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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 (Adds market reaction, analyst comments)
By Huw Jones
LONDON, April 29 (Reuters) - European banks must show theycan survive simultaneous routs in bonds, property and stocks, inthe toughest test so far by regulators aiming to restoreconfidence in an industry that had to be rescued by taxpayers inthe financial crisis.
The European Banking Authority (EBA) said on Tuesday itwould gauge the resilience of 124 banks from the 28-countryEuropean Union to see if they would still have enough capitalafter facing 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.
The benchmark STOXX Europe 600 banks index was up1.5 percent at 1028 GMT, with almost all its members gainingground. The biggest risers were Commerzbank, Nordea - which posted results - and SocGen.
"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,"said Neil Williamson, head of EMEA credit research at AberdeenAsset Management.
"To be fair, deflation in the Eurozone 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 Eurozone," 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 European Central Bank(ECB), which has said printing money or quantitative easing ispossible if deflation becomes a real threat, something itcurrently doesn't expect.
ECB President Mario Draghi told German lawmakers on Mondaythat quantitative easing remained a way off. The bank testscould be one reason why.
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.
Separately, European insurers are also being tested by theirregulator, as policymakers seek to address market criticism thatthe EU has not been as robust in its response to the financialcrisis as the United States.
European banks such as UniCredit are alreadybolstering their capital to avoid the humiliation of failing thetests, and before the ECB becomes their supervisor from Novemberas part of a euro zone banking union.
Previous tests failed to convince markets and this timeround the ECB is reviewing the balance sheets of the top eurozone banks to ensure the test is based on reliable numbers inthe first place. Banks that fail the test will be given time toplug capital holes by raising money from investors, scrappingdividends or selling assets.
HIGHER THRESHOLD
Although the European economy is improving after severalyears of fallout from a banking and subsequent euro zone debtcrisis, regulators opted for their toughest test yet after thefailure of each of the previous three exercises to convincemarkets that banks have enough capital.
The EBA had already said the test would cover three yearsfrom January 2014, during which time banks would have to keepcore capital equivalent to at least 5.5 percent of theirrisk-weighted assets, a higher threshold than in the previoustest.
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.
Banks will also have to show that while their assets arebeing pummelled, they can manage their liabilities, meaning theycan meet the higher funding costs such distressed markets wouldbring despite the test's cap on income from interest andtrading.
Experiences from the recent past are also being included inthe test, such as spikes in market interest rates, and turmoilin central and eastern European currencies in the wake of recentforeign exchange crises, such as in Hungary.
The stress test includes national variations in how thedifferent assets react to the economic downturns.
For example, the gap between expected house prices and the"adverse" scenarios banks are tested against varies massively,with banks in Britain, Sweden and Finland tested against thebiggest departures from expectations and banks in Spain andPortugal, which have already suffered massively property slumps,tested against the smallest slumps. (Additional reporting by Laura Noonan and Mike Peacock; Editingby Mark Potter and David Holmes)
