Testing times for Geithner's plans

Some US banks are walking wounded. Some are the living dead. A full 21 months into the credit crisis, investors are still unclear about which banks are which. The banking system cannot function without confidence. So, Tim Geithner, the US Treasury secretary, is fighting chronic uncertainty with transparency. The results of the "stress tests", an exercise to identify undercapitalised banks so the government can make sure they have enough capital to recover, will be announced on Thursday.

Regulators have examined the 19 biggest US banks. They have decided which of them they believe would be healthy - and which would lack sufficient capital to survive - under two different economic scenarios. Since, post-Lehman Brothers, bank bondholders are protected from bearing any losses, institutions with insufficient capital cushions will be forced to raise new equity, whether from private sources or from the public purse.

To make these judgments, the authorities have estimated banks' future income, losses and the cost of bygone mistakes. To do so, they have made a number of contentious assumptions, notably about future macroeconomic conditions. Since the tests were announced in February, the authorities' choice of scenarios has started to look optimistic - especially for unemployment.

These calculations also rely on assumptions about how the financial system's stockpile of complex, illiquid, unpriceable assets will respond in these conditions. Few of these toxic securities were ever traded. Hardly any are bought and sold now. There are no real markets for these assets, so there are no reliable market prices. Indeed, the Treasury believes these anaemic markets are significantly undervaluing the securities and, so, prefers to back out prices from models.

Owing to the uncertainty and the capacity for disagreement at each of these steps, it is crucial that the authorities publish as much fine detail as they can. Unless analysts can follow regulators' calculations, check their views on general asset classes and compare notes on specific balance sheets, worries about modelling assumptions may lead them to disregard the whole exercise. A vague rubber stamp will not be enough; if it undermines confidence in the government's grasp of the crisis, it could even be worse than nothing.

The government is also choosing to judge capital need using a rather old-fashioned measure; the ratio of total common equity to total assets, rather than complex risk-weighted Basel capital measures. Total common equity is a crude metric, but it is what investors currently prefer. That is why it is the right measure for this purpose; TCE has the best chance of persuading investors that large American banks have enough capital to support their massive balance sheets. Restoring their confidence would be an impressive achievement. It would not, however, end the credit crisis.

Banks hold only about one third of the financial sector's outstanding loans. American consumers and businesses have relied heavily on still-frozen non-bank lending flows. Some of Mr Geithner's many other policies aim to revive these markets, but, for now, they remain clogged. If the banks were to expand to fill in for these jammed credit markets, they would need trillions of dollars of further capital against which to lend.

Moreover, clean bills of health for banks would not mean markedly less government control of the financial sector. The Treasury has said banks will be allowed to repay government capital injections - and so escape the onerous terms and conditions attached to them - only if they are able to issue new debt without government guarantees.

Even if the state has no stakes in banks, however, government oversight of the sector will still be necessary. Big US banks are still backed by the government. The state, therefore, has a legitimate role in making sure that these institutions act prudently. Given the banks' macroeconomic importance, the state must also make sure they do not act in a manner which would hurt the public interest, such as rapid, widespread deleveraging.

By the end of Thursday, the US will have revealed a great deal more about its banks than any other country. Even if investors are not convinced, applying a single standard to all banks and publishing detailed results will provide the market with useful information.

This is all in striking contrast to Europe's reluctance to act. According to the International Monetary Fund, the US banks have another $550bn of writedowns to come; the equivalent figure for the eurozone and UK is $950bn. The real information gap lies not in Mr Geithner's stress tests, but in Europe's unwillingness to match them.

Copyright: The Financial Times Limited 2009