WASHINGTON — The Treasury Department announced details Wednesday of how it and federal regulators plan to do stress tests of the 19 largest banks to determine whether they have enough capital to survive a severe recession.
Regulators are to examine banks with more than $100 billion of assets under two scenarios: a baseline reflecting consensus expectations and a more adverse scenario. Both would specifically project gross domestic product growth, the unemployment rate, and changes in housing prices.
The Capital Assistance Program, or CAP, "is designed to ensure that major U.S. banking organizations have sufficient capital to perform their critical role in our financial system on an ongoing basis and can support economic recovery, even in more severe economic environments," the bank regulators said in a statement.
Under the more adverse scenario, the test is to assume a GDP of negative 3.3% in 2009 and a gain of 0.5% in 2010; it will test an unemployment rate of 8.9% in 2009 and 10.3% in 2010; and it will assume house price declines of 22% in 2009 and 7% in 2010.
After the tests, which the Treasury said it expects to complete by the end of April, regulators will determine whether a bank needs more capital. If it does, the bank will have six months to raise it in the private sector or opt for access to capital from the Treasury. The tests will be done by interagency teams to ensure consistency.
The new capital will be in the form of convertible preferred securities that can be converted to common stock at a 10% discount to the Feb. 9 market price. The securities would carry a 9% dividend yield and be convertible after approval of an institution's primary federal regulator.
The stock would automatically convert into common equity if it is not redeemed or converted after seven years.
Treasury said banks that have already received funds from the Capital Purchase Program begun last October are eligible to apply for more funds through CAP. Existing preferred shares may also be changed to convertible shares.
Banks applying for government funds will have to explain how they intend to use the capital "to preserve and strengthen their lending capacity — specifically, to increase lending above levels relative to what would have been possible without government support."
The Treasury said it would make these plans public.
Recipients will also be subject to restrictions on paying common stock quarterly dividends, repurchasing shares, and pursuing cash acquisitions.
V. Gerard Comizio, a partner in the corporate department at Paul, Hastings, Janofsky & Walker LLP, questioned whether private investors would come to a bank's aid if the government has deemed it to have "failed" a stress test.
"The real story here is how the government will sell the private investor market to invest in undercapitalized banks," Mr. Comizio said. "If the primary issue is a bank's need for a 'capital buffer' under the stress test and no private-sector capital steps up, why use real taxpayer money to strengthen the buffer, versus a government guarantee or certificate promising to add to the buffer, if needed?"
A senior government official speaking on condition of anonymity dismissed the idea that the test was pass/fail.
"It is one tool the examiners will use to understand the risks of a firm's activities, its balance sheets, its commitment[s]," the official said. "The assessment is going to include risk far greater than what is represented — far greater, meaning more expansive, not deeper, but more expansive than what the template would suggest."
The official said the Treasury will not publish the test results.
Under the tests, regulators will consider the inherent risks of an institution's exposures and business activities, the quality of the balance sheet assets, off-balance-sheet commitments, earnings projections, expectations regarding economic conditions, and the composition and quality of its capital.
Treasury declined to answer how much money would be invested through the CAP but said there would be no cap on the funds available.
President Obama said in a speech Tuesday night that the $700 billion already allocated to the Troubled Asset Relief Program is unlikely to be sufficient to accomplish all of its goals.