As we already know, major financial institutions are currently going through a "stress test" as outlined by Treasury Secretary Geithner. The reason for this, in theory, is to determine those banks that need help and give all other banks a clean bill of health. Those that need help (i.e. that fail the "stress test") will either be required to raise their own capital, or will be required to accept more capital (i.e. another bailout) from the federal government. The idea is that, in the end, everyone should be comfortable that all the banks are sound.

The real risk right now, however, isn't that some banks may be undercapitalized, but rather that the government will say they are undercapitalized and force them to accept government money... with strings attached.

Purpose of Stress Tests

It would seem that the entire reason to do these "stress tests" is to reassure the public that the banks are solid. However, I haven't seen any evidence that individuals are uncertain about the safety of their deposits. I don't see much in the way of runs on any banks that would require the federal government to reassure everyone that their bank is safe. That's what this whole stress test would seem to accomplish: To say "Look, our banks are safe. You can be confident in your bank."

But, again, I don't see any widespread lack of confidence in anyone's banks. And even if people might be a little apprehensive, a lack of runs on banks suggests that people are confident that the FDIC really will insure their deposits.

Update 4/10/2009: It turns out the day after I wrote this article, a former bank regulator--Professor William Black--said the same thing: that it's a sham to give us confidence in the banks (see the video at 2:20).

Additionally, perhaps they believe that banks aren't loaning enough to each other because they don't trust the other bank is good for the money. But as of last week, banks are borrowing less money from the Federal Reserve--which means they're getting the money they need elsewhere .

So what is the purpose of the stress tests? To give the public confidence in their banks when there's no evidence of a lack of confidence? It's not like people are running to their banks and withdrawling all their money. It's not like people are refraining from purchases because they fear for the stability of their bank. To give banks confidence in each other? Reduced borrowing from the Federal Reserve suggests that the banks are getting the money they need somewhere else.

So what's the point?

Control

This is speculation, but it doesn't seem that far-fetched anymore. It could be about control. Government control.

Last week the president of the United States fired the CEO of a private company (GM). In the wake of that rather amazing move, some people have been asking whether that's a double-standard: Bank officials at AIG get to keep their bonuses while the highest executive at CEO gets fired.

Treasury Secretary Geithner responded:

Geithner denied there was a double standard and put banks on notice that they may need to change leadership teams in exchange for accepting more money in the future.

"If, in the future, banks need exceptional assistance in order to get through this, then we'll make sure that assistance comes with conditions, not just to protect the taxpayer but to make sure this is the kind of restructuring necessary for them to emerge stronger," he told "Face the Nation" on CBS. "And where that requires a change of management of the board, we'll do that."

In other words, the government has no qualms with firing more people from private companies.

Now consider that some banks were forced to take TARP/bailout money they didn't want, and the government is refusing to take TARP/bailout money back from some banks:

Fast forward to today, and that same bank is begging to give the money back. The chairman offers to write a check, now, with interest. He's been sitting on the cash for months and has felt the dead hand of government threatening to run his business and dictate pay scales. He sees the writing on the wall and he wants out. But the Obama team says no, since unlike the smaller banks that gave their TARP money back, this bank is far more prominent. The bank has also been threatened with "adverse" consequences if its chairman persists. That's politics talking, not economics.

In other words, some banks don't want bailout money but the government is refusing to take it back. This leaves the bank on the hook for all the conditions that the government puts on the bailout money.

As part of the new administration's overhaul of the $700 billion bailout effort, banking regulators are requiring stress tests for the 19 largest banks to see whether they will need additional support to withstand a more severe downturn than the country is experiencing now.

Those tests are scheduled to be completed by the end of April. After that, the banks in need of additional capital will be given time to raise it on their own.

If they are not able to do so, they will be provided with extra support from the bailout fund. But the administration has said the additional support will come with tougher requirements to make sure the banks' are using the money to increase lending to consumers and businesses.

So, to recap: Some banks that have already received bailout funds they didn't want want to give it back. The government won't take it back. That leaves these banks on the hook for any conditions the government wants to place on banks that received bailout money. Further, the stress tests now have the potential to force additional banks to receive more money that the government says they need.

If we're going down the road of a bailout, wouldn't it be reasonable to believe that a bank should only be bailed out if it wants to be bailed out? Presumably it would utilize that option before opting for bankruptcy, but not before. Isn't that what we want?

Instead, the "stress tests" are such that the federal government will decide if a bank needs more money. It doesn't matter if the bank agrees.

Taking Control of the Banks

Consider the following scenario: If the federal government tells a bank, "Our stress test says you are undercapitalized by $50 billion. You need to raise $50 billion or you will be forced to accept $50 billion from the federal government." So the bank tries to find $50 billion by offering bonds or selling stock or selling assets. Perhaps it fails. So the government says, "Well, that means you have to accept our money and all the strings attached."

All of the sudden the bank is under control of the U.S. Government. It didn't want to be bailed out, it didn't want to accept the money, but it was forced to because some arbitrary "stress test" said they needed to accept more money. And, as Geithner has said, the U.S. Government will not be shy about firing more people at private companies as it sees fit.

Also notice the last sentence of the quote above that "additional support will come with tougher requirements to make sure the banks' are using the money to increase lending to consumers and businesses." In other words, the government will not only potentially fire more employees of a private company, they may force the private company to make loans that the company might not feel are prudent.

That's exactly what got us into this mess in the first place! But now not only might the government dictate bad lending policy, it seems ready to take control of private companies, fire employees, and do it all itself.

Is This Irrational Fear?

Hey, maybe it's irrational fear. Two weeks ago I would have said, "Yeah, that's irrational."

However, ever since Geithner announced the "stress tests" I (and others) have wondered, "What's the point of that?" It seemed like a useless formality. A bank that is at the point of going bankrupt due to insufficient funds will certainly let the government know. Why make an effort to force banks to take more government money that they don't need today? Why not give it to them when they need it?

But then, last week, the president of the United States somehow fired the CEO of GM. And then the Treasury Secretary said that executives at banks could receive the same treatment . And it was reiterated that banks that fail the stress test may be forced to take government money even if they don't want it. And banks that have already received bailout money are not being allowed to pay it back.

My concern may be ultimately be found to be unfounded, but I'm not the only one worried. An article at the Wall Street Journal has the same concern:

By managing the money, government can steer the whole economy even more firmly down the left fork in the road.

If the banks are forced to keep TARP cash -- which was often forced on them in the first place -- the Obama team can work its will on the financial system to unprecedented degree. That's what's happening right now...

Think about it: If Rick Wagoner can be fired and compact cars can be mandated, why can't a bank with a vault full of TARP money be told where to lend? And since politics drives this administration, why can't special loans and terms be offered to favored constituents, favored industries, or even favored regions? Our prosperity has never been based on the political allocation of credit -- until now.

The truth is that every day it seems we're further and further into uncharted territory.

First we had a nearly one-trillion bank bailout. We started bailing out car companies, and we're bailing them out again--and the government is in a position to dictate what kind of cars will and won't be built. Banks were forced to take bailout money even if they didn't want it, and some larger banks aren't being allowed to pay back bailout money they don't want. The president of the United States has brazenly fired an employee of a private company and the Treasury Secretary has threatened more of the same for the banking industry. And the stress tests could easily be used to force more banks to accept more federal money and subject them to this unprecedented government meddling in private companies. All the while politicians will apparently be able to tell said banks how and to whom to loan money.

Many of us conservatives warned back in September that the bailout was potentially opening Pandora's box. Unfortunately, we were right. Ever since September it's been like a domino effect with ever-expanding consequences and ever-increasing federal power.

I hope I'm wrong about the potential impact of these stress tests and the potential for the government to effectively take control of an even larger portion of the banking industry. We hoped we were wrong about Pandora's box in September, too.

Unfortunately, we were right.