Government Moves to Shore Up Banking System

Washington: The federal government will ease the terms of its investments in more than 350 financial institutions to increase the benefit of the taxpayer dollars they have already received, regulators announced this morning.

The change also applies to new investments, and regulators said they will begin Wednesday to test the health of the nation's largest banks to determine how much more government money those banks might need to weather the crisis.

"The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth," said a joint statement issued by the Treasury Department, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, Office of Thrift Supervision and Federal Reserve.

The change in the investment terms was sought by Citigroup and other banks that are trying to convince investors they can survive their financial problems.

The government has invested almost $300 billion in banks so far. In exchange for its investments, the government required the banks to issue preferred shares that pay interest and are designed to encourage repayment after a few years.

The changes announced this morning create a two-step process. Companies can replace the government's preferred shares with a new kind of preferred shares that can be converted into shares of the company's common stock. The conversion would be at the discretion of the companies in consultation with regulators.

The change has several important benefits for the banks, and it allows the government to provide those benefits without directly investing additional money.

Companies that convert the government's investment to common shares can reduce required dividend payments and ease repayment pressure for the banks. The change could encourage more people to invest alongside the government. And there is a significant but technical accounting benefit. The swap would significantly improve banks' performance on a measure of health used by financial analysts called tangible common equity, which basically judges a bank's reserves against future losses.

The government would take a larger ownership stake in companies that completed the swaps. But that might not give the government increased control, simply because regulators already are taking a heavy hand in the affairs of the most troubled banks. At Citigroup, for example, regulators now play a key role in the company's decision-making.

Initial reaction from the banking industry was positive. Scott Talbott, a spokesman for the Financial Services Roundtable, said the changes showed the government's support for the industry.

"This is a signal that the government believes the financial institutions are strong and provides them with the flexibility of terms should the economy worsen," Talbott said.

The changes apply to the government's existing investments of almost $300 billion in more than 350 financial firms. Companies can replace the shares they already have issued to the government with the new kind of preferred shares. Talbott said he expected many of the largest banks to make the switch.

One company expected to act quickly is Citigroup, the troubled New York giant whose executives had encouraged the government to make these changes.

Citigroup executives had approached federal regulators to discuss steps the government could take to strengthen the troubled company, according to two people familiar with the matter.

The giant New York bank is under mounting pressure to convince investors that it can survive its financial problems. The government already has invested $45 billion in Citigroup and promised to limit its losses on a portfolio of more than $300 billion of loans and other troubled assets. But investors remain nonplused, and the company's stock price has dropped 71 percent this year.

Regulators also gave more details about plans announced by Treasury Secretary Timothy F. Geithner this month to perform "stress tests" on banks.

The tests are designed to assess how banks would fare if the recession continues to deepen, regulators said. The goal is to see whether banks have enough capital to weather a downturn in which unemployment and other economic indicators become much worse, driving up the level of defaults on loans and the losses that banks would sustain.

The tests will be performed on about 20 of the nation's largest banks. The results will show whether the companies need more capital as a buffer against possible losses. Companies that need additional capital will be given a chance to raise the money from private investors, regulators said this morning. If they cannot, they might be required to accept an additional investment from the government.

"This program is designed to ensure that these major banking institutions have sufficient capital to perform their critical role in our financial system on an ongoing basis and can support economic recovery, even under an economic environment that is more challenging than is currently anticipated," the agencies said.

The two steps announced this morning create a clear scenario in which the government could emerge as the majority owner of some of the nation's largest banks.

The Obama administration has said repeatedly that it does not plan to nationalize a large number of banks, but senior officials have privately said that some of the most troubled banks could be taken over as a last resort.