Fed Faces a Main Street 'Stress Test': Street Whispers

NEW YORK (TheStreet) -- The Federal Reserve has a new reason to question whether its post-crisis banking sector fixes targeted at Wall Street behemoths can also work on Main Street America.

After taking on "too big to fail" lenders, the Fed now faces the challenge of defining its oversight of smaller banks that dot Main Street and are at the heart of local commerce, in a crucial test of its increased power after the 2010 Dodd Frank Act.

On Monday, the Federal Reserve said it would delay a stress-testing program for banks with assets between $10 billion and $50 billion, caving in -- at least for now -- to protests from small and midsized lenders who argue they are struggling to keep up with a growing post-Dodd Frank Act regulatory burden.

In December 2011, the Fed proposed that savings and loan institutions with more than $10 billion in assets comply with annual company-run stress tests, subjecting them to capital requirements. In its delay, the Fed said concerns on the limited resources and readiness of those lenders gave it reason to reconsider how and when it will invoke the tests.

Separately, on Monday, the Federal Deposit Insurance Corporation also said it would postpone stress tests.

The delay is a setback to the Fed's overall stress testing program, which got positive reviews after March tests of "too big to fail" lenders like JPMorganChase (JPM), Bank of America (BAC), Goldman Sachs (GS) Morgan Stanley (MS) and Wells Fargo (WFC) showed sector-wide capital ratios that give America's largest lenders the strength to withstand a European debt spiral or a double dip U.S. recession. The tests also paved the way for most of America's largest banks, excluding Citigroup (C), to launch dividend boosts, share buybacks, or both, in a catalyst to what's been a 2012 banking sector rally.

But while stress tests are being seen as a positive for America's largest banks, Monday's delay for smaller banks -- many holding $10 billion to $50 billion in assets are regional and even community lenders -- signals that programs designed for "too big to fail" institutions may not work on Main Street.

"These are not the banks that are going to damage you," says Nancy Bush, the head of banking sector research firm NAB Research. "These are the companies that should be doing the most lending to small businesses and Main Street and guess what? They aren't. This is a problem for the Fed," she adds, noting the costs of regulations like stress tests.

Already, the Fed has been criticized for near-zero interest rate policies and added easing measures that are cutting at the earnings of traditional lenders, while acting as a subsidy for the largest banks, which deal in global markets and scores of financial products beyond traditional mortgage, small business and consumer loans.

The Fed may find that it needs to discriminate between rigorous tests for "too big to fail" banks and less harsh measures on the health of banks that don't present a systematic risk to the market. New Dodd-Frank capital requirements and those of Basel III already ask that systemically important institutions hold excess capital compared to lenders of a lesser size.

Rules on bank oversight may now also make the distinction.

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