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How the banks’ stress tests will work

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BOB MOON: Remember when the bank examiner came calling in “It’s A Wonderful Life?” Multiply that many times over and you’ll get a picture of the intense examination the nation’s top 20 banking powerhouses are about to face under the guise of something called a bank “stress test.” And until the results are clearly established, bank regulators can’t really know for sure what kind of medicine is actually going to be needed. Notice, they signaled today that they have no plans to nationalize banks.

As our Washington Bureau Chief John Dimsdale reports, this close look at the books is the first step in the next phase of the government’s bank rescue plan.

JOHN DIMSDALE: Just like a doctor making your heart race to find the flaws, a financial stress test subjects banks to increasingly dire economic scenarios to discover where the flow of money breaks down.

John Douglas runs the banking practice at the law firm Paul Hastings. He says the regulators will apply hypothetical external shocks to the banks’ assets and liabilities.

JOHN DOUGLAS: What happens at various levels of unemployment or various levels of house price declines? What does that do to the financial situation of the banks?

Running the banks’ operations through their paces also helps regulators identify hidden liabilities like off-shore accounts or over-valued assets, says Jane D’Arista with the Financial Markets Center.

Jane D’Arista: We don’t know a lot, and we need to know a lot more. How much is off-balance-sheet now, relative to the capital that these banks have? And what is on-balance-sheet? Can we get a market to price?

That way, regulators can subtract liabilities from assets to see what the banks are worth. And that gives the government a sense of which banks to support, according to the Milken Institute’s James Barth.

James Barth: Do they seize the institution, put the institution in conservatorship, or liquidate the institution? Or does the Treasury Department say, ‘We’re going to inject capital into this institution or not?’

And potential private investors in banks will also scrutinize the test results, says John Douglas.

DOUGLAS: The more knowledge that the private sector has about the true condition of a bank, the more likely the private sector is to invest. Our banking system will only recover once private capital starts coming back into these institutions in a serious way.

And government regulators say that’s just what they’re aiming for.

In Washington, I’m John Dimsdale for Marketplace.

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