The government began administering its new stress-tests for twenty of the nation's largest banks on Wednesday (with 'large' defined as having assets in excess of $100 million).
The idea of performing the tests is to gauge how much capital a bank has under various scenarios. For example, regulators will model the effects on banks’ loan portfolios of an unemployment rate at 10% in order to see if that bank will have enough of a 'cushion' to withstand the losses. If the model indicates that it will not, it would be forced to raise private capital.
Of course, in this environment, raising private capital will likely prove to be difficult. In that case, the government would become the source of new funding. To this point, government cash injections have mostly been in the form of non-voting preferred shares, which pay a dividend. Those shares could be converted into common shares (with voting rights) should the need arise.
Investors in the stock market and the banks are increasingly at odds over how to assess the health of financial institutions. Until the financial system deteriorated last fall, investors focused on what is known as Tier 1 capital, which consists of common stock, preferred stock and hybrid debt-equity instruments.
Now, however, they are focusing on what is called tangible equity capital, which includes only common stock, saying it is a better way to measure the risk in bank shares.
Tier 1 capital gives regulators comfort because it captures a bank’s ability to weather a financial storm but stock investors, who suffer the first losses, are worried about their own exposure. Tangible common equity, or T.C.E., they argue, is the best measure for them.
Federal Reserve Chairman Bernanke, at a House Financial Services Committee hearing today, reiterated that the government is not planning to use the stress tests for full-scale nationalizations that wipe out stockholders, and continued to draw a distinction between nationalization and a government minority interest with strict oversight and supervision.
Nationalization is when the government “seizes” a company, “zeroes out the shareholders and begins to manage and run the bank, and we don’t plan anything like that,” Bernanke told lawmakers in Washington today.
“It may be the case that the government will have a substantial minority share in Citi or other banks, but again we have the tools between supervisory oversight, shareholder rights, and other tools to make sure that we get the good results we want in terms of improved performance,” he said.
Such a path might avoid “all the negative impacts of going through a bankruptcy process or some kind of seizure, which would be I think disruptive to the markets,” Bernanke said.
Sheila Bair, the head of the Federal Insurance Deposit Corporation, said on Tuesday that the nation’s banking industry was safe. “All these large banks exceed regulatory standards for being well capitalized, so for right now, they’re fine,” she said.
“I think the big issue is how much of an additional buffer they have to withstand more adverse economic situations and that’s something we’re going to try to figure out with a stress test.”