U.S. banking regulators on Wednesday launched a stress test program to assess the largest banks' ability cope with the possibility of a deeper recession in which the unemployment rate climbs above 10 percent next year.
The stress tests, mandatory for the roughly 20 institutions with over $100 billion in assets, will be used to determine whether the banks need more capital from a new U.S. Treasury program for government preferred stock investments that can be converted into common equity.
The new Treasury program, known as the Capital Assistance Program, will be placed alongside a previous program that has injected nearly $200 billion into banks since last October. Both will draw from remaining funds in the Treasury's $700 billion financial rescue fund.
The stress tests, to be conducted by end of April by the Federal Reserve, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Office of Thrift Supervision, will measure banks against two economic scenarios. The first or baseline scenario is based on the consensus of private forecasters for the economy and the second or more adverse outlook anticipates a longer and deeper recession.
Regulators will conduct an assessment of all these banks to try and figure out how much capital they need to meet even that weaker scenario, Federal Reserve Chairman Ben Bernanke told the U.S. House of Representatives Financial Services Committee on Wednesday.
Banks will be told how much capital they need to raise, if any. Some will not need any capital, but some will, he added.
Bernanke said banks will first have the opportunity to try to raise capital in the private market, but if they cannot do so, the Treasury will offer to buy convertible preferred shares in the bank.
If losses grow, this can be converted to common equity, giving the government a direct ownership stake and enhancing the bank's ability to absorb writeoffs.
The Treasury does not intend to disclose the results of the stress tests, leaving that decision up to banks. It said banks found by the stress tests to need more capital will have six months to either find private funds or take money from the Treasury which will charge a 9.0 percent annual dividend rate.
A government official told a background news briefing it was important that such banks do one or the other, but did not say what would happen if they refused.
Officials said the extra, temporary capital cushions would most likely be around one to two percent of an institution's risk-weighted assets, but there was no explicit limit the amount of capital the Treasury would give to large banks.
We obviously stand behind the program. There's no explicit cap on the program, the government official said. We stand ready to provide the necessary capital to the banking sector so it can be a contributor to the economy.
BASELINE VS MORE ADVERSE
News of the test details helped spark a brief late rally in financial shares, helping Bank of America
Analysts said the stress-test scenarios were not as onerous as some had feared.
I think a lot of people realize as they look at the details of this stress test that a lot of these banks are going to be able to pass it, said Stephen Massocca, managing director at Wedbush Morgan in San Francisco.
The baseline scenario assumes real gross domestic product will fall 2.0 percent in 2009 and rise 2.1 percent for 2010. The more adverse scenario assumes a 3.3 percent fall in GDP for 2009 and a rise of just 0.5 percent in 2010.
For the unemployment rate, the baseline assumes 8.4 percent for 2009 and 8.8 percent for 2010, with the more adverse scenario at 8.9 percent for 2009 and 10.3 percent for 2010.
For home prices, the baseline assumes a 14 percent drop this year, while the more adverse scenario assumes a 22 percent drop.
(Additional reporting by Karey Wutkowski in Washington and Chuck Mikolajczak)