WASHINGTON -The Treasury Department issued a blueprint yesterday for administering "stress tests" for large banks to assess their ability to withstand a more severe economic downturn and said it was giving them immediate access to additional money from the government's $700 billion financial rescue program.
At the White House, President Barack Obama later called for stronger regulation of the financial sector, unveiling principles that will guide development of new rules for banks during the next four weeks.
The president revealed the principles after meeting with Treasury Secretary Timothy F. Geithner and members of the House and Senate finance committees.
"While free markets are the key to our progress, they do not give us free license to take whatever we can get, however we can get it," Obama said.
In releasing the terms of its Capital Assistance Program, an initiative that includes the stress tests, the Treasury said the new support will be provided through government purchases of preferred shares of bank stock that can be converted into common shares at a 10 percent discount from the price prevailing before Feb. 9. This change in the rescue program is aimed at giving financial markets greater confidence, since common shares carry more weight in calculating a bank's capital than preferred shares, which many investors regard as loans that must be repaid.
The preferred shares will carry a 9 percent dividend and be convertible at the bank's option, subject to approval from federal regulators.
After seven years, the shares would automatically convert into common shares if not redeemed or converted before that date, Treasury said. It said the program is designed to provide incentives for banks to replace federally provided capital with private capital or to redeem the government capital when conditions permit.
Banks receiving government capital will be subject to federal limits on executive compensation, Treasury said. In their applications, it said, "banks must submit a plan for how they intend to use this capital to preserve and strengthen their lending capacity," and Treasury will make these plans public when the banks receive the money.
The purpose of the Capital Assistance Program "is to restore confidence throughout the financial system that the nation's largest banking institutions have a sufficient capital cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers," Treasury said in yesterday's announcement.
"By reassuring investors, creditors and counterparties of banking institutions - as well as the institutions themselves - that banks have capital in a sufficient amount and quality to withstand even a considerably weaker-than-expected economic environment, the CAP instrument should improve confidence and increase the willingness of banking institutions to lend."
Under the program, federal banking regulators will conduct stress tests to evaluate the capital needs of major U.S. banks under worst-case scenarios that assume depression-like conditions, such as much higher unemployment rates and a further plunge in home prices.
If the tests indicate that "an additional capital buffer is warranted," banks will have an opportunity to first seek private sources of capital, Treasury said. It added: "In light of the current challenging market environment, the Treasury is making government capital available immediately through the CAP to eligible banking institutions to provide this buffer."
Eligible U.S. banks with more than $100 billion in consolidated assets are required to participate in the stress tests and may tap the funding "immediately as a means to establish any necessary additional buffer," Treasury said. It said eligible banks with consolidated assets below $100 billion "may also obtain capital from the CAP."
Companies that need government money will be required to issue preferred shares that pay the government a regular dividend, basically the same terms on which the government has invested almost $200 billion in more than 400 banks since November. The key difference is that the preferred shares can be replaced with common shares.
The change is critical because of the accounting rules that govern what kinds of money banks can count as capital. The basic rule is that capital is money a bank never needs to repay. The most basic form of capital is money raised by selling common shares.
Many investors do not regard preferred shares as capital because the dividend on those shares rises sharply after five years, encouraging repayment.