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* Tests include surge in unemployment and recession
* Also include average fall of a fifth in property prices
* Results of tests due in October
* ECB says banks must fill capital holes within 9 months
By Huw Jones and Eva Taylor
LONDON/FRANKFURT, April 29 (Reuters) - European banks mustshow they can survive simultaneous routs in bonds, property andstocks, in the toughest test so far by regulators aiming torestore confidence in an industry that had to be rescued bytaxpayers in the financial crisis.
The European Banking Authority said on Tuesday it wouldgauge the resilience of 124 banks from the 28-country EuropeanUnion to see if they would still have enough capital afterfacing a toxic cocktail of theoretical shocks.
The EU watchdog set out the scenarios which banks such asDeutsche Bank, BNP Paribas and Barclays could face, in tests whose results will be published inOctober, raising hopes among some policymakers that banks canfinally turn a corner and lend more to the economy.
Previous tests failed to convince markets so that Europeanbanks have traded at a discount to U.S. rivals due to doubtsover whether they have accurately valued assets on their books.
This time round the European Central Bank is reviewing thebalance sheets of the top euro zone banks to ensure the test isbased on reliable numbers in the first place.
After the details of the tests emerged the benchmark STOXXEurope 600 banks index was up 2.03 percent by 1550 GMT,with almost all the banks in the index rising.
"The scenario is not as severe as it could have been,"Fernando de la Mora, Madrid-based head of stress testing atconsultancy Alvarez & Marsal, said. "There are certainlycountries that could have been stressed more."
De la Mora said countries including Spain, which havealready suffered a severe downturn, were exposed to less severestresses than countries like Britain, France and eastern Europe.
"The granularity and relevance of the scenarios is muchbetter than Europe's first two stress-test attempts, but theabsence of widespread deflation is an elephant in the room,"Neil Williamson, head of EMEA credit research at Aberdeen AssetManagement, said.
"To be fair, deflation in the euro zone would have such direconsequences for both public and private finances, that toinclude it could have risked too big a jolt to the fledglingconfidence returning to the euro zone," Williamson said.
Over a three-year stress test period - a year longer than inthe previous exercise - banks must show they can cope with acumulative loss of 2.1 percent in economic output, much worsethan the 0.4 percent decline in the last test.
Such a poor economic performance would push up unemploymentto 13 percent and send house prices down 20 percent on average,triggering defaults on loans held by banks, the EBA said.
From a macro-economic point of view, analysts say it isunlikely banks will significantly raise lending until the testsare done, and maybe not even then, depending on what they show.
CORPORATE ASSETS
That has profound implications for the ECB, which has saidprinting money or quantitative easing is possible if deflationbecomes a real threat, something it currently does not expect.
ECB President Mario Draghi has said that quantitative easingremained a way off. The bank tests could be one reason why.
But ECB vice president Vitor Constancio said: "There is norelation between the two things," referring to the tests andquantitative easing.
The ECB is looking at buying corporate assets rather thangovernment bonds, but there is neither the structure nor size ofmarket to make that workable yet. If the ECB did buy governmentbonds with new money, most of it would flow to the banks, whichmight then not lend it on, so the impact would be muted.
Data released on Tuesday showed bank lending to euro zonecompanies and households fell 2.2 percent year-on-year in March.
Constancio said the euro zone largest banks have alreadytaken steps to strengthen balance sheets by an estimated 104billion euros since July 2013 ahead of the ECB's check-up.
European banks such as UniCredit taking action oncapital to avoid the humiliation of failing the tests, andbefore the ECB becomes their supervisor from November as part ofa euro zone banking union.
Banks that fail the test will be given up to nine months toplug capital holes by raising money from investors, scrappingdividends or selling assets.
"Specifying 6-9 months to remedy an assessed capitalshortfall significantly constrains the extent to whichdeleveraging can be used to raise capital," Jason Napier, headof European banks research at Deutsche Bank, said.
Napier said this meant banks were likely to turn to capitalmarkets to fund shortfalls rather than slim down businesses.
HIGHER THRESHOLD
Although the European economy is improving after falloutfrom the financial crisis, regulators opted for their toughesttest yet after the failure of each of the previous threeexercises to convince markets that banks have enough capital.
The European tests pose a less severe shock than thosecarried out by the U.S. Federal Reserve, but Europe requiresbanks to hold a higher proportion of high-quality capital toabsorb potential losses in a stressed scenario.
The impact of the theoretical economic slowdown will be feltin six shocks hitting all assets held on banks' trading books,compared with two shocks in the prior test.
This time round banks cannot include planned measures toboost capital after the December 2013 cut-off date for the test. (Additional reporting by Laura Noonan and Mike Peacock inLondon, Eva Taylor in Frankfurt; Editing by Mark Potter, DavidHolmes and Jane Merriman)
