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Banks Brace for Stress Tests

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Regulators want to see just how much pain financials can endure.

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As financial markets reel, equities probe lows unseen in over a decade, and optimism wanes on Main Street, President Obama and Treasury Secretary Tim Geithner are rolling out a series of so-called "stress tests" to firm up confidence in the country's banks.

The tests, designed to ensure banks will survive even if economic conditions continue to deteriorate, focus on the books of 20 of the country's largest banks. According to Bloomberg, the stress tests begin today.

The approach harkens back to tactics used during the Great Depression - yet another reminder of just how bad things have gotten for the US banking system.

Last week, Federal Reserve Chairman Ben Bernanke explained how a similar approach in 1933 solidified confidence in the nation's banks:

"Roosevelt shut down the banks for a week and said we are just going to check the books and open them up only when we think they are solvent. And a lot of the banks opened up pretty quick. So, it's not really clear how much they really looked through the books, but when they opened them up again, people felt much more comfortable, and more confident in the bank."

The current plan doesn't just aim to "check the books." Instead, regulators will evaluate the strength of banks like Citigroup (C), Bank of America (BAC) and JPMorgan (JPM), already up against the ropes, based on how the'll perform if put through a more "stressful" economic test.

In other words, what happens if the wheels really fall off the wagon.

For example, let's assume most economists believe housing prices, which have already corrected more than 20%, will stabilize after having fallen 30%. The last 10% of declines would have a certain effect on residential mortgage losses (among other assets), so Treasury bean-counters try to estimate whether banks could withstand the losses such a scenario would create.
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