But the tests, which are expected to be completed by the end of this month, are being conducted out of public view. Federal law prohibits the unauthorized disclosure of the results of any bank examination, including the stress tests. Some investors wonder if the new tests are rigorous enough, given the potential problems lurking inside the banking industry.
Regulators recognize that for the tests to be credible, not all of the banks can be winners. And it is becoming increasingly clear, industry insiders say, that the government will use its findings to press certain banks to sell troubled assets. The hope is that by cleansing their balance sheets, banks will be able to lure private capital, stabilizing the entire industry.
In some cases, however, the investments of existing shareholders could be severely diluted by large sales of new stock.
Some of the banks could also face more stringent restrictions on employee compensation or be ordered to change their boards or management. In extreme instances, the government could wind up taking larger, perhaps even controlling, stakes.
The state of the industry will come into sharper focus next week, when big banks like Citigroup and JPMorgan Chase start reporting first-quarter results. Many analysts predict the reports will show banks are on the mend, with help from low interest rates, fat lending margins, dwindling competition and profits from trading in the financial markets in January and February. In the last six weeks, financial shares have soared on hopes that the worst for the industry is over.
But some analysts say investors’ hopes are misplaced. With the recession, banks are likely to record further large losses on credit cards, corporate loans and real estate.
“Nothing has changed with the fundamentals,” said Meredith A. Whitney, a prominent banking analyst who has been bearish on most financial institutions.
The stress tests are playing a pivotal role in the Obama administration’s sweeping plan to shore up the financial industry. Forcing many banks to raise capital might undermine the still-fragile confidence in the industry. But if only a few banks raise more money, the test might lose credibility with investors.
“Clearly there is a desire to put a seal of good bookkeeping on these banks,” said Lou Crandall, the chief economist at Wrightson ICAP. “Whether they will use this to select a couple of sacrificial lambs is unclear. It’s a big uncertainty hanging over the system right now.”
The tests, led by the Federal Reserve, rely on a series of computer-generated “what-if” projections in the event the economy deteriorates. Those include unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010.
Top regulators say the effort could signal a new approach to supervising the risks that banks take. While federal regulators routinely monitor the financial condition of banks, one goal of the tests is to devise a common set of standards for judging losses across all 19 institutions. Examiners are also considering instruments that are not carried on banks’ balance sheets. They long escaped tough scrutiny.
As part of the tests, the banks analyzed each category of loans they held and compared their results with the “high” and “low” range of government loss estimates. If a bank expected fewer losses than the government, the regulators asked the institution to explain why.
The banks were also asked to project their earnings over the next two years to give the regulators a better sense of how much capital they would have to absorb the coming losses.
Several people involved in the process say there is a wide range of results among the institutions. Those that fall short will have six months to raise capital from private investors; if they are unable to do so, the Treasury Department has said taxpayer money will be available.
Some federal and industry officials say regulators may use the results to prod reluctant banks to sell assets under that program.
Michael Poulos, a director at Oliver Wyman, the consulting firm, said many big investors were burned after investing in financial companies last year and are averse to doing so again. The stress test findings, he said, could “make private capital more eager to come in because they will get a view of the bottom.”
At a recent breakfast with a dozen or so corporate and banking executives in New York, Treasury Secretary Timothy F. Geithner warned he would take a tough stance. Many banks, he suggested, believe the investments and loans on their books are worth far more than they really are, according to a person who attended the meeting.
Mr. Geithner said that was unacceptable. The banks, he said, will have to sell these assets at prices investors are willing to pay, and so must be prepared to take further write-downs.
--Reuters contributed to this report.