When doctors want to know how heart patients are faring, they put them through stress tests, forcing them to perform strenuous exercise to see how well their cardiovascular systems stand up.
The Obama administration wants to do something similar to understand how to fix the nation's ailing banks.
Administration officials say they plan stress tests for banks with assets exceeding $100 billion — the 20 or so biggest U.S. financial institutions. Details will be released on Wednesday.
In the financial services business, stress tests are a widely used method of figuring out how strong a bank's balance sheet is — essentially using computer models based on historical data to judge how it would withstand various hypothetical situations.
The process is sometimes called "shocking" its books. How would a bank's loan portfolio fare if the growth rate fell as low as it was in 1991, or 1930? How would its deposit base do if unemployment rose to where it was in 1982?
"The stress test is designed to answer the question, 'How much worse would things get if the economy continues to deteriorate?' and, therefore, 'How much capital should the banks be required to hold to protect against that adverse outcome?' " says Albert Kyle, professor of finance at the University of Maryland.
Failure To 'Shock' Enough
But in recent years, many banks and their regulators have neglected to perform the tests or failed to consider what would happen if things got really bad, says Karen Shaw Petrou, managing director of Federal Financial Analytics. That's one big reason why so many banks were unprepared for the mortgage downturn, she says.
"No one saw this coming, because the stress testing was best-case. That's not a stress test," Petrou says.
The tests that the administration wants to perform will be much stricter than those given in the past and will look at a much broader range of hypothetical stresses, according to an administration official who spoke on condition of anonymity.
A Bigger Role For Taxpayers?
Those banks that fail the tests will have to seek new capital, either by raising it in the public markets — something that's all but impossible these days — or turning to the federal government for help, the official said. As a result, taxpayers could end up with a bigger share of troubled institutions such as Citigroup and Bank of America.
Kyle sees the tests as more of a political gesture than anything else. Stress tests are a valuable analytical tool for banks and regulators, but given how far bank stocks have fallen lately, he says, it's probably too late now for the tests to do much good.
"The markets have been delivering this message now for a couple of years, and regulators have been very slow to force banks to raise more capital — so slow that it's kind of too late," Kyle says.
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