The following articles is from the Economist

THE stress tests on America’s 19 largest banks were “a careful look under the hood” of the financial system, explained Tim Geithner, the treasury secretary, just before the eagerly anticipated results were officially released on Thursday May 7th. The mechanics’ verdict was that the sputtering engine would be as good as new with a partial refit. Others were left wondering if the service had been anywhere near thorough enough.

Until now, America’s government has run a convoy system with its big banks, treating all alike for fear of stigmatising the feeble. Now, for the first time, it is sorting the strong from the weak—even if it has made clear that none will be allowed to fail. The issue, it says, is quality, not quantity. Almost all of the banks, regulators suggest, have enough capital overall to ride out even the worst-case scenario envisaged in the tests. But ten of them need to plump up the common-equity component of the cushion.

In other words, banks have plenty of capital, but too much of it is the wrong kind. Regulators, taking the market’s lead, have come to prize common stock over other forms of “tier-one” capital, such as preferred stock. Since it need not pay dividends it is the purest form of capital, providing an immediate buffer against losses. They are now insisting that common equity makes up at least half the total.

The total common-equity shortfall is deemed to be $75 billion, much less than many had expected. It was much larger—$185 billion—at the end of 2008 but since then banks have closed the gap by accelerating sales of non-core businesses and restructuring capital instruments. Those caught short include Citigroup, Wells Fargo, Bank of America, GMAC and several regional banks. BofA alone needs to find $34 billion.

JPMorgan Chase, Goldman Sachs and State Street, by contrast, were given a clean bill of health. These winners will be impatient to repay government aid they took (or were forced to take) under the Troubled Asset Relief Programme and thus free themselves from restrictions on pay, dividends and hiring foreigners. But they will first have to show that they can fund themselves comfortably without government support. Banks have relied on guarantees from the Federal Deposit Insurance Corporation to issue more than $330 billion of debt since last year’s meltdown.

For those banks that need to raise more equity, one option is to sell non-core businesses. Another avenue is to issue shares to the public. Even if these efforts fail, taxpayers may not face another steep bill. Some of the capital-deficient banks have large piles of preferred shares that can be converted into the common sort, sparing them from having to ask for fresh government funds. They will be reluctant to convert the government-owned preferreds that they got at the height of the crisis, as Citigroup has had to do, since that gives the government a sizeable equity stake—and, potentially, voting rights and board seats. Once Citigroup completes its share exchange, the taxpayer will own roughly a third of the bank.

Bank of America hopes to avoid this intrusion by converting a chunk of its $33 billion of preferred stock that is held by private investors, not the government. It said on Thursday that it did not plan to take up a government offer to guarantee $118 billion-worth of troubled assets on its balance-sheet.

There is still much to worry about. The government could end up having to stuff sizeable sums of new capital into some of the regional banks, which are disproportionately weighed down with fast-souring commercial-property loans. SunTrust, for instance, may struggle to cover its $2.2 billion shortfall, equivalent to a third of its market capitalisation. Likewise, analysts wonder where GMAC, a battered mortgage and auto lender, will get $11.5 billion, if not largely from the taxpayer.

A bigger concern is whether the stress tests were stressful enough. The regulators insist they were tough, envisaging loan losses rising to levels not even seen in the Depression, including an eye-popping loss rate of 22.5% on credit cards. Overall, at $600 billion, the government’s worst-case estimate of losses in 2009 and 2010 was roughly in the middle of the range of private forecasts. The IMF recently projected losses for American banks over the same period would be $550 billion.

Yet if the loss estimates look reasonable, as do the forecasts of the underlying earnings the banks will make, has the hurdle for capital been set too low? This requires common equity be 4% of risk-weighted assets, (which equates to about 2.5% of actual assets). This looks pretty feeble. At the end of 2008 the 19 institutions had a ratio of 5%, so the stress test actually allows them to lower their capital levels as they absorb losses. In a recent simulation the IMF suggested the equivalent of a 7-10% ratio of common equity to risk-weighted assets was an appropriate minimum level for America’s banks. Europe’s lenders are running with a ratio of 7%.

The stress tests have worked in one sense. They have produced a credible estimate of the likely losses banks will face. But the second part of the test—establishing a buffer big enough to allow banks to absorb those losses and command confidence without state support—looks to have been fudged. It is still hard to imagine the banking system being able to stand on its own two feet without explicit state guarantees of debt issuance and the implicit understanding that the government would step in again. As Mr Geithner admitted, we are only in the “early stages of repair.” The mechanics should keep their spanners at the ready.