19 banks won’t be allowed to fail

WASHINGTON – The Federal Reserve on Friday said the government is prepared to rescue any of the banks that underwent “stress tests” and were deemed vulnerable if the recession worsened sharply.

Outlining the tests’ methodology, the Fed said the 19 companies that hold one-half of the loans in the U.S. banking system won’t be allowed to fail – even if they fared poorly on the stress tests.

The announcement reinforced the Fed’s view that major financial firms are “too big to fail,” and that the government must do whatever is necessary to save them, said former Fed examiner Mark Williams.

“It appears ‘too big to fail’ is a fundamental philosophy – it’s a philosophical principle,” said Williams, a finance professor at Boston University.

In extreme cases, a rescue could include a government-backed merger, similar to what regulators did in helping Bank of America to buy Merrill Lynch and JPMorgan Chase & Co. to buy Bear Stearns.

Critics say that policy has put taxpayer money at risk to give banks billions in government bailouts and guarantees.

Separately Friday, bank executives were being briefed on their test results in meetings across the country. By law, the banks cannot publicize the results without the government’s permission, but Wall Street buzzed with anticipation and most financial stocks rose. The Dow Jones industrial average added more than 119 points to 8,076.29.

Friday’s Fed release contained little new or concrete information. But Fed officials said in a conference call with reporters that banks will be required to keep an extra capital buffer beyond current requirements in case losses continue to mount.

The stress tests, a centerpiece of the Obama administration’s financial rescue plan, were intended to boost market confidence by giving investors clarity about the relative strength of the largest financial firms.

But critics have said the effect was just the opposite: creating uncertainty that fed market instability.

“I really don’t think this is going to add transparency to the system,” said Linda Allen, a finance professor at Baruch College.

Allen said the stress tests wouldn’t make much difference. She said they are similar to bank examinations that are done regularly to ensure banks have enough money to absorb further losses.

In the stress tests, regulators are putting banks through two scenarios.

One scenario reflects forecasters’ expectations about the recession. It assumes unemployment will reach 8.8 percent in 2010 and house prices will decline by 14 percent.

The second imagines a worse-than-expected downturn: Unemployment would hit 10.3 percent in 2010 and house prices would drop 22 percent this year.