Banks must fail the test to receive new assistance from the government. But what does it measure?

by Christina Rexrode

The Treasury Department has hinged a big part of its plans for the banking industry on a so-called stress test, but has revealed almost nothing about what the test might entail.

The government's latest lifeline for major banks, announced Monday, has one main qualification: A bank has to essentially fail the stress test, which is meant to determine if it could survive a worse-than-expected decline in the economy.

Treasury Secretary Tim Geithner has described the stress test only as "a more consistent, realistic and forward looking assessment about the risk on balance sheets," administered by "the government agencies with authority over our nation's major banks." The testing, part of an initiative called the Capital Assistance Program, is to begin Wednesday, the Treasury said; it's unclear if it will reveal more about the tests then.

Critics say the Treasury's vagaries are stoking uncertainty in the markets. Some suspect that the agency itself doesn't know what the test will measure, and is rolling out the test now only because it panicked after bank stocks spiraled last week.

"This is getting almost comical - the lack of information, the rules of the game changing hour by hour," said Chris Mutascio, an analyst at Stifel Nicolaus.

"We can make the case that any of our companies could ‘pass' or ‘fail' these potential tests because we have no idea what the regulators and Treasury are going to consider," added Baird analyst David George.

Others think the agency does know the details but wants to keep them a secret. That could be because the stress tests are considering worst-case scenarios, and the government doesn't want the tests to be construed as predictions. For example, if a stress test takes into account 12 percent unemployment, the public could believe that the government is predicting 12 percent unemployment.

Some analysts fear the Treasury will use the stress tests as political cover to do as it sees fit with the nation's banks - taking bigger stakes in banks or taking them over.

Others worry that the test itself will become politicized. "It could become where, if you're in good standing with the Democratic Party, you're going to do just fine on the stress test, and if you've been a big Bush-McCain supporter, maybe things won't go so well," said Bert Ely, a Virginia-based banking consultant. "What's going to be the basis for challenging these assumptions?"

Regulators already routinely test banks' financial viability, though it appears that the stress tests would be stricter. For example, they could focus on a measure called tangible common equity, or TCE, which essentially measures what shareholders would get if an institution were dissolved. That's a more conservative measure than Tier 1 capital, which regulators often cite.

Generally, regulators want banks to have TCE levels of 3 percent. Mutascio, the analyst, estimates that Charlotte-based Bank of America Corp. would have to reach a cumulative two-year rate of 9.55 percent losses on loans before it fell below that measure. The bank's fourth-quarter net charge-offs were 2.36 percent.

Wells Fargo & Co., which bought Charlotte's Wachovia Corp., would have to reach losses of 6.58 percent, Mutascio said. Its fourth-quarter loan losses were 2.69 percent

Whatever the stress tests measure, they should take a longer-term approach, such as three or four years rather than the traditional 12 months, said RBC Capital Markets analyst Gerard Cassidy. "The banking system can absorb its losses over the next three years," he said. "But if you forced the system to take those losses today, the system would be insolvent. One of the solutions is time."

The Office of the Comptroller of the Currency, the main regulator of national banks like Bank of America and Wells Fargo, tells its examiners to look for red flags such as significant changes in a bank's allowance for losses, large levels of off-balance sheet activity, and growth that varies notably from the budget or strategic plan. It also instructs examiners to look at less-quantifiable characteristics, such as whether the board of directors is knowledgeable and whether employees are skilled to handle new products.

Of course, regulatory tests can't predict everything. Both Wachovia Corp. and Washington Mutual Inc. were considered well-capitalized when they were taken over.