Citigroup Inc. and Bank of America Corp. will need to raise more capital if they can't convince regulators that "stress test" results were mistaken, according to two people familiar with the matter and a Wall Street Journal report.
The banks are hard at work preparing their appeals, said the people, who spoke on condition of anonymity because everyone involved in the process has been ordered not to discuss it. Objections could include suggestions that regulators don't fully understand the companies' operations, they said.
But the companies face an uphill battle in convincing officials the results are mistaken because the tests can't look too easy, analysts said.
Shares of Bank of America and Citi each dropped about 5 percent in afternoon trading. Wells Fargo & Co., PNC Financial Services Group Inc. and others also dipped. JPMorgan Chase & Co., American Express Co. and a few more of the 19 banks tested by the government traded slightly higher.
Investors have grown more concerned about regional banks with many risky loans on their books. Defaults on those loans could skyrocket in a worsening economy. Banks that carry such loans, including KeyCorp and SunTrust Banks Inc., are likely to be asked to improve their capital reserves.
"It's not surprising there are some slaps on the wrist or calls for recapitalization," for example at Citi or Bank of America, said Simon Johnson, a former IMF chief economist now at Massachusetts Institute of Technology's Sloan School of Business. "It's in keeping with their overall strategy" of waiting out the banking system's problems, he said.
Federal Reserve officials told reporters Friday that all 19 banks that underwent stress tests will be required to keep an extra buffer of capital reserves beyond what is required now in case losses continue to mount. That would mean some banks will likely have to raise additional cash. But the Fed stressed in a statement that a bank's need for more capital reserves to meet the requirements should not be considered a measure of the "current solvency or viability of the firm."
Fed officials held top-secret meetings with bank executives last week to give them preliminary findings of how each bank would fare if the recession got much worse. The government plans to announce the results of the tests May 4, and banks will have the opportunity to appeal the findings.
By law, the banks cannot publicize the results without the government's permission. Banks have until Tuesday to make their cases. They will receive the final test results Friday, and the information will be released next week.
Regulators and the banks are actively discussing the preliminary results, people with knowledge of the situation said Tuesday. They spoke on condition of anonymity because of the sensitive nature of the process.
The results will determine the fates of the companies, which together hold one-half of the U.S. banking system's loans. Banks found to need more capital face several possibilities: The government could convert its stake in them to common shares, force them to raise money from investors or eventually release more funds from the Treasury Department's $700 billion financial bailout.
The banks' options are designed to ensure banks have enough cash to withstand the mounting loan losses they would absorb in a bleaker economy.
The news about Charlotte, N.C.-based Bank of America and New York-based Citi was first reported in The Wall Street Journal Tuesday.
Bank of America declined to comment.
Citigroup said in a statement, "Until the results of the stress tests are announced, our regulators have prohibited all financial institutions, including Citi, from making any comments related to the stress tests."
A Citi spokesman added that the bank is continuing with its plan to exchange debt for equity and shed assets as part of a program to further bolster its capital position.
Citi has reached a basic agreement to sell its Japanese brokerage unit, Nikko Cordial, to Sumitomo Mitsui Financial Group Inc. for 500 billion yen ($5.2 billion), according to The Nikkei business newspaper. Citi declined to comment on the potential sale of the unit.
Fed spokeswoman Michelle Smith on Tuesday declined to comment on Bank of America and Citigroup.
Treasury spokesman Andrew Williams said department officials would not comment on whether regulators told Bank of America and Citigroup they may need to raise more capital.
As executives of the nation's largest banks review their stress-test results, even the top performers are lobbying regulators to raise their scores before the numbers are finalized Friday.
For Treasury, the easiest way to bolster bank balance sheets is to convert the government's existing stake from preferred shares — a form of debt — into common shares that carry voting rights. This would help Treasury avoid returning to Congress for more bailout money — a request lawmakers are likely to rebuff.
If the test showed a bank would need more money to endure a much worse recession, regulators will force it to meet higher standards for capital reserves, to offset possible future losses.
Banks deemed to have enough capital may learn whether they'll be permitted to repay billions of dollars the government injected into them last fall, analysts and officials said. Most large banks have said they want to repay the money to escape executive compensation limits and other obligations.
Shares of Citigroup fell 15 cents, or 4.9 percent, to $2.92 in afternoon trading. Bank of America shares declined 59 cents, or 6.6 percent, to $8.33.