ANALYSIS:THE SHOCK therapy prescribed yesterday by the US government may not be enough to cure the many ills of the nation's banking system.

That was the initial reaction from capital markets to the $2,000 billion financial rescue plan outlined by US treasury secretary Tim Geithner.

During his long-awaited speech, the stock market extended its morning losses and continued to fall afterwards, amid investors’ fears the new measures would not restore confidence in the battered sector.

Financial shares led the plunge, with large banks such as Citigroup, Bank of America and Goldman Sachs and Morgan Stanley down sharply.

The treasury plan, which will place more constraints on banks’ operations in return for more government funds and a $1,000 billion public-private “bad bank” for toxic assets, stops short of the nationalisation demanded by some analysts. As he announced another round of financial aid to an industry that has already received some $350 billion in federal funds, Mr Geithner tried to sound tough, reminding Wall Street that “access to public support is a privilege not a right”.

In exchange for that privilege, in the future all banks with more than $100 billion in assets will have to undergo a “stress test” to be carried out by a battery of regulators including the Federal Reserve and the Federal Deposit Insurance Corporation. Unlike current reviews, which focus on a backward-looking snapshot of a bank’s balance sheet, the new test will try to estimate whether the institution has enough capital to absorb future losses.

The move is aimed at countering criticism that widely used thermometers of financial health, such as capital adequacy ratios, fail to gauge banks’ ability to withstand wild gyrations in capital markets and sharp falls in asset prices.

But it remains unclear what new metrics the Fed and other regulators will use in setting the stress test. The carrot for the financial groups that pass the test and are deemed to be healthy enough to survive is an extra pot of government money.

Under the plan, the government will buy convertible preferred shares – a hybrid of debt and equity – into the institutions that need capital. Banks could then ask the government to convert the shares into common equity – at a discount to their share price on Monday “if needed to preserve lending in a worse-than-expected economic environment”. The bad news for shareholders is that the conversion would almost certainly dilute, if not completely wipe out, their investments.

“This confirms that common equity does matter, and that not all capital is created equal,” wrote UBS analyst Matthew O’Connor in a client note.

Recipients of aid will have "to show how every dollar of capital they receive is enabling them to preserve or generate new lending", Mr Geithner said. – ( Financial Timesservice)