Update: This FAQ from the Federal Reserve has a good run-down on the stress tests.

This week, FDIC chair Sheila Bair issued a statement to reassure bank shareholders against the threat of nationalization that “a ‘stress test’ for some 20 of the largest banks this week will help federal policymakers determine ‘what type of additional capital investments the government may need to make.'” While this may help federal regulators assess the stability of the big banks, the public may remain largely clueless. This is due to a Treasury Department decision to not release the results of “stress tests.”

On February 11, the New York Times reported that “exams for 18 or so of the biggest banks are set to begin immediately, and the first results could arrive within weeks. They are not expected to be made public for every institution.” This seems less than adequate. Marc Ambinder of The Atlantic makes the point that results will be kept private except,

They don’t have to be. And won’t banks who’re found to be in good shape be eager to brag about their health? (“I’d image they’d want to should that from the mountaintops,” a government official told reporters today.”) Ok — so you have a bunch of banks revealing their test results — presumably, the banks that are healthy will be more open, leaving the banks that are less well capitalized keeping the secret. But won’t it then be obvious which banks are in real trouble?

After the missteps and general opacity of the first TARP, the level of trust among the public is quite low. Many would find the assertion that a bank is “healthy” as incredulous. What is needed is transparency for these “stress tests.”

Calculated Risk laid out a fairly good format for this back on February 12. They first explain that tested banks will likely fall into three categories: 1) Healthy. 2) In need of further TARP aid. 3) Nationalize or sell. Here’s what they say about releasing the “stress tests”:

The NY Times article suggests that the results will not be made public for every institution, but that will just lead to rumors and speculation. It would be better to announce the category of all 18+ banks at the same time (in 30 days or so). At that time announce the capital infusions for the category 2 banks, and the nationalization of the category 3 banks.

Do it all at once, band-aid style. The release of this information is vital to restoring the trust of the American people in the government’s effort to rescue the banking sector and restore credit.

The tests are described by the New York Times as follows:

The new test is likely to be more stringent than the standards used to determine which banks would receive money under the first round of the federal rescue. And unlike in the government’s initial investments, the amount of capital that banks receive will be based on the depth of their problems.

Regulators plan to assess the potential losses a bank could face over the next two years, rather than the typical one year, according to government officials close to the situation. They are also expected to look at banks’ exposure to derivatives and other assets normally carried off their balance sheets, and make sure that banks also carry an additional capital cushion. Their assumptions will be guided on a “worst case” basis.

The exams could be used not only to determine which large banks would receive additional aid but also to help weed out small, unhealthy banks, hastening consolidation in the industry.