And now comes the ‘stress test’

NORTH BAY – The Capital Assistance Program, part of the new recently passed stimulus package rolled out Feb. 25, is designed to ensure that United States banking institutions are adequately capitalized via a so-called “stress test.”

Under this new program, according to a statement issued by the overseeing entities – the Treasury, the Federal Reserve Board, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Office of Thrift Supervision – the capital needs of the major banking institutions will be evaluated under a the scenario of a more challenging economic environment.

“A strong, resilient financial system is necessary to facilitate a broad and sustainable economic recovery. The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses,” the statement read.

Dr. Robert Eyler, chairman of the Department of Economics at Sonoma State University and director of the Center of Regional Economic Analysis, said this is the government’s way of quasi-nationalizing the banking system without going full force.

“I don’t think there will be full nationalization of the banking system,” he said. “It would take too much to get it going and too much to reverse it when the economy is stabilized.”

The CAP, unlike the Capital Purchase Program, is required by the Fed for any bank with more than $100 billion in assets. The 19 holding companies that fall into that category hold roughly 80 percent of the capital in the country, according to Dr. Eyler.

If they are found to have bad assets, they will be required to sell the shares to the Treasury.

It is not just the big banks either, he said. Local community banks eventually will be subject to the stress test and are getting ready to have their balance sheets looked at, according to Dr. Eyler.

One of the problems he sees in the program is that banks that have made mistakes will receive funds while banks that have balance sheets that are fine will go through a lot of work for no benefit.

There are several steps to the program. There is the stress test, the creation of a public-private investment fund and the purchasing of those assets by individual investors and investment banks.

The stress test will make all banks give over their balance sheets to the multiple agencies involved who will go over the financials with a template designed to show where the weaknesses are in the banks.

There will then be a decision by the governing agencies as to how many shares will be needed to be purchased, thus giving the banks enough capital to stabilize them.

The capital investments made by Treasury will be placed in a separate entity set up to manage the government’s investments in United States financial institutions.

This will form a public-private partnership where private investors can opt in to buy the shares, which will take the burden off the taxpayers. Doing this, the governing entities said, will allow financial institutions to be able to reduce balance sheet risk, support new lending and help improve overall market functioning.

The program will provide up to $500 billion now with the possibility of expanding up to $1 trillion over time, depending on how many banks need the assistance.

The shares will be in the form of mandatory convertible preferred stock, which would be converted into common equity shares when needed to keep banks in a well-capitalized position. They will be able to be retired under improved financial conditions before the conversion becomes mandatory.

Banks that participated in the Troubled Asset Relief Program will also be allowed to convert the preferred shares into common shares, according to this program. That will allow institutions to maintain or enhance the quality of their capital, the statement said.

The intention is not to imply a new capital standard but to provide relief for possible future losses.