U.S. Regulatory Troika Provides Results of "Stress Tests" for Banks

The adverse economic scenario used to calibrate the stress tests was credible, as it is moderately worse than the IHS Global Insight May baseline scenario, which projects a contraction in real GDP of 3.1% in 2009, followed by slow growth of close to 1.5% in 2010.

The estimated additional capital requirement for the 19 banks in aggregate was $185 billion at the end of 2008, but substantial action was already taken in first-quarter 2009 to bolster capital positions. Only 10 banks will be required to raise $75 billion in common equity capital over the next six months, while nine banks passed the tests without any additional capital requirements.

The largest capital requirements by institution include: Bank of America, $33.9 billion; Wells Fargo Bank, $13.7 billion; GMAC, $11.5 billion; and Citigroup, $5.5 billion. Several regional banks will be required to raise additional capital ranging from $0.6 billion for PNC to $2.5 billion for Region's Bank.

Banks needing to add to their capital buffers will be required to develop a detailed plan over the next 30 days, and will have to implement that plan within six months. Banks will be encouraged to source additional capital from private sources, including sales of assets, restrictions on dividends, and restructuring current capital instruments (i.e., converting preferred shares into common shares).

The additional capital requirements specified are not particularly burdensome—the 10 banks involved should not have major difficulties raising the capital required, and the conversion of the Treasury's holdings of preferred shares to common shares can be used as a backstop. The 19 firms involved in this review have U.S. Treasury preferred equity securities of $216 billion.

While improving bank earnings, plus less downward pressure on the overall economy, has taken pressure off the banking system and alleviated concerns about solvency of major institutions and the U.S. financial system as a whole, credit markets remain under severe pressure and bank credit in the U.S. financial system declined by nearly $50 billion in first-quarter 2009. Despite all the pump-priming of the Federal Reserve, the credit system is still failing.

Thus, while the "stress tests" reveal a better-than-expected picture of the present and future capitalization of the banking system, and a path for greater financial stability in the future, credit markets are a heck of a long way from functioning normally and in a manner that would be constructive for economic recovery.

This implies that the Federal Reserve will need to maintain maximum forward thrust on monetary policy and its various balance-sheet programs for several more quarters in order to nurse the credit markets back to a recovery mode.