How the recession tested the big banks

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By Timothy Geithner (China Daily)
Updated: 2009-05-08 07:51

Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Federal Reserve announced on Wednesday the results of an unprecedented review of the capital position of the nation's largest banks.

This is an important step forward in President Barack Obama's program to help repair the financial system, restore the flow of credit and put our nation on the path to economic recovery.

The president came into office facing a deep recession and a damaged financial system. Credits had dried up, forcing businesses to lay off workers and defer investment. Families were finding it difficult to borrow to finance a new house, buy a car or pay for college tuition. Without action to restore lending, we faced the prospect of a much deeper and longer recession.

Obama confronted these problems with dramatic action to address the housing crisis and to restart credit markets that are responsible for roughly half of all business and consumer lending. The administration also initiated a program to provide a market for legacy loans and securities to help cleanse bank balance sheets. These programs are helping repair lending channels that do not rely on banks, and will contribute to fixing the banking system itself.

However, the banking system has also needed a more direct and forceful response. Actions by Congress and the Bush administration last autumn helped bring tentative stability. But when Obama was sworn into office in January, confidence in America's banking system remained low.

Because of concerns about future losses, and the limited transparency of balance sheets, banks were unable to raise equity and found it difficult to borrow without government guarantees. And they were pulling back on lending to protect themselves against the possibility of a worsening recession. As a result, the economy was deprived of credit, and caused severe damage to confidence and slowed economic activity.

We could have left this problem as we found it and hoped that, over time, banks would earn their way out of the mistakes they had made. Instead, we chose a strategy to lift the fog of uncertainty over bank balance sheets and to help ensure that the major banks, individually and collectively, had the capital to continue lending even in a worse than expected recession.

We brought together bank supervisors to undertake an exceptional assessment of the strength of our nation's 19 largest banks. The object was to estimate potential future losses, and ensure that banks had enough capital to keep lending even in the face of a deeper recession.

Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.

The Federal Reserve marshaled hundreds of supervisors to spend 45 days rigorously reviewing the banks' detailed loan data. They applied exacting estimates of potential losses over two years, along with conservative estimates of potential earnings over the same period, and compared them with existing reserves and capital.

The results were then evaluated against strict minimum capital standards, in terms of both overall capital and tangible common equity.

The effect of this capital assessment will be to help replace uncertainty with transparency. It will provide greater clarity about the resources major banks have to absorb future losses. It will also bring more private capital into the financial system, increasing the capacity for future lending; allow investors to differentiate more clearly among banks; and ultimately make it easier for banks to raise enough private capital to repay the money they have already received from the government.

The test results will indicate that some banks need to raise additional capital to provide a stronger foundation of resources over and above their current capital ratios. These banks have a range of options to raise capital over six months, including new common equity offerings and the conversion of other forms of capital into common equity. As part of this process, banks will continue to restructure, selling non-core businesses to raise capital. Indeed, we have already seen banks, spurred on by the stress test, take significant steps in the first quarter to raise capital, sell assets and strengthen their capital positions. Over time, our financial system should emerge stronger and less prone to excess.

Banks will also have the opportunity to request additional capital from the government through Treasury's Capital Assistance Program. Treasury is providing this backstop so that markets can have confidence that we will maintain sufficient capital in the financial system. For institutions in which the federal government becomes a common shareholder, we will seek to maximize value for taxpayers and enable these companies to attract private capital, thereby reducing government ownership as quickly as possible.

Some banks will be able to begin returning capital to the government, provided they demonstrate that they can finance themselves without Federal Deposit Insurance Corporation guarantees. In fact, we expect banks to repay more than the $25 billion initially estimated. This will free up resources to help support community banks, encourage small-business lending and help repair and restart the securities markets.

This crisis built up over years, and the financial system needs more time to adjust. But the president's program, alongside actions by the Federal Reserve and the FDIC, is already helping to bring down credit risk premiums. Mortgage interest rates are at historic lows, putting more money in the hands of homeowners and helping slow the decline in housing prices. Companies are finding it easier to issue new debt to finance investment. The cost of borrowing for municipal governments has fallen significantly. Issuance of securities backed by consumer and auto loans is increasing, and the interest rates on these securities are falling. The Federal Reserve reports that credit terms are now starting to ease a bit.

This is just a beginning, however. Our work is far from over. The cost of credit remains exceptionally high, and businesses and families across the country are still finding it too hard to borrow to meet their needs. We are continuing to execute our programs to relieve the burden of legacy assets, help small businesses and community banks, and tackle the mortgage and foreclosure crisis. The ultimate purpose of these programs is to ensure that the financial system supports rather than impedes economic recovery.

We have not reached the end of the recession or the financial crisis, but the bank stress tests should advance the process of repairing our financial system and provide a better foundation for recovery.

The author is the US secretary of the Treasury. New York Times Syndicate

(China Daily 05/08/2009 page9)