When we hit middle age we worry more about our health. We have physicals more often to carefully assess our general health. One key test is the stress test, which provides information about how the heart performs when there is an increased demand for blood (such as when exercising). If we have clogged arteries, the heart can’t meet the demand for blood, and the changes can be seen on an EKG and ultrasound.

The U.S. Treasury and Fed have conducted stress tests on the nation’s largest banks. These stress tests are similar to a cardiovascular stress test. The banking stress test tried to assess whether there would be enough capital (think blood) in times of stress on the system. The thinking is that if a bank has enough capital, it will be able to weather an economic storm. Fed Chairman Ben Bernanke recently told the Wall Street Journal “Projecting credit losses in an uncertain economic environment is difficult, to say the least, but the intensive, painstaking nature of this process gives us confidence in our results, we believe that our estimates of needed capital buffers are appropriately conservative.”

So what does it mean for a bank to have a capital buffer?

To get to the answer let’s look at the balance sheet. The traditional equation of the balance sheet looks like this:

Assets = Liabilities + Equity

We like to convert the equation with a change in terms and some simple algebra. Our Financial Intelligence version of the equation becomes:

Own (assets) – Owe (liabilities) = Worth (equity)

Now if what you Own in a business is less than what you Owe, that is bad. When Own < Owe, the business has a negative net worth, and when a business gets there, that means trouble. At that point, we start using words such as insolvency or bankruptcy.

The goal of Timothy Geithner of the US Treasury and Ben Bernanke of the Fed is to keep our major banks from getting to the Own < Owe situation. Problems arise when the economy is down and banks take loan losses. In other words they have to write down or decrease what they own. As banks write down their assets (what they own) according to our simple equation, Own - Owe = Worth, worth has to go down. Clearly, as these write-offs increase, the chance for the dreaded Own < Owe becomes a real possibility.

Remember that banks leverage their worth with a lot of liabilities in the form of deposits (your deposit is what they owe you, so it is a liability to the bank) and borrowing from other banks. Most banks run at a ratio of Owe (liabilities) to Worth (equity) between 10 and 20 to 1. So a small drop in what a bank owns can quickly wipe out the bank’s worth.

When Bernanke talks about a capital buffer, he is saying he wants to make sure that the banks have enough worth to survive having to take write-offs on more loans.

Original post created by: Karen Berman & Joe Knight @ HBP