Government regulators will examine the financial strength of banks to assess their ability to weather economic storms. The objective, presumably, is to calm U.S. and international markets by assuring them that the government is in control. Government officials understand the need to monitor banks, they will have the data to assess large banking institutions, they will run the stress tests now and publish the results in May, and they will take whatever actions are necessary for the common good.

Large banks are required to “participate” but these tests might be pushed further down the food chain. Business enterprises that definitely are subject to the stress tests include J.P. Morgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley, MetLife, PNC Financial Services Group, US Bancorp, Bank of New York Mellon, SunTrust, State Street, Capital One, BB&T, Regions Financial, American Express, Fifth Third Bancorp, Keycorp, and GMAC.

Regulators will subject these entities to two scenarios: a consensus forecast and a “worst-case” scenario. The idea is to predict the balance sheet and the income statement of these banks and determine whether they are capable of surviving these unsavory elements. In short, are the banks well capitalized or are they undercapitalized?

The Fed released details of it methodology on April 24 and may be found at http://online.wsj.com/public/resources/documents/scap2009424.pdf . Most of the decisions are straight-forward, but a few aspects of the methodology are puzzling.

For instance, the regulators will focus on Tier 1 capital, which includes intangibles (though later it says it deducts goodwill), deferred tax assets (with some caps), and preferred stock. They should instead eliminate all three of these items. What intangibles are worth during a down-turn is itself intangible, but zero is perhaps as good an estimate as any the bank managers will provide. Intangibles generally arise during rosy times and prove how ephemeral they are during recessions.

Likewise, deferred tax assets have value when the entity will generate taxable income in the future. If the economy has severe dislocations, the value of the deferred tax assets vanishes.

Preferred stock is essentially debt, so it is a bit disingenuous to treat it as owners’ equity. One begins to wonder whether the purpose of these stress tests is really to evaluate the well-being of banks during hard times or whether it serves a more political purpose when regulators try to get as many banks as possible to pass these stress tests.

The Fed mentions that the new FASB guidance (I cannot call them principles) on impairments was allowed for the baseline scenarios but not for the “worst-case” scenario. It does not give a reason for this inconsistency. It would have been preferable to omit FASB’s nonsense on other-than-temporary impairments decided on April 2.

The Fed also mentions that “proposed changes to FAS 140” would add $900 billion to the bank balance sheets. But, the Fed should not stop there. Given the impotence of the SEC and the FASB in the area, if the Fed really wants to assess bank viability during adverse conditions, it should have required banks to consolidate all special purpose entities. That likely would add billions of dollars of liabilities to those balance sheets.

We shall find out the results in May, and it will be interesting to see what occurs next. Given that capital markets are skittish about banks and their intangibles, their deferred tax assets, their preferred stock, and their extensive, risky positions within special purpose entities, I doubt that the results will calm the markets. Somebody is going to have to improve the accounting and give an exam that banks might actually fail in a highly public fashion before the markets will be pacified.