Central View: Why Stress-Test Large Banks?

Julie L. Stackhouse

Earlier this year, Treasury Secretary Timothy Geithner outlined a comprehensive plan to restore stability to our financial system. The plan encompasses several components, including a public/private investment program for legacy loans and securities, a mortgage refinancing program and a Capital Assistance Program (CAP).

The CAP has received significant attention because it serves as a complement to the recently completed "stress- test" of the nation's 19 largest financial organizations. The stress-test is a forward-looking assessment by bank supervisors, intended to ensure that these very large banks remain well-capitalized in the event of a worse-than-expected recession.

So, why was it beneficial to stress-test large banks?

Large-bank lending is of vital importance to the health of the economy. Large corporations redeploy loans from large banks into productive economic resources. Without a healthy financial system, economic growth weakens.

Market concerns over the capital positions of these large organizations have made it impossible for them to raise the capital they need on favorable terms and have led them to pull back from lending. This pullback materially reduces the ability of the financial system overall to perform the critical role of credit origination. A capital buffer increases the likelihood of lending and reduces the risk that problems at a very small number of institutions—through the many linkages across institutions—lead to the failure of otherwise viable institutions.

What happens now that the stress test is complete? By early June, the 10 banking organizations needing to augment their capital buffer were to develop detailed capital plans to be approved by their primary regulators, in consultation with the FDIC. The 10 organizations will have six months to implement the plans. If needed, the Treasury is making capital available under the CAP as a bridge to private capital in the future. The assistance, in the form of mandatory convertible preferred stock, is expensive. CAP securities carry a 9 percent dividend yield. After seven years, the security will automatically convert into common equity if not redeemed or converted before that date.

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