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Stress Tests Show One Bank Would Need More Capital

One of the 19 financial institutions that received a government stress test would require additional capital, based on the initial findings, according to an industry source.

“At least one firm, under the stress test assumptions, will require more capital,” said the source.

Though the source did not identify the company, the government in its report Friday said results were "conveyed" to the participating firms at the end of April, so the bank in question would be aware of the Federal Reserve’s assessment.

Both the Fed and the Treasury Department declined comment.

According to terms of the stress-test process laid out by the government, the banks have until April 28 to review and appeal the government's conclusion. Regulators will be discussing the test results with the companies during that time period.

The government Friday revealed the criteria and methodology of the highly controversial tests in a two-dozen page report as part of a two-stage disclosure process. The actual results will be released May 4.

Banks found to have inadequate capital, will have six months to raise the money, through a variety of means in the private sector. If unsuccessful, the government has said the institutions will be eligible for a capital infusion through its Capital Access Program.

Though the eagerly awaited report concluded, “most banks currently have capital levels well in excess of the amounts needed to be well capitalized," there has been significant speculation about the overall outcome and it has become something of a political hot potato for the Obama administration.

"There are two things that are terribly wrong,” former FDIC Chairman Bill Isaac told CNBC.com. “First, that was publicly announced. I can't imagine what Treasury was thinking when it made that move. It has been causing incredible angst in the markets … The second big problem is that the Treasury is directing the stress testing, apparently with direct involvement of the White House at the highest levels. Bank regulation by law is supposed to be carried out by the independent banking agencies without any political interference.”

What’s more, analysts say the tests face a fundamental credibility issue. The tests can neither be too tough nor too soft or the outcome might be suspect; at the same time, some have speculated that at least one bank would have to come up short .

The government has repeatedly said the tests are not “pass/fail”, but analysts say it is inevitable that the results create something of two-class system of institutions, something resembling the weak and the strong, which investors will then factor into stock prices.

The tests are meant to increase confidence in the nation's fragile financial system and to make sure the institutions can withstand a worsening economy by creating a so-called capital buffer.

Reaction to the report Friday was mixed among banking analysts and investors, while industry groups generally had a favorable view.

“The market may disappointed by the lack of details," said FBR Capital Markets analyst Paul J. Miller in a note to clients. “But, at the margin, it does seem regulators will give each institution a real review, rather than a rubber stamp of approval for the group. These names [companies] are largely uninvestable until the full results are released on May 4.”

The tests have also raised some concerns that investors could essentially take the economic assumptions and capital criteria involved and replicate the test process on the same 19 banks or any other company for that matter.

The report, however, appears to have avoided that by not disclosing all the criteria involved in determining capital needs, especially anything that might be considered a key benchmark, saying “regulators did not rely on one single indicator of capitol, but examined a range of capital adequacy.” Moreover, the government has said the testing process would not introduce any new industry standard.

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At the same time, analysts say it is clear that regulators are taking a close look at the tier 1 capital—a key existing metric—as well as common equity. Tangible common equity, TCE, for instance, excludes good will and deferred taxes, both of which might be considered fairly big unknowns and/or unduly favorable elements in the current economic and financial environment.

“It’s a more conservative measure of capital,” said independent banking analyst Bert Ely of Ely & Company.

TCE has been rumored to be a key metric from almost the instant the stress tests were announced as part of the administration's financial stability plan and the term has since become more commonly used.

“The market is focused on TCE,” said Ely. “We’re seeing it in first-quarter earnings. That’s relatively new.”

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