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Q&A: What's at stake in U.S. bank stress tests

WASHINGTON (Reuters) - U.S. bank regulators are due to release on Thursday the results of “stress tests” of how 19 of the largest U.S. banks would withstand a sharp economic downturn.

The tests seek to give a view of the banks’ health and restore investor confidence that has been seriously dented by the worst financial crisis since the Great Depression.

Here are some questions and answers about the tests:

WHY ARE THE TESTS HAPPENING AND HOW DO THEY WORK?

They are a cornerstone of the Obama administration’s plan to stabilize the U.S. banking system after a credit crunch caused by a surge in mortgage delinquencies.

Authorities hope to show investors that banks have enough capital to withstand a hypothetical deep dive in the economy or that they are buffering financial reserves sufficiently.

Regulators have looked at losses that banks would suffer across a range of assets if unemployment spiked to 10.3 percent, the economy shrank as much as 3.3 percent over a full year and house prices fell 22 percent. Critics say those scenarios are too mild, given the depth of the recession.

Regulators have also determined what capital cushion the banks would need to survive those hypothetical losses and stay financially healthy.

WHAT HAPPENS TO A BANK FOUND SHORT OF CAPITAL?

Banks falling short in the tests may receive help by the government taking equity stakes and gaining convertible preferred shares and warrants in return.

But lenders will be pushed first to try to raise private capital on their own. They may also sell assets and convert existing preferred shares to common equity. Banks will be given six months to hit their capital targets.

Some banks may already have recapitalization plans in place when the results of the stress tests are announced.

The government has about $130 billion left of a $700 billion bank rescue fund approved by Congress last year. It would struggle to get a green light to spend more, given public opposition to the idea of bailing out Wall Street.

About half the 19 banks subjected to the tests are expected to need more capital but those new financing needs will be manageable, a source familiar with the talks told Reuters.

News reports have said Citigroup and Bank of America, two of the banks seen needing most capital, may need around $10 billion each as a result of the stress tests.

WILL THE GOVERNMENT END UP OWNING MORE OF THE BANKS?

It depends in part on the economy and on financial markets. The government has said financial stability is its priority but that its preference is that any banks that need to recapitalize do so with private capital.

If the economy suffers another setback, persuading investors to buy shares in banks will be much harder.

Some analysts worry that by drawing public attention to hypothetically thin capital levels at banks, the government is creating conditions for investors to sell the shares.

WILL INVESTORS BELIEVE THE TESTS HAVE REALLY GOTTEN TO THE

BOTTOM OF THE BANKING SECTOR’S PROBLEMS?

That is the goal of the tests. If nothing else, the tests will provide greater transparency about risk exposure at banks. In normal circumstances, bank exams are kept confidential to prevent any vulnerabilities from spooking investors, so some analysts worry that the stress test process could backfire.

WHAT IS AT STAKE FOR THE OBAMA ADMINISTRATION?

The stress tests are central to President Barack Obama’s efforts to right the financial system and the economy, the issue that has dominated his presidency so far.

Also at stake is the credibility of U.S. Treasury Secretary Timothy Geithner who faced questions about his suitability for the job in early 2009 as he tried to come up with the details of his plan to tackle the crisis in the banking sector.

The tests could provide an exit strategy for the government’s involvement in banks, a goal of the administration which has rejected calls to nationalize lenders.

HOW DO THE STRESS TESTS DIFFER FROM NORMAL BANK TESTS?

They differ in that regulators are examining 19 banks simultaneously, by the same standards, and subjecting them to the same hypothetical worst-case scenarios and projecting losses for a range of assets.

Another difference is that the government plans to make public part or all of the results. Supervision results are usually shared only with individual banks.

HOW ARE FINANCIAL MARKETS LIKELY TO REACT?

The test results could rattle markets. An announcement that a bank needs to raise more capital could make that task difficult by scaring away private investors who might fear a last-resort government rescue that would dilute its shares.

However, many believe that markets have already priced in the need for some firms to raise additional capital, which could trigger a relief rally once the process is complete.

Bank shares were battered on worries that the government might resort to nationalization but they have rallied sharply on hopes that Geithner’s plan will work.

Since early March, the KBW index of bank stocks has almost doubled although it is still down about 18 percent since January 1.

Reporting by Mark Felsenthal; Editing by James Dalgleish

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