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Stress Test Raises Questions About Bank Capital

The Obama administration's announcement that it will begin a series of stress tests on Wednesday on the biggest financial institutions to determine their potential capital needs is already stoking great speculation about what criteria the government will be using.

The stress test concept, which the government first mentioned two weeks ago, is even more intriguing to some because the concept has drawn comparisons to government efforts to assess the health of individual banks during the Great Depression.

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The Treasury Monday made it clear that the concept (and the larger effort to provide additional capital to banks if necessary) does “not imply a new capital standard and it is not expected to be maintained on an ongoing basis." Nevertheless, it raises questions about the utiltiy of the existing metrics.

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.

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.

Amid growing speculation about additional federal financial support, Citigroup late Sunday emphasized its Tier 1 ratio of 11.9 percent in a brief statement, saying it one of "the highest in the industry.” It did not cite its Tier 2 or combined capital ratios

Tier 2 is a more complicated measure and essentially involves supplementary capital, consisting of five categories: undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated-term debts.

Undisclosed reserves are not common. Revaluation reserves involve assets that have increased in value, such as real estate. General provisions involve the occurrence of a loss, but of an inexact nature. Hybrid instruments are a combination of debt and securities and are issued by the bank. Subordinated debt is debt that ranks after other debt in the event a company falls into receivership.

To be well-capitalized under regulatory definitions, a bank must have a Tier 1 capital ratio of at least 6 percent and a combined Tier 1 and Tier 2 ratio of at least 10%.

At this point, The Treasury is thought to be looking at another key metric in undertaking its stress stest. 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 Bert analysts Bert Ely. “Many [banks] have already written down goodwill,” and they might realistically write down more of it.

Put another way, TCE is what you get when assets and liabilities are netted out.

State Street , interestingly, is now taking steps to strengthen its tangible common equity and recently updated its full-year 2008 earnings to reflect that.

According to one industry source, banks do not want this metric used, and would prefer the Tier 1 capital ratio requirement, which might explain why Citigroup highlighted it in its statement.

Tier 1 is a “more favorable metric,” says Ely, given the devalued nature of many bank stocks. The Tier 1 ratio is also seen as advantageous because it factors in the riskiest assets.

According tothe research firm Friedman Billings Ramsey, "the tendency for banks to hide behind regulatory capital ratios has gotten the banking system into an over-levered position that now must be painfully unwound."

FBR adds that TCE is the only capital measure shareholders should focus on.

"Tier 1 capital with stocks at current levels suggest that more than one big bank is critically undercapitalized," says Walked Todd, a former Fed official now with the American Institute for Economic Research.

The Obama stress test will be used to decide which firms are under capitalized. Regulators will then ask the banks to raise private capital.

If under capitalized, then reguars will ask bank to raise capital. If unsuccessful at that, the institution is eligible for new capital injections through the Treasury's capital acess program, or CAP, which is replacing the existing CPP program created by the Treasury under Henry Paulson.

Walker Todd, a former Fed official and economic historian, says the stress test is reminiscent of a concept the Reconstruction Finance Corporation used in the 1930s to weed out unhealthy banks and focus its capital on the healthy ones.

Some suspect the stress test will eventually be used to help the government pick winners and losers.

"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,'” says Ely

The stress test, he adds, will “essentially move toward [determining] a liquidation value.”