Did the bank stress tests work?

By David Ellis, staff writer

NEW YORK (CNNMoney.com) -- Stressed might be about the last word used to describe the banking industry these days.

Not only have top lenders staged a dramatic return to profitability, investors appear to be feeling confident again. And even as regional banks grapple with weakened loan demand and concerns about the commercial real estate market, most are flush with capital.

Many argue that's due in no small part to the Obama administration's so-called stress-test program it administered almost one year ago to the nation's 19 largest banks.

Just last week, Comptroller of the Currency John Dugan, one of the regulatory chiefs for the industry, lauded the program, calling it "the most significant and successful policy proposal of the new Administration to address the banking crisis."

But for all its achievements, it may be too early to declare a decisive victory just yet.

For starters, questions still remain as to whether regulators used appropriate economic forecasts to gauge the health of the big banks.

When the report was released last May, some critics charged that the projections were not stressful enough, noting they did not take into account just how quickly the U.S. economy was unraveling.

Now there are doubts as to whether regulators considered just how long the economic recovery might take.

"If you looked at the assumptions being used, it was a two-year time period so they really compressed the credit cycle," said Terry McEvoy, an analyst with Oppenheimer & Co., who tracks some of those 19 banks that were part of the stress-test program, including Atlanta-based SunTrust (STI, Fortune 500).

When regulators first designed the program, the aim was to test how banks' loan portfolios would perform in two different economic environments, including an "adverse" scenario, through the end of 2010.

With the economy showing signs it is on the mend, experts have downplayed the possibility of conditions devolving into a worst-case scenario by year's end. Still, there are concerns that the recovery will move sluggishly through this year and into 2011, particularly when it comes to jobs.

At the end of March, the national unemployment rate stood at 9.7%. Policymakers at the Federal Reserve don't expect the jobless rate to budge much by the end of this year and are predicting that unemployment will still be relatively high at the end of 2011.

That could very well lead to more home foreclosures and an escalation in delinquencies on credit cards and other consumer loans, which tend to track national employment levels.

One upshot of the stress test, McEvoy said, is that lenders have already reserved money for potential losses and have plenty of more capital sitting around - just in case.

In the latest quarter, for example, the nation's top four consumer banks - Bank of America (BAC, Fortune 500), JPMorgan Chase (JPM, Fortune 500), Wells Fargo (WFC, Fortune 500) and Citigroup (C, Fortune 500) - all reported Tier 1 capital ratios, a key measure of a financial institution's ability to absorb losses, well above what regulators deem healthy.

The only problem, however, is that forcing banks to sit on all this cash can be costly to their bottom line, said Pierre Ellis, a senior economist at Decision Economics.

Instead of making loans or investing that money, banks currently have to hold it as they wait for regulators to determine new industry rules on capital levels.

"It is almost certain they will have higher requirements on capital, which tends to reduce profitability," he said.

There is no doubt that the stress test provided some much-needed transparency to investors about the underlying health of many of these firms, at a time when fears about the sector were boiling over.

What the tests did not do however, is help get some of these financial institutions back on the road to profitability.

Several of the smaller regional banks that were included in the program, such as Regions Financial (RF, Fortune 500) and KeyCorp (KEY, Fortune 500), continued to lose money in the first quarter. The consensus among analysts is that these and other regional banks will continue to hemorrhage money through the remainder of the year.

Troubles within their traditional lending businesses are driving much of the losses. But the flood of new shares that banks were forced to issue so much new stock in the wake of the stress-test program isn't helping either.

Having more shares outstanding will also add pressure to their results, at least on a per share basis, said McEvoy. "Like everything good, there is a cost," he said. "This is going to cost them for a while." To top of page

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