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Updated, May 7, 6:40 p.m. | Federal regulators said on Thursday afternoon that the nation’s 19 largest banks must raise $75 billion in extra capital by November, a verdict more upbeat than the industry had expected.

On Thursday, the government is set to announce the results of the financial stress tests for 19 large banks. Sources have already disclosed what most experts already knew: some of the biggest banks are still short of of money, though they may not be receiving more federal funds.

The stress test was put in place to determine whether the banks can get through the recession and shore up confidence in the federal oversight of the nation’s banks. Has this process achieved these goals? Or, as critics claim, has the process failed to measure the depth of the banks’ problems?

An Insufficient Effort

Yves Smith has written the blog Naked Capitalism since 2006. She has spent more than 25 years in the financial services industry and currently head of Aurora Advisors, a management consulting firm.

In the Opinion section Timothy Geithner: How We Tested the Big Banks

The fact that the stress tests took place at all was an admission of regulatory failure. Financial firms are subject to oversight, most important, of safety and soundness, on an ongoing basis. The notion that a one-shot effort is a substitute for insufficient supervision is spurious.

Given that the minders were badly behind the curve thanks to years of believing that the industry could manage itself prudently, a crash effort to catch up was not a bad idea. But this should have taken place a year ago, when Bear Stearns exposed that no one really knew what was up at these firms. The fact that a bailout package was crafted based on a cursory emergency weekend review of complex trading exposures clearly demonstrated the dangers of ignorance.

These stress tests fell far short of the needed level of review.

But the stress tests fell far short of the needed level of review. First, they were administered by the industry based on scenarios provided by the industry. Most observers found the “adverse” case to be too optimistic. Even worse, banks got to use their own risk models, the same ones that got them into trouble. And there was no independent verification of the quality of the accounting. The number of examiners per bank was well short of what you’d need to probe a single business, much less an entire firm.

Second, the industry got to negotiate the results. This is simply unheard of. That suggests both a lack of confidence in the process and a lack of belief on the part of the key actors (Treasury Secretary Timothy Geithner, in particular) that the government needs to set the parameters and demand compliance.

Not a Real Test at All

William K. Black, an associate professor of economics and law at the University of Missouri-Kansas City, is author of “The Best Way to Rob a Bank Is to Own One.” He served as a senior official for, among other government agencies, the Federal Home Loan Bank Board and the Office of Thrift Supervision.

Leaks claim that the test found that Bank of America needs $33.9 billion in additional capital. The bank reportedly has the highest requirement of any of the banks that were tested. Treasury officials are leaking furiously that the results of the stress tests prove that no large bank is insolvent or even seriously undercapitalized. The stress tests, as predicted (and designed) have found that there is no banking crisis — all is well. Even Bank of America can “raise” the “additional” capital with the stroke of a pen by designating prior aid from the Treasury as “capital.”

Treasury used a ‘one size fits all’ stress test that grossly understated derivatives risk — the primary risk that the largest banks face.

The case of Bank of America illustrates the mysterious nature of the stress tests. Here’s what we’ve been told: the Federal Reserve sent roughly 180 examiners for about eight weeks into the 19 biggest banks. In that time period a team of that size would be able to examine the asset quality of two or three massive banks with plain vanilla assets. You cannot do a meaningful stress test without examining thoroughly each bank’s asset quality. Doing a meaningful stress test takes weeks after completing the asset examination.

It is a particularly complex, individualized process when the assets are financial derivatives because evaluating counter-party risk is exceptionally difficult. We know that Treasury used a “one size fits all” stress test that grossly understated derivatives risk — the primary risk that the largest banks face.

Bottom line: there were no real examinations. Banks continue to overstate asset quality. The bankers pressured Congress, which extorted the Financial Accounting Standards Board, which gutted the accounting rules on loss recognition. Because there were no real examinations, there were no real stress tests. So only one question is key: why does Treasury believe that anyone will believe its compound fiction?

How to Read the Results

Douglas Elliott, a former investment banker, is a fellow in the Initiative on Business and Public Policy at the Brookings Institution.

Regulators have just put the country’s 19 largest banks through a comprehensive “stress test” to estimate their ability to withstand an economy worse than what has been predicted. We will learn two key things when the results are released on Thursday afternoon. First, how much more capital will the regulators require the banks to raise? Second, what does this tell us about how deep the banking crisis will be?

If the need for capital exceeds $200 billion, the system is in trouble.

There have been a number of leaks confirming my previous estimate that the total capital raised will be between $100 and $200 billion (see “Interpreting the Bank Stress Tests”). The banks are being given two numbers, the total capital they need and how much has to be in the form of common stock, the strongest form of capital. The big need will be coming up with more common stock –- most of this can be achieved by converting the government’s preferred shares into common shares. Taxpayers will effectively be going from lenders to partners. We’ll have more risk, but more potential return as well.

A capital need in this expected range will not tell us much about how the regulators really feel. A larger number would require the government to commit taxpayers’ funds that might force an early return to Congress for more money, which both the administration and Congress desperately want to avoid. So if the number exceeds $200 billion, it will mean the regulators truly are worried about the system. If we get a number smaller than $100 billion, it will be a positive sign that things are better than they have looked, since there is political room to go above $100 billion.

Lessons Learned

Simon Johnson is a professor at the M.I.T. Sloan School of Management and co-founder of the global crisis Web site BaselineScenario. He is a senior fellow the Peterson Institute for International Economics and a regular contributor to the Times’s Economix blog.

We’ve learned a great deal from the stress tests, but not perhaps what we hoped to learn.

The tests, of course, were billed as assessing the capital adequacy of major banks, i.e., would banks have enough capital if the recession proves deeper and loan losses larger than the current consensus expectation? But the “stress” scenario used by the government turns out to be a mild and short-lived downturn, so the tests were effectively designed to allow everyone to pass. Actual official outcomes for each bank are the result of complicated closed door negotiations, and at the bank level all we have learned is who has more or less political power.

The handling of the stress tests shows the administration prefers to adopt a “wait and see” policy toward banks.

The big lesson is how the government will treat the financial system. Larry Summers has made it plain that the Obama administration will do what it takes to “support financial intermediation,” and sees this as a “critical node” to ensure an economic recovery. A Goldman Sachs report out this week (and the documents of this firm read increasingly like official policy statements) makes the point clearly — big banks will earn their way back to solvency through exercising their greater market power (Lehman and Bear Stearns are gone), government-subsidized debt (courtesy of the Federal Deposit Insurance Corporation), and various forms of implicit subsidy (through “legacy” loan removal programs).

The handling of the stress tests shows the administration prefers to adopt a “wait and see” policy toward banks. If the economy recovers, this will help the banks get back on their feet. If the economy doesn’t recover, more subsidies for banks will soon be in the mail.

A Far-Too-Public Test

Bert Ely is a banking consultant.

The bank stress tests should never have been launched in such a public manner — they represent a serious public-policy blunder that hopefully will not be repeated. Government banking supervision has always had, or is supposed to have, a forward-looking element to it. Accordingly, banking supervisors are supposed to communicate to a bank the actions it must take to remain well capitalized in the face of current and anticipated economic conditions. Banks are then supposed to take those actions. All of this is done quietly so that market and public confidence in a bank is not rattled as a bank and its government overseers debate what actions a bank must take to remain in good financial condition.

Within a month or two, we may hear cries for another stress test, which will continue to muddy the waters about the banks’ conditions.

The stress tests have been harmful in two regards. First, the Treasury white paper describing the tests was so vague as to undermine the credibility of the tests. Consequently, the stress test results may lack credibility, too, especially if enough investors believe that they paint too rosy a picture of the financial condition of those banks seen as the most troubled.

Second, many view the stress tests as a one-off review of the banks where as banking supervision, of necessity, is a continuous process for the simple reason that conditions within a bank and within the economy are constantly changing. Within a month or two, we may hear fresh cries for another stress test, which will continue to muddy the waters about the conditions of the nation’s largest banks.

Investors and regulators instead should view bank stock prices — specifically the ratio of the market value of a bank’s common equity to the book value of that equity — as a far better and more timely measure of a bank’s financial condition and prospects.

A Nice Melodrama

Alex J. Pollock, a fellow at the American Enterprise Institute, spent 35 years in banking, including 12 years as chief executive of the Federal Home Loan Bank of Chicago.

The stress tests have definitely achieved their principal purpose, which was, as I see it, to show that the Administration had a plan and was doing something: “Our plan is to have stress tests, and we are carrying them out.” A nice drama, or melodrama, ensued, with a problem, the build up of suspense, and a happy ending, as shown by the big rally in relevant bank stock prices as the results were leaked.

Stress tests in general are a perfectly sensible, traditional financial idea: see how some entity fares in a given set of scenarios. Of course, much depends on all the estimates that go into such a test. It is ironic that the tranched subprime mortgage-backed securities that have caused so much trouble for everybody were all given credit ratings by stress tests.

Booms are full of overoptimism, busts of overpessimism. It may be that the stress tests are part of a transition to a helpful, less pessimistic stage.