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What are bank stress tests?

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Are your finances strong enough to withstand another couple years of this battering economy? Can you suffer additional losses and still pay your bills and, if not thrive, at least survive if the economy continues to deteriorate?

That’s what federal banking regulators are trying to determine with the country’s largest banking institutions. The stress tests you’ve heard about are “forward-looking economic assessments.” Do these organizations have enough capital to withstand another two years of an economy that may be worse than is currently anticipated?

Nineteen banks and thrifts, each with more than $100 billion in assets, are being put to the test. As a group, they hold an estimated two-thirds of the assets in the U.S. banking system. Most Americans do business with one or more of these institutions. Among those being tested are JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, SunTrust Bank, Goldman Sachs and PNC Bank.

The stress tests will evaluate each institution’s finances under two scenarios — a baseline and a more adverse scenario.

Baseline scenario

Economy — Shrinks by 2 percent (adjusted for inflation) in 2009 and grows by 2.1 percent in 2010.
Unemployment — Averages 8.4 percent in 2009 and 8.8 percent in 2010.
Housing prices — Drop 14 percent in 2009 (from where they ended December 2008) and drop 4 percent in 2010 (from December 2009).

More adverse scenario

Economy — Shrinks by 3.3 percent in 2009 and grows by 0.5 percent in 2010.
Unemployment — Averages 8.9 percent in 2009 and 10.3 percent in 2010.
Housing prices — Drop 22 percent in 2009 (from where they ended December 2008) and drop 7 percent in 2010 (from December 2009).

The Federal Reserve is expected to release some information May 4 about the stress test results. Institutions that aren’t well-capitalized will have six months to try to raise the necessary funding in the private markets. Any that can’t raise the money will be bailed out by the government.

Government intentions foggy

“The whole idea of going through this process is to give people greater confidence in the banking system,” says David Waddell, CEO and senior investment strategist at Waddell & Associates in Memphis, Tenn.

“I’d be surprised if they do anything that would create concern over the banking system. But the government’s intentions are foggy. It’s probably to be able to go back to Congress and say they need more money but they have to do it in a way that doesn’t spook the market and doesn’t cause a run on the banks.”

Even if information released clearly shows which banks are weak, Waddell says he doesn’t think that consumers will stop banking with a particular institution any more than they quit flying when the government’s National Threat Advisory is elevated.

Consumers may not feel the need to take their money elsewhere based on the stress test results, but they should make sure their deposits are fully protected. Generally, that means staying within the FDIC insurance limit of $250,000 per depositor. But Waddell isn’t a fan of consumers blindly putting their money in an institution just because it’s covered by the FDIC.

“Part of the problem with the way consumers approach banks is that the government is there guaranteeing deposits so we don’t have to do our own due diligence. If there’s a weak bank in my local market and I have $100,000 in a checking account there, I don’t care because the government has guaranteed it. There’s a moral hazard, in my opinion, in the system, and that moral hazard has only gotten bigger since the FDIC raised the limit to $250,000 on deposits.”

Protect your deposits

The FDIC says its Deposit Insurance Fund should be sufficient for the foreseeable future, and if by some chance additional funds are needed, it has a U.S. Treasury line of credit that can be tapped. Nevertheless, it will be interesting to see whether the FDIC’s coverage limit remains at $250,000 after Dec. 31. Deposit insurance is slated to fall back to $100,000 per depositor Jan. 1, 2010. (Insurance coverage for some retirement accounts, such as IRAs, was permanently increased to $250,000 per depositor in 2006.)

Staying within FDIC limits, or National Credit Union Administration, or NCUA, limits if you’re with a credit union, is paramount to protecting your deposits. There are trillions of uninsured dollars in bank accounts across the nation. The FDIC says uninsured depositors receive an average of 72 cents on the dollar when a bank fails. Can you afford to lose a quarter of your money?

There are ways to protect excess deposits. Some banks will divide your excess deposits among non-related banks within a particular network. That and several other methods are explained in “Six ideas for insuring your deposits.”

The FDIC shows how to properly title your accounts so you make the most out of the available coverage. The agency also provides a calculator to determine your coverage.

To get an idea of the financial strength and stability of a particular commercial bank, savings bank or credit union, explore Bankrate’s Safe & Sound database.

While the government is focusing on the nation’s biggest institutions — and propping them up when needed — there are more than 8,000 institutions that, apparently, aren’t too big to fail. Safe & Sound can show you how well an institution is faring on a quarterly basis.