Last updated: February 21, 2009 12:17 am

Stress tests to map future for ailing banks

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Partial nationalisation or full nationalisation could be the only options left for the Obama administration as it decides what to do with banks such as Citigroup that have been worst hit by the credit crisis and collapsing confidence in bank stocks.

Next week the authorities will conduct stress tests that will show how large the capital hole would be at each bank in different scenarios.

Armed with this information, the US authorities must decide whether to support all of these banks as going concerns in the private markets or push some of them into the Federal Deposit Insurance Corporation.

In recent days the idea of nationalising the weakest banks through the FDIC gained momentum, with Alan Greenspan, the former Federal Reserve chairman, Lindsey Graham, the Republican senator, and others coming out in favour.

But the Obama administration pushed back on Friday against the idea that this was inevitable. A Treasury spokesman said: “We will preserve a financial system that is owned and managed by the private sector.”

Wherever possible, the administration plans to support banks in the private markets by providing contingent capital that converts into equity as needed.

The problem is the weakest banks need more equity now. While the government could take instruments that convey equity-like risks without equity-like rights, that would be politically risky. So the choice may be between taking stakes in these banks, which amounts to partial nationalisation, and FDIC control, which amounts to full nationalisation on a temporary basis.

The strategic approach is under pressure from the market. The further shares in the weakest banks fall, the less attractive it is to support them in private markets.

Already stress tests will have to be completed before a toxic asset purchase programme is set up. In an ideal world the sequencing would be the other way round, since the purchase plan is intended to give information on the value of those assets.

Instead, regulators will value assets in trading books based on marks to current market prices. They will try roughly to harmonise the way different banks value these assets.

The stress tests will focus on loan books that are not marked to market, with regulators sizing potential losses beyond the normal 12-month horizon.

Senior policymakers have different expectations of what the exercise will reveal and it is not clear they have resolved how to treat the most vulnerable banks.

In the case of full nationalisation the authorities would use special powers to stand behind whatever liabilities it chose. There would be no funding risk and it would be easier to separate a “good bank” from a “bad bank”, since the government would not have to worry about the price at which toxic assets were transferred.

But full nationalisation of one bank could destabilise others. With global banks such as Citigroup, policymakers would have to be confident that their actions would not trigger disorderly seizures in other jurisdictions.

Rodgin Cohen, chairman of law firm Sullivan and Cromwell, said nationalisation could have international repercussions. If there were no way round this, the authorities might have to support complex international banks as going concerns in private markets – taking equity stakes as needed.

The choice has important consequences for bondholders. Partial nationalisation implies no loss to them. Full nationalisation via the FDIC leaves that open, though officials are wary of inflicting losses on debtholders.

Citigroup is seen as the test case. If it is supported in the private markets, all other systemically important banks will probably be too.

If it is pushed into the FDIC, the question will be which other banks will be as well – with Bank of America seen as next on the list. Even partial nationalisation may not be a soft touch. Existing shareholders would face huge dilution.

Moreover, the government as controlling shareholder, in conjunction with regulators, could force a bank to break itself up and sell off its assets.

Additional reporting by Julie MacIntosh

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