Q&A: What will happen if banks fail stress tests?

— -- The much-hyped "stress tests" conducted by the government on the nation's largest banks is considered a critical component to shoring up the U.S. financial system, which in turn is key to the Obama administration's plan for economic recovery.

Friday, the Federal Reserve and other bank regulators informed the 19 largest banks of the results of the stress tests, and whether they will need an extra cushion, or "buffer," of capital to make it through a deepening recession. The results of these tests will be made public on May 4.

This week, each bank will have the opportunity to discuss results of the test and the amount of capital required with regulators. The Fed released a white paper Friday describing the parameters of the stress tests, removing some of the secrecy surrounding the process, which has caused confusion in the markets and befuddled analysts.

Here are some key questions on the tests and why they were conducted:

Q: What is the objective of the stress test?

A: The goal is to avoid the panic that the country faced last fall when several large financial institutions, including Washington Mutual, Lehman Bros. and Freddie Mac, either failed or were taken over by the government. To ensure that, 150 bank examiners and economists from the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. supervised the process. They put the nation's 19 largest banks through rigorous tests to determine if they are healthy enough to endure a worsening economy and continue to provide credit to families and businesses. These banks, which have more than $100 billion in assets, were targeted because they collectively hold two-thirds of the assets and more than half the loans in the U.S. banking system.

Q: How is the test conducted?

A: The tests subject banks' balance sheets to two scenarios, one of which reflects current economic forecasts, in which the economy contracts 2% in 2009 and grows 2.1% in 2010, with an unemployment rate of 8.8% in 2010. The second assumes that the recession will worsen, with unemployment climbing to 10.3% from the current 8.5% and home prices falling 22% in 2009.