Q&A: Bank stress tests

Extra money will allow banks to cope with any further losses

Tests designed to measure the health of 19 of the biggest US banks have revealed that 10 need a combined $74.6bn (£50bn) of extra funds to boost their reserves.

Banks are now scrambling to raise the extra funds but, broadly speaking, the test results suggested that the US banking industry was in better shape than many had feared.

The process was not without controversy.

What happens to the banks that failed the tests?

By 8 June, they must give regulators their plans for raising the money, and raise it by November.

THE 10 THAT NEED MORE CAPITAL Bank of America - $33.9bn Wells Fargo - $13.7bn GMAC - $11.5bn Citigroup - $5.5bn Morgan Stanley - $1.8bn Regions Financial - $2.5bn SunTrust Banks - $2.2bn KeyCorp - $1.8bn Fifth Third Bancorp - $1.1bn PNC Financial Services - $600m

Bank of America is the most at risk, needing an additional $33.9bn. It plans to issue shares and sell some assets to cover the shortfall.

Wells Fargo and Morgan Stanley have both announced plans for a stock offering.

Private investors may well be reluctant to pump new money into "failed" banks.

"No one should want to own shares in a bank with even the prospect of partial government ownership," said Pofessor Peter Morici from the Robert H Smith School of Business at University of Maryland

Treasury Secretary Timothy Geithner said that if banks were unable to raise funds from private sources, the government would step in with public money as a last resort.

But regulators predicted that this would be unnecessary.

Why were the "stress tests" needed?

The point of the tests, which were carried out by the US Federal Reserve, was to find out which banks, if any, might require more cash reserves in the event of the economic outlook worsening.

Under the worst-case scenario - a 2010 unemployment rate of 10.3%, an economic contraction of 3.3% and a 22% further decline in house prices - banks could see a further $600bn in losses, the central bank concluded.

The results have been more upbeat that many in the industry had expected.

When the tests were first announced in February, there were fears that they might show that some banks needed to be nationalised.

Were the tests robust enough?

Some commentators have questioned whether the tests have been strict enough.

Some analysts have questioned whether tests were strict enough

They say the worst-case assumptions the banks' books were subjected to were not much different to the current economic situation. Unemployment hit 8.5% in April and could top 9% in May.

Critics, including the investor Warren Buffett, also said the tests did not take into account the different business models used by lenders.

The tests were based on a one-size-fits-all mathematical model that made automatic assumptions and as such the results are open to interpretation, they said.

What factors did the tests look at?

The Federal Reserve's criteria for the tests set out its baseline forecasts for economic growth and "worst case" scenarios.

Banks were expected to show they had enough cash reserves to cope with both the current forecasts and a "worst case" outcome.

The Fed forecasts a fall in GDP of 2% this year and growth of 2.1% next year.

However, banks also had to show they could withstand a 3.3% drop in GDP in 2009 and growth of only 0.5% in 2010.

Supervisors took into account factors such as the quality of a bank's assets, its projected earnings, risks of the institution's exposures, and the composition and quality of its capital.

So, for example, they might ask how many of a bank's home loans would go bad if interest rates rose by 1%.

Who was being tested?

The tests were carried out at 19 of the largest financial institutions in the US - those with assets of over $100bn (£66bn).

These institutions represent about two-thirds of all assets held by US banks.

Regulators have said they will not allow any of the 19 firms to fail because it would be too dangerous for the financial system.

The banks that do not require extra funds are Goldman Sachs, JPMorgan Chase, Bank of New York Mellon, MetLife, American Express, State Street, BB&T, US Bancorp and Capital One Financial.

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