Reviews, 'Stress Tests' May Reveal Deeper Bank Troubles

By DAMIAN PALETTA

WASHINGTON -- The rigorous review the Obama administration plans to conduct across the nation's largest banks as part of its revamped bailout could reveal a troubled network of financial institutions that have been slow to acknowledge bad loans and are struggling to build reserves.

If the condition of many banks is as weak as some analysts predict, regulators could be faced with tough decisions: Do they use federal money to help prop up flailing banks, or do they shut down some firms and limit the cost to taxpayers?

"If they are trying to dig deeper and essentially do some sort of quasi-appraisal of the underlying assets behind the loans, both on commercial and residential real estate, then they are going to see very widespread problems," said Matthew Anderson, a partner at Foresight Analytics in Oakland, Calif., who conducts extensive reviews of troubled banks.

The "stress tests" are mandatory for close to 20 of the country's largest banks, regardless of whether they are seeking additional federal aid. Any of the 8,500 other federally insured financial institutions can voluntarily submit to the review, people familiar with the matter said. It's not clear yet whether the Treasury will use the tests as a condition of granting aid for these smaller banks.

Government officials are saying the tests, in which they try and gauge a bank's condition under the worst case scenario in two years, won't be used to separate banks that survive from those that are liquidated.

"I don't think there is a pass-fail on the stress test," a government official said. "This stress test is not a test for who is insolvent or not."

Rather, government officials say the tests will be used to gauge how much extra capital big banks might need as a buffer to continue lending through the economic downturn. The Treasury Department said Tuesday that it would invest an additional $100 billion and $200 billion into banks on top of the $250 billion it has already said it would put in.

Lawmakers, analysts, and some bankers argue the banking system is worse off than many acknowledge. David Burg, a portfolio manager at Alpine Mutual Funds in Purchase N.Y., said a severe stress test could show that 98% of banks "need a lot more capital."

Regulators are moving aggressively to contain the wobbling banking sector after being accused of moving too slowly in the past year. Thirty-four banks have failed in the past twelve months, a faster pace than any period since the savings and loan crisis. Scores more banks are on the verge of collapse and the FDIC had 171 banks on its "problem" list at the end of the third quarter.

"Essentially what you've got are a set a banks that have not been as transparent as we need to be in terms of what their books look like," President Barack Obama said in an interview with ABC News Tuesday. "And we're gonna have to hold out the Band-aid a little bit and go ahead and just be clear about some of the losses that have been made because until we do that, we're not going to be able to attract private capital into the marketplace."

Regulators said Tuesday the purpose of their new comprehensive reviews and severe "stress tests" is to "clean up and strengthen" the banks they oversee. They said if they find institutions that need more capital that the government will offer funds as a "bridge" to money from private investors.

"We are going to bring together the government agencies with authority over our nation's major banks and initiate a more consistent, realistic, and forward looking assessment about the risk on balance sheets, and we're going to introduce new measures to improve disclosures," Treasury Secretary Timothy Geithner said Tuesday.

The regular exams that banks undergo with state and federal examiners tend to focus on bank's current health. The new uniform reviews will submit their finances to the worst-case scenarios and could create a better way for the government to assess the state of the industry.

The tests could signal a willingness by the Obama administration to extend money to troubled banks, whereas the Bush administration resisted giving money to banks it deemed weren't "viable." For example, National City Corp. was forced to sell itself after regulators argued it wouldn't qualify for federal aid. National City had more than $100 billion in assets and would likely have undergone the government's new stress test.

Some bankers and finance executives were alarmed by the purpose of the stress test, alleging it could cause investors to flee from suspect banks and paint a gloomy picture of the industry's condition.

Other industry officials said the review, if done properly, could reassure the public about the overall health of most banks.

"I think if done right, it can be a positive in terms of perception and confidence," said Ed Yingling, chief executive of the American Bankers Association trade group. "There are so many exaggerated views in the marketplace of the strength of these institutions that assuring the public that a full scale review is taking place could be helpful in terms of confidence."

Mr. Anderson estimated that more than 100 banks will fail this year, while RBC Capital Markets estimated this week that more than 1,000 banks will fail over the next three to five years.

"As a bank regulator, there is a tendency to look at the glass as half empty," said former Comptroller of the Currency Eugene Ludwig, who is now chief executive of Promontory Financial Group. "Can you paint a scenario in many banks in a financial storm where they have too many bad assets and don't have enough capital? Absolutely. Do we have a fundamentally sound, diversified financial system? Yes."

Write to Damian Paletta at damian.paletta@wsj.com