There is no doubt that a healthy financial system is key for a strong economic recovery. There is also little doubt that many banks will still see large amount of losses in some of the assets they hold (although there are disagreements about the exact amount). And it also seems clear that the amount of expected losses might be larger than the capital that banks hold today, thus the need for some of them to raise additional capital.
The FT reports in today's edition that banks negotiated with regulators to reduce the amount of equity that would be required after the stress test (the Wall Street Journal run a similar story yesterday). One of the arguments the banks used is that they would be able to generate some of this capital by earning profits over the coming quarters. How realistic this is? If some of these banks are 'zombies' (technically insolvent), how will they generate profits? Wasn't this the purpose of the stress tests, to identify these banks now, make sure that their balance sheet is healthy rather than letting them stick around hoping that the economy improves? But if the banks are not healthy and cannot lend, how can the economy improve?
An interesting argument is made by James Surowiecki, citing research from Joe Peek and Eric Rosengreen. When looking at the Japanese experience, the slow recovery was not only due to the presence of 'zombie banks' but also to the presence of 'zombie corporations' which were supported by these banks. In fact, a lot of the credit given by Japanese banks to companies was given to companies who could not repay their previous debts (by keeping these companies alive the banks did not need to record the losses). According to Peek and Rosengreen, the government and regulators also encouraged banks to give credit to those companies. If banks had better allocated their credit, we would have seen the necessary renewal at the corporate level and an earlier exit from the recession.
How do we know that banks in the US and other advanced economies will not engage in the same behavior than banks in Japan in the decade of the 90s? If you want to be optimistic you might argue that the strong ties between Japanese banks and corporations and are not present in advanced economies (although one can easily argue that this might not apply to all countries). You can also be hopeful that governments do not put too much pressure on banks to lend without the proper lending standards (although we have already seen enormous pressure on banks to lend). Finally, you can also hope that the banks are not given incentives to create short-term profits at the expense of their long-term survival (although it might be that the november deadline for US banks to raise the needed equity could indeed provide the wrong short-term incentives).
And if all this is not enough to make you feel optimistic, you can always start a cartoon series about zombie banks (see the video below).