Bank 'Stress-Tests' Could Discourage Many to Lend

The government's "stress-test" of the nation's largest banks could end up discouraging lending as banks hoard cash to appear healthier to regulators, banking analysts say.

The reason: most banks want to avoid taking more government money because of the onerous restrictions the government places on the funds. As a result, they are likely to become even more conservative with their money and pull back on lending—defeating a major goal of the bank bailout in the first place.

"The stress test may well create some unintended consequences, and among those unintended consequences would be the chance that banks would hoard capital leading up to the government examinations," says Greg McBride, senior financial analyst at Bankrate.com.

Supporters of government efforts to determine the financial strength of the top 20 banks—which began Wednesday—say it's probably too late  for banks to hoard cash. But banks that are deemed to have inadequate ratios will be given six months to raise capital, and McBride said that could be the period in which banks looking to avoid the heavy hand of government intervention hold onto their cash.

Such a phenomenon would fly in the face of efforts to get banks back to lending again.

At the same time, banks struggling to meet government requirements would suffer under a negative light, creating still more issues in need of resolve.

"Banks not faring well under the stress test may have a more difficult time raising private capital and see their stock prices fall even further," McBride says. "In the end they would be even more dependent on a government injection, not less."

Still, some analysts say the stress-testing process will achieve at least one important goal for banking by creating a transparency missing at a time when toxic assets are making it nearly impossible for many banks to present a true picture of their financial health.

But whether that actually creates a stronger lending climate remains to be seen.

One of the main purposes of the stress testing is "being able to look the world in the eye and say our banks have sufficient capital now," says Ernie Patrikis, former first vice president at the New York Fed. Yet he acknowledges disadvantages for banks that will take government funding.

"In the short run it will help encourage the stability of the banking system. Over the longer run the more capital the banks have to hold, the higher will be their cost of doing business," says Patrikis, partner in the White & Case bank and insurance regulatory practice in New York. "In a normal economy they may be at a competitive disadvantage with the unregulated sector."

The banking industry could come out of the process essentially in the same shape it has through the various other government bailout plans.

As the banks have burned through an alphabet soup of federal aid--the Troubled Asset Relief Program and the Term Asset-Backed Securities Loan Facility among them--the industry has remained generally stingy when it comes to lending as institutions use federal funds to shore up capital ratios.

"That's been the problem with the first phase of the bailout already," says Leo Tillman, a former strategist at Bear Stearns and BlackRock and author of "Financial Darwinism." "I think we need to balance accountability in lending with prudent risk management, and that balance can be struck."

But the urge to resist federal funding and the restrictions that come with it could be a temptation that puts further clamps on lending.

"Essentially, banks that come up short on the stress test have two choices," Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University, said in an e-mail response. "1) Raise capital; or 2) sell assets. Both are problematic because private capital sources today have dried up and asset sales would probably be at considerable discounts that would only exacerbate their capital problems.

"For many banks, a sale or merger will be the last grasp before petitioning for federal capital infusions."

At the same time, consumers will need to be selective when looking to finance major purchases, as analysts expect any pressure on big banks to trickle down to smaller institutions.

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"There are still a lot of smaller community banks, regional banks and credit unions that didn't make risky loans and haven't cut back on their lending activity," Bankrate's McBride says. "What the consumer should do in response is make sure that you're shopping around and casting a wide net.

"Credit is tight, but there are still plenty of lenders open for business."

© 2011 CNBC.com