The Office of the Comptroller of the Currency and other regulators recently issued a request for comments on “Proposed Guidance on Stress Testing for Banking Organizations with More than $10 Billion in Total Consolidated Assets.” My firm and many others will be responding to the informational request, but the initiative is more than a little surreal. Stress levels at the large banks included in the stress test exercise remain high by historical standards, as shown by this chart of gross charge-offs for the large bank peer group and Citigroup.

You will notice that loan default rates for the largest US banks fell sharply in the first quarter of the year, fueling hopes for a rebound in bank earnings and dividends. The majority of people who own bank stocks select them as income producing assets, not vehicles for desperately seeking alpha in terms of market price gains. Thus stability in bank earnings is a crucial issue in terms of the cash flow paid each quarter to share holders.

Federa Reserve Board governor Daniel Tarullo has recently indicated that the largest banks may be required to hold more capital to protect the global financial system from the risk of failure. Higher capital means less leverage, less lending, and lower earnings and dividends, hardly a prescription for fueling an economic boom. Individual and corporate savers are transferring hundreds of billions per year to the banking sector, yet solvency issues still remain unresolved.

Yet even as Tarullo and his colleagues in the US and other industrial nations talk about capital adequacy, the global financial system and the largest banks remain faced with more basic issues of excessive debt. The situation in Europe with Greece, Ireland and other supposedly “peripheral” states facing default is the current focus of market attention.

Governor Tarullo and his counterparts at the European Central Bank have been trying for months now to guide the financial markets into some type of controlled crash landing, but with fanciful goal of avoiding default on the debt of banks and the states themselves. Many EU banks are now state-backed, explicitly or implicitly, so the distinction between public and private is now relatively moot.

But the sad fact is that the EU states do not have the money to fudge the issue any longer. Though discussion contunues about a “voluntary” debt exchange with respect to Greece, that seems like a very ambitious goal. A more likely scenario is that Greece and Ireland will eventually, poilitically, be forced into a default and formal debt negotiations a la Latin America in the 1980s. Banks in the EU and around the world will then need to write-down Greek, Irish and other exposures.

In the event, many of the banks of the supposed “core” EU states will need to be restructured, again, and once more the issue of funding raises questions about how all of the necessary restructuring will be financed. One of the reasons for the AIG bailout, let us not forget, was avoiding another capital hit for the large French and German banks which are marginally solvent looking at the data from the IMF.

US banks will also face losses in the event of a Greek default, both in terms of direct exposures visible in SEC filings and regulatory reports, and indirect idiosyncratic exposures that flow through counterparties and customers. The top several US banks have reportedly written credit default swap protection on approximately one-half the total outstanding debt of all PIIGs nations combined, a total many times their capital.

As and when the situation in Europe ripens, the issue for the Fed and other regulators will no longer be capital adequacy and stress testing, but solvency. Add to Tarullo’s worry list the procession of operational issues and expenses related to the US housing sector and economy still bearing down on the largest US banks. For example, the largest US banks still face some $200 billion in securities violations related to mortgage securities that have survived the legal preliminaries and are now headed for trial.

The bad news is that the latest volatility hitting the markets with respect to Greece is only the start of a period of renewed volatility in the global markets related to debt and deflation. The good news is that this latest period of market disturnbance may what is needed to force political leaders and their agents in the regulatory community to start the process of restructuring the largest US banks in earnest.

I have long advocated a strategy of turning debt into equity in the large zombie banks on both sides of the Atlantic to speed the restrucuring process. The politically powerful holders of this debt, represented by by the likes of PIMCO and BlackRock, have so far avoided the reckoning. But default events in Greece, Ireland or elsewhere during the balance of 2011 are likely to end the great pretense that the issue is capital adequacy and refocus us once again on the reality that restoring solvency is the road to economic recovery.