to answer the same question in different ways.

At other points he said the tests were “intended to make sure they [the banks] have enough capital to fulfill their function,” which presumably means lending, and to make sure "there’s enough capital to meet capital standards.”

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Earlier in the day, FDIC Chairwoman Sheila Bair said the purpose of the tests were to determine if the banks "have an adequate enough buffer,” as she put it to CNBC, to survive even more difficult economic conditions, given the forecasts for a declining economy in the months and, perhaps even year, ahead.

Like the administration in general so far, neither Bair nor Bernanke revealed what the stress test would entail and what metrics would be applied, an area that has generated much speculation.

"I don't know why they announced a stress test, but it was a bad and unnecessary move which has caused a great deal of confusion and consternation," says Former FDIC Chairman Bill Isaac.

"The regulators are not disclosing what changes they have made to the normal stress tests that are part of their regular examination," adds Robert C. Schwartz, a partner in the law firm of Smith, Gambrell & Russell, who represents banks.

The Treasury Monday made it clear that the stress test concept does “not imply a new capital standard and it is not expected to be maintained on an ongoing basis."

Under current regulations, the capital requirements of banks are based on Tier 1 and Tier 2 ratios, which measure capital to so-called risk-weighted assets.

Tier 1 is the more important of the two and basically consists of shareholder equity, retained profits and good will, minus accumulated losses.

CNBC.com Ben Bernanke

An important distinction in the current environment is that the value of the equity is not based on the current price in the market, but what was originally paid to purchase the stock.

Under current regulations, a bank must have a Tier I ratio of at least 4 percent to be adequately capitalized and a combined Tier 1 and Tier 2 ration of 8 percent. To be well capitalized, the ratios need to 6 percent and 10 percent, respectively.

“I think they are going to drill down deeper into the concept of capital,” says Schwartz.

At this point, The Treasury is thought to be looking at another key metric. Known as tangible common equity, or TCE, it essentially measures the book value of common shares, excluding such intangibles as goodwill and deferred taxes.

The goodwill factor is significant, says independent bank analyst Bert Ely. “Many [banks] have already written down goodwill,” and they might realistically write down more of it.

According to one industry source, banks do not want the TCE metric used, and would prefer the Tier 1 capital ratio requirement.

Tier 1 is a “more favorable metric,” says Ely, given the devalued nature of many bank stocks.

“Tier 1 and Tier 2 are not as meaningful in this environment as the tangible equity,’ adds Schwartz.

He adds TCE is “inherently unfavorable” to banks, because negative earnings are eroding capital, which means equity goes down.

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Bernanke Tuesday said the government wanted to make sure there’s “enough capital to meet Tier 1 standards.”

Stress tests are not a new concept, according to banking experts. They have been used in both the US (Fannie Mae and Freddie Mac) and Japan.

“In principal, they’re a good thing,” says former savings and loan regulator and White House economist Lawrence White. “They’re better than the static Tier 2 and Tier 2 requirements because they try to take into account some bad case, or worse-case scenario.”

“All the scenarios should be well within the knowledge of the officials by now,” counters Rob Johnson, a former chief economist for the Senate Banking Committee during the S&L crisis of the late 80s.

The stress tests, however, may wind up being more useful to the government that initially meets the eye.

During the Great Depression, the Reconstruction Finance Corporation used something resembling a stress test during the famous bank holiday weekend when a third of the nation’s remaining 17,000 banks went of business, says Walker Todd, a former Fed official and economic historian.

If an institution had assets of at least 90 percent of deposits and other liabilities, the government would provide additional capital in the form of a loan to get to par, or a one-to-one basis. About five thousand institutions received aid this way, says Todd, with he government receiving preferred stock in exchange.

Todd worries that the forthcoming “stress tests will be fudged” if they are not used to “address the toxic assets.”

"The whole question will be not is what on the liability side but how you price the assets," says Johnson. "If you mark them down enough you can wipe out capital."

He thinks the stress tests foreshadow a move to a tougher government policy.

“There’s this kind of pretense of doing scientific analysis and being impersonal and masking the fact that this is very political,” he says. “The government is putting a marker in the sand. At some level it’s got some teeth because Wall Street is worried.”

Johnson and others say the stress tests look like the first step in picking winners and losers.

Bair’s comments Tuesday appeared both somewhat conditional and non-committal.

"I think we need to do the stress test first,” said Bair, “before we determine what type of additional capital investments the government may need to make."

"They’re going to establish an analytical basis to determine how much capital to commit to banks and at one point to be able to say, 'enough is enough' and we’re going to take this bank over,'” predicts Ely.

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