A Second Try at Calming Bank Investors

President Obama called for stronger regulation of the financial sector Wednesday, unveiling principles that will guide development of new rules for banks during the next four weeks. Video by AP
By Binyamin Appelbaum
Washington Post Staff Writer
Wednesday, February 25, 2009

The revised financial aid plan for troubled banks that the Obama administration is launching this week is the government's second attempt to convince investors that it is giving banks the money they need to cover mounting losses and survive the recession.

The government has insisted that its investments should be counted as capital, the reserve that banks must maintain against losses. The Bush administration went so far last year as to rewrite the regulatory definition of capital to include the federal aid, which comes in the form of preferred shares.

So far, investors have not been swayed. To them, the government aid doesn't look like reliable capital. It looks a lot like a loan that the government wants back.

"When you're not sure about a bank's losses, you're going to pay a lot of attention to the cushion that protects you against those losses. And in all the markets that matter, they don't really have a lot of regard for official capital reserves," said Richard Herring, a finance professor at the University of Pennsylvania's Wharton School.

To address the skepticism, the Obama administration is now changing the rules to allow banks to convert the government's investment into the kind of capital investors take seriously: common shares.

But officials don't want that conversion to actually happen, because then the government would end up owning banks.

These officials hope that investors will accept the banks' access to capital as equal to actual capital, and therefore the banks will never need to make the switch.

The success of the government's strategy can be seen beginning today, as investors judge the gambit and decide whether to put their own money in bank shares.

Officials believe the gamble is worthwhile to avoid taking ownership of banks.

"I don't see any reason to destroy the franchise value or to create the huge legal uncertainties of trying to formally nationalize a bank when it just isn't necessary," Federal Reserve Chairman Ben S. Bernanke said yesterday in testimony before Congress. "I think what we can do is make sure they have enough capital to fulfill their function, and at the same time we exert adequate control to make sure that they are doing what's necessary to become healthy and viable in the longer term."

Officials plan today to describe a systematic approach that will use "stress tests" to measure how much more capital many of the largest banks will need. The banks then will be instructed to raise the money from private sources or accept it from the government.

"For these companies to have access to capital in the form of common equity when they need it, that is a confidence-building measure," a senior administration official said. "If they can't reach that point privately, we are prepared to stand behind them to make sure they have access."

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