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Tickers in this Article: WFC, NTRS, COF, FITB
The latest plan to save the financial system is a thoughtful attempt, but it may have the unanticipated side effect of increased market volatility in the short-term, as investors flee the banks that perform poorly in the government-sponsored stress tests.

The Obama Administration's Capital Assistance Program (CAP) is comprised of two parts aimed to assess the health of the largest U.S. banks and then to establish a new round of capital for those banks, if needed.

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The new plan reportedly will rely on a less commonly used financial ratio called the tangible common equity (TCE) ratio to measure the financial strength of the banks. TCE is calculated by dividing a bank's tangible common equity by its assets. A bank's common equity and asset information can be attained easily from reports filed with the government by the bank.

Stress Test
Assessing a bank's strength will help simulate the effect on profitability and capital that will occur under different economic scenarios over the next two years. If the assessment indicates that more capital will be needed, a bank can apply to receive more capital under CAP or it can raise it privately. The government is offering capital as a preferred security that is convertible into common equity, which will count in the numerator of the TCE. (These securities offer an answer for investors who want the profit potential of stocks, but not the risk. Learn more in Introduction To Convertible Preferred Shares.)

Under CAP, banks that already received capital from the government under the Bush Administration as a part of the first round can convert it into the new, preferred security being offered.

Tangible Common Equity
We won't know the results of the assessment for several weeks, but we can look at the TCE ratios of the largest banks as of the end of 2008.

At 8.8%, Capital One Financial (NYSE:COF) has one of the highest ratios. However, its current TCE ratio is down from the 10% reported by the company just three months earlier. Northern Trust (Nasdaq:NTRS) has the second highest TCE ratio at 8.6%, which is up significantly. Meanwhile, Wells Fargo (NYSE:WFC) has one of the lowest TCE ratios, at 2.7%, which is less than half of the 6.1% it reported at the end of the third quarter. Considering that Wells Fargo has been regarded as one of the strongest large banks, this is surprising. Another surprise is Fifth Third Bancorp (Nasdaq:FITB), which reported a TCE ratio of 4.5%. This bank has been left for dead by the market and is down 89% from its 52-week high.

Although some issues irritate the new plan, the administration continues to work towards solutions. When the results of the stress tests are made public, market panic surely will ensue in the shares of any bank required to raise more capital. As the shares plunge, these banks will have a more difficult time raising capital privately. The results of the government's stress tests will be equivalent to publishing a bank "death watch" list.

The assessment is also redundant. All of these banks already have run internal stress tests on their loan portfolios. Surely, they would share this information at the request of the government. Any bank that hasn't run these scenarios should be marked for death. (Find out how economic capital and regulatory capital affects risk management in How Do Banks Determine Risk? and Financial Institutions: Stretched Too Thin?)

Bottom Line
The plan by the Obama Administration may cause market panic in the shares of banks that do not perform well under the government-sponsor stress tests. Furthermore, performing and making public the results of these assessments seems counterproductive to stabilizing the financial system. (Learn more about the government's measures to fix the financial mess in Liquidity And Toxicity: Will TARP Fix The Financial System?)

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