Today, the government released the results of the stress tests performed on the nation’s 19 largest banks. Thanks to a series of leaks, we already knew that the not-very-stressful tests resulted in large-but-not-catastrophic capital holes for the banks to fill. Bank of America leads the pack — needing to raise $34 billion — but most banks need to raise far less, if any.
However, one interesting aspect of the announcement is how the government plans to help the banks raise the capital that they need. While the banks will presumably do their best to go out and raise capital from private investors, if they can’t, they will have the option of converting the shares that the government bought with the initial round of TARP into a new financial instrument:
This new instrument, called a “mandatory convertible preferred” share, gives banks the ability to create common equity as needed. The preferred shares convert to common shares when a bank or its regulator decides they should.
This means that the banks can convert government debt into equity if they hit a rough patch and the need arises. But as Robert Reich pointed out, “by this sleight-of-hand, the public takes on more risk,” moving from a preferred creditor to a common shareholder.
But more importantly, this whole song-and-dance means that the banks are still operating with a government guarantee, but without government control. They can go out and try to raise money, and investors know that the government is going to cover them if things go badly. The plan assures that the banks will remain alive, no matter how troubled, because Treasury will always swoop in to save the day. As James Kwak and Simon Johnson put it:
In the end, when a financial system is dominated by banks that are too big to fail – and they do fail – the only options are an FDIC-style takeover or the kind of public-private co-dependency that we see today. As far as the current crisis is concerned, the die is cast and the big banks won.