WASHINGTON — The Obama administration will begin taking a hard look at the financial condition of the country’s 20 biggest banks this week to judge whether they could hold up even if the downturn worsens further than policy makers already expect.
These reviews of the banks’ books, known as “stress tests,” are heightening a dilemma for Obama aides about how candid they should be about the health of banks like Citigroup and Bank of America. The tests are expected to take several weeks.
Bank shares were pummeled last week, partly because of rumors that the government might nationalize some of the banks. Officials consider many of the top 20 banks “too big to fail.”
On Monday, the administration reiterated in a statement that it thought banks should remain private but also offered some reassurance that it would support the banks as needed.
“The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth,” the government said. “Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.”
In the statement, the government said that any investment would be in the form of convertible preferred shares that would be converted into common shares and sold as financial conditions improve.
The stress tests come as anxiety is building among investors and industry analysts about the Treasury Department’s broader plan to shore up the banking system. People familiar with the plan, which has been criticized by executives and analysts as vague, say its crucial details may not be ready for another few weeks.
In yet another sign of distress for the banks, Citigroup officials were in active talks with federal regulators on Sunday night about plans for the government to take a bigger ownership stake in the bank, according to a person close to the talks.
Citigroup approached the regulators with a plan that would allow them to convert a large amount of the government’s $45 billion of preferred shares, which is treated as debt, into common stock, this person said. The government owns a stake of roughly 8 percent, but that could grow to as much as 40 percent.
Converting the preferred shares while also issuing more common shares would bring Citigroup closer to the mix of equity that the government is likely to demand when it introduces the stress test. But that would severely dilute the value of shares held by existing Citigroup stockholders.
Still, the big banks say they remain relatively healthy and that, with time and support from the government, they will regain their footing.
But many economists, Wall Street analysts and even some bank executives contend that some of the banks are already effectively insolvent.
Even though banks have reported billions of dollars of losses from bad loans, these critics say, the major institutions still carry trillions of dollars in additional toxic assets and are too damaged to resume normal lending.
This camp says it would be best to nationalize some of them now — with the government wiping out shareholders and taking over the operation of some institutions, at least temporarily — rather than to drag out the process while the economy spirals further downward.
The stress tests will use computer-run “what if” situations to estimate what would happen to each bank under Depression-like conditions, with unemployment surging to 10 or 12 percent, for example, or home prices dropping 20 percent further, Treasury and Federal Reserve officials said.
Fed officials emphasized that these hypothetical events were “highly unlikely” to occur.
Top advisers to President Obama, including the Treasury secretary, Timothy F. Geithner, have insisted repeatedly that they want to keep the major banks in “private hands” and have no intention of nationalizing them. But because the tests involve nightmarish economic conditions, the results of the tests are likely to strengthen the case that some of the major banks need more capital. That would increase the likelihood that the government would increase its stake and dilute or even wipe out the shares held by private investors.
On Friday, Treasury and Fed officials put out the message that the stress tests themselves should not be seen as cause for anxiety. The tests, officials said, would simply make clearer whether a particular bank needs more capital now or might need more in the future if conditions become worse.
Their implication was that federal regulators were not about to impose strict numerical rules to decide whether a bank had “passed” or “failed” the stress test. Federal officials are not expected to publicly disclose the findings about any specific bank, though they are expected to provide at least a rough idea of the new questions they are asking.
Some officials argued that the tests might actually provide reassurance about the strength of many banks. Indeed, Treasury and Fed officials said they had consulted with industry executives in devising the tests.
Bank executives reached over the weekend said that the tests might not produce information that is very different from what regulators already know about the banks. The Federal Reserve already has hundreds of examiners on site at the largest banks, monitoring their businesses.
Meanwhile, the revelation that details of the Treasury’s new bank rescue plan might not come for several weeks leaves banks and their shareholders to stew.
“These stress tests are just going to raise more questions and add to the uncertainty,” said Bert Ely, a banking analyst in Alexandria, Va. “The only thing that is likely to calm them down is if the administration flatly declares that it won’t take over banks.”
Administration officials have tried to make that point, but they have stopped short of making absolute declarations — probably because many industry analysts say some banks that are “too big to fail” may well be too feeble to stand on their own.
President Obama’s chief spokesman, Robert Gibbs, said on Friday that the administration “continues to strongly believe” that a privately held banking system was “the correct way to go.”
But on Friday, and for much of last week, investors acted as if they were betting on government takeovers and dumping bank shares in response. Shares in Citigroup, for example, fell 44 percent, and Bank of America stock dropped 32 percent.
Indeed, investors appeared to be challenging government assertions in exactly the same way they did last summer, when they called the Bush administration’s bluff about the financial needs of Fannie Mae and Freddie Mac, the government-sponsored mortgage-finance companies, which eventually had to be taken over.
Because a complete government takeover could wipe out or at least dilute the value of existing common shares, investors sold bank shares at a furious pace last week.
Rumors about a government takeover of one or more major banks accelerated sharply last week after Alan Greenspan, the former Fed chairman, said on Wednesday that the government might be forced to temporarily nationalize some banks.
When Senator Christopher J. Dodd of Connecticut, chairman of the Senate Banking Committee, alluded to Mr. Greenspan’s remarks and reluctantly endorsed them in an interview on Friday, investors hammered bank shares once again.
Louise Story and Eric Dash contributed reporting from New York.
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