Banks told to bolster their capital reserves

'Stress tests' expected to see Bank of America and Citigroup raise new money

Banks on both sides of the Atlantic are being warned by regulators that they must hoard additional capital to weather the recession and future economic storms, in another series of steps designed to limit the risk-taking that pumped up the industry's earnings during the credit boom.

Shares in Citigroup and Bank of America, two of the biggest banking giants in the US, fell sharply amid reports the Treasury has asked them to raise additional money after concluding "stress tests" of their operations.

And the UK's chief regulator, the Financial Services Authority's chairman Lord Turner, earmarked higher capital requirements as "a possible way forward" out of the financial crisis.

The US Treasury handed the country's 19 biggest banks the preliminary results of the stress tests last week, requiring at least BofA and Citigroup to raise additional capital to fill holes in their balance sheet which could open up if the recession lasts longer and is deeper than expected.

The pair, however, are believed to have queried some of the conclusions of the mathematical models used by the Treasury, the Federal Reserve and other regulators who worked on the tests. Some executives are also questioning the methodology itself, according to reports in the US press yesterday.

The stress tests are central to the Obama administration's efforts to restore confidence in the banking system. It has told banks that they would have six months to fill any capital shortfall identified under the tests, but if they could not ultimately raise money from private investors, the government itself would put up money from the Wall Street bailout fund.

Citigroup and Bank of America have already taken $45bn (£31bn) each from that fund, and having to take additional taxpayer money could mean part-nationalisation, with the government emerging as a major shareholder. Until now, government investment has come in the form of preferred shares, which do not count as capital under some measures.

"If you were to ask people last week which banks would most likely have to raise more capital, I think Bank of America, Citigroup would have been the common answer," Walter Todd, a portfolio manager at Greenwood Capital Associates, said. "To some degree their stock prices reflect a certain amount of dilution from issuing stock directly or converting preferreds."

Citigroup shares shed 5.9 per cent yesterday, while BofA shares tumbled 8.6 per cent. The cost of insurance against a debt default by either bank rose.

All 19 institutions being stress-tested have been told not to comment publicly on the process, but analysts are fearful that the coming days could prove volatile if rumours about the relative health of the different banks begin to circulate. The Treasury says it will reveal the results of the test and the amount of new capital each bank must raise next week.

The Wall Street Journal reported yesterday that BofA is being told to raise billions of dollars, while the size of the capital requirement at Citigroup is not clear.

The requirement to raise new money – if it is not reversed in the final discussions this week – could be a last straw for the leadership of Vikram Pandit at Citigroup or Ken Lewis at Bank of America, both of whom have been insistent that their banks are not running short on capital.

"I would guess both of them are gone by summer," Charles Geisst, the author of Wall Street: A History and a finance professor at Manhattan College, said. "They're caught between a rock and a hard place. They have to try to paint a rosy picture for investors, but, on the other hand, maybe what we need in the world is more forthright comments about the state of affairs at the banks, and they're not making those."

Mr Lewis faces a shareholder vote on his re-election today, and rebel shareholders have orchestrated a campaign against him, saying BofA's problems stem from his acquisition last summer of Merrill Lynch.

Lord Turner, in a speech in New York on Monday night, said there was no consensus yet on the amount of capital banks should be required to hold, but that firms dubbed "too big to fail" could be held to higher capital-ratio standards.

He said the move would increase the cost of banking, but "deliver the benefit of reduced instability". New UK rules could come as early as next month.