What it means
By the start of 2009, the crisis had left banks short of capital and unwilling to lend, and many assets on their books were hard to price. The new administration's Treasury Secretary set out a broad plan intended to deal with several problems at once.
The aim was to restore confidence so that credit could flow to households and businesses again. One element was a stress test of the largest banks, which asked how each would cope with a severe economic downturn.
Banks that lacked enough capital to survive the scenario had to raise more, either privately or with government support. The publication of the results was meant to replace uncertainty with information.
Another element was a public-private investment programme, which used government money alongside private investors to buy troubled loans and securities from banks. The idea was to set a market price for assets that had stopped trading, and to move them off bank balance sheets.
The plan also expanded a Federal Reserve facility to support lending backed by consumer and small business loans. The plan included help for the housing market, with measures to support refinancing and loan modification for struggling borrowers.
It also included steps to support small business lending and greater transparency about how the rescue money was used. Taken together, the measures were presented as one framework instead of a series of emergency actions.
Transparency was a stated principle of the plan. The Treasury committed to publishing details of how funds were used, and banks receiving support faced limits on matters such as dividends and executive pay.
These conditions were meant to make the public more willing to accept the use of taxpayer money. The nuance is that opinions differ on how well each part worked, and some programmes were smaller or slower than originally hoped.
Many commentators see the stress tests as the most influential element, because they helped restore confidence in the banks. For a finance reader, the plan is a case study in how governments combine capital, liquidity and transparency to deal with a crisis.
In practice
Real-world examples.
Example
A large bank is told by the stress test that, in a severe downturn, its capital would fall below the required minimum. It raises new equity from private investors and converts some existing securities to shares. The bank announces the plan, and its share price stabilises as investors see that the capital gap has been covered.
Example
A private investment firm joins a government-backed programme to buy troubled mortgage loans from banks. The government provides part of the funding, so the investor puts up less money and shares the profits. The firm's finance team models the return on its smaller capital outlay.
Example
A homeowner with a mortgage payment that has become too large applies for a loan modification under the housing measures. The lender lowers the interest rate, which cuts the monthly payment. The homeowner avoids foreclosure.
Case study
Seen in the real world.
Eastport Trust is an illustrative, fictional bank that held $80,000,000,000 in assets at the time of the crisis. A stress test showed that in a severe scenario, its capital would be 1.5% of assets short of the required level.
The shortfall in dollars was 80,000,000,000 x 0.015 = $1,200,000,000. The bank's board chose to raise the capital through a combination of selling shares and selling a non-core business, instead of relying on government funds.
Once the plan was announced, the bank's funding costs fell and its customers' confidence returned. The bank's treasurer reported to the board each month on progress towards the target, and the capital raising was completed within the planned six months. The illustrative lesson is that publishing a credible, specific estimate of a shortfall helped the bank to address the problem.
Watch out
Common mistakes.
- Treating the plan as a single bailout cheque, when it was a package of different measures.
- Assuming every country's crisis plan is the same, when this entry covers the American programme announced in 2009.
- Believing that the stress tests were only a punishment, when they also provided information that investors needed.
Questions
People also ask.
What was the main aim of the plan?
To stabilise the banks and restart lending by restoring confidence and providing capital where it was needed.
What was a stress test?
It was an analysis of whether a bank would have enough capital to survive a severe economic downturn.
Is the plan still in force?
No, the emergency programmes were wound down over time, though the use of stress tests became a regular part of banking supervision.
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