Bank rescue takes 2 tracks

Emerging details of the Obama administration’s revamping of the government’s financial-system rescue reveal that the Treasury Department intends to operate two distinct programs to infuse capital into the nation’s banks.

One will seek to ensure the survival of the biggest banks so that they may at some point return to something like business as usual. These institutions, which number fewer than 20, will undergo a mandatory “stress test” to see if they can withstand a “worst-case” scenario: an economic crisis lasting two more years.

If the exam indicates one of these big banks is in bad shape, it will have to take on new capital -- from private investors if available or, if not, from the government.

The second program will include about 8,300 smaller banks, relatively few of which had anything to do with exotic mortgages or the toxic securities backed by them.

These banks, not considered too big to fail, probably will get a less extensive review, Treasury officials say, and will receive capital not if they are in bad shape but only if they are strong enough that they probably don’t need the investment.

Indeed, the government is looking at this group of banks, each with assets of less than $100 billion, as being more likely to increase lending.

“To run a stress test on all of them would take an awful long time, and a lot of the smaller banks are in better shape,” said a senior administration official. “At many of them, if you give them fresh capital they’ll turn around and start making new loans.”

The Treasury Department began investing in banks last October under the $700-billion Troubled Asset Relief Program to stabilize the financial industry and promote economic recovery.

Its second phase was outlined Tuesday by Treasury Secretary Timothy F. Geithner, who provided few details. Officials later said they were still working on the specifics of the plan.

Filling in some gaps, Treasury spokesman Isaac Baker said smaller banks probably would be screened in a process similar to that used in the first phase of TARP. That began with reviews by front-line regulators, who then made recommendations on whether funding should be approved to one committee of top Treasury officials and another made up of senior members of the four bank regulatory agencies.

The regulatory reviews focused on the confidential safety and soundness rankings that regulators give to banks. They also looked at bank strength indicators, known as performance ratios, which gauge factors including bad loans and reserves.

Banks with the highest rankings were recommended for capital, while banks with the lowest grades were asked to withdraw or file supplemental information. In other words, only those banks deemed viable enough to survive without extra capital were supposed to be eligible for Treasury funds.

These routine regulatory rankings normally factor in economic conditions for the coming year, Treasury officials said.

Under the new plan, the mandatory big-bank screening will be wider ranging, making two-year projections based on several scenarios, including a continued downturn.

“In effect, you would pre-position capital in the [major] banks so they could run off that capital even in a severe downturn,” said the senior administration official, speaking on condition of anonymity because the plan’s details had not been finalized.

The Obama administration’s approach would formalize a difference in treatment that has been apparent from the start of TARP but wasn’t acknowledged.

Last October, when the Treasury kicked off the bailout, it insisted that nine huge banks (including Merrill Lynch & Co. and Bank of America Corp., which later merged) take a total of $125 billion in capital.

Since then, more than 300 additional banks have received federal funds -- not on command, but by applying for funds and waiting for approval.

The big banks that have gotten the most money could potentially be insolvent if their books reflected the true price their assets would bring in a sale today, said TARP critic Campbell R. Harvey, a Duke University business professor.

“The capital is mostly being funneled to the troubled banks that aren’t going to do anything for us in the way of new lending,” he said.

Most economists and government officials believe the big banks are so intertwined with all aspects of the economy that not strengthening them would risk a meltdown of the entire financial system.

“I think we all agree that if one of these banks can make it, it’s better that it not fail or be taken over,” said Brookings Institution economist Douglas J. Elliott.

If a bank fails the stress test, it will be difficult to find private investors to provide capital in the current environment, Elliott said. And with bank stocks trading at multiyear lows, the Treasury could gain control of a bank by forcing it to accept more government funds.

“I can easily envision a situation where you’re talking about nationalizing the weakest banks,” he said.

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scott.reckard@latimes.com