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* Stress test to cover three years from December 2013
* Core capital must be above 5.5 percent for bank to pass
* Details of actual stress scenarios due in April or May
* French banking source says ECB already strutting its stuff
* Critics say treatment of sovereign debt still too feeble
By Huw Jones
LONDON, Jan 31 (Reuters) - European Union banks face theirtoughest probe yet in a bid to weed out the sector's weaklings,the bloc's chief watchdog said on Friday, announcing stresstests intended to help draw a line under the financial crisis.
More than half a decade since the start of the 2008-2009credit crunch, and despite more than 1 trillion euros ($1.4trillion) of state support, confidence in the sector remainsfragile and the EU's latest health checks are intended to settleany lingering doubts over its finances.
The European Banking Authority (EBA), the EU watchdogcoordinating the tests, said on Friday that to pass, banks musthave a core capital ratio of above 5.5 percent during thethree-year stressed scenario, including above 8 percent at thestarting point.
This reflects the amount of capital reserves banks have toput aside to cover unpaid loans or market bets that go wrong andrepresents a higher bar than in previous tests or before thecrisis, when it was typically about 2 percent.
For the banking sector as a whole a key issue is whether thetests will force another round of multi-billion eurocapital-raisings via share issues, but the answer to thatquestion won't emerge until later in the process.
Some banks like Deutsche Bank and Monte deiPaschi have moved early to bolster their balancesheets but there may be more to come. The Bank of Italy forinstance has said some smaller Italian lenders may need 1.2billion euros in total.
Analysts have estimated the tests could show a totalshortfall of up to 100 billion euros.
The 2014 tests will apply to 124 banks across the EU, suchas leading lenders BNP Paribas, accounting for roughly30 trillion euros in assets. The stresses being tested will berevealed in April or May.
"The more rigorous the better," said Francisco Gonzalez,chairman of Spanish bank BBVA. Angel Ron, chairman ofrival Banco Popular, said the 5.5 percent threshold isdemanding but his bank was is "very well prepared".
The EBA is mapping out a timeline and common methodologythat must be applied to all banks, but some national supervisorswill add additional risks to be tested. Germany, for example, islikely to also test for exposure to the shipping business, towhich some of its banks lent heavily.
The Bank of England said its own stress test of eight banks,including Barclays, HSBC and RBS, willrun alongside the common EU test, dashing any hopes amonglenders it would be a substitute.
The outcomes of prior balance sheet or asset quality reviews(AQR), due to be completed in June, and the stress test itself,which starts in May, will be combined into a single result foreach lender in October, spelling out the size of any capitalshortfall.
The German banking lobby said extra national tests wouldmuddy the picture, but the EBA said they would be reportedseparately from the common EU test to make comparisons valid.
LAST RESORT
The EBA has yet to decide how much time a bank would have toplug a shortfall after the results are published, thoughpolicymakers insist taxpayers are the last resort.
There is also debate over how to treat bank holdings ofgovernment debt in the so-called "available for sale" category.Some supervisors may apply a more lenient treatment than others,but the results in October will make clear what treatment wasapplied so analysts can run their own tests.
Professor Hans-Peter Burghof of Hohenheim University inGermany said the treatment of sovereign debt was too feeble,echoing criticism of past exercises. "The stress test is a veryblunt tool and because of that it is unrealistic to hope thatconfidence in European banks will come back," he said.
After the failure of past tests to root out problems, thestakes are higher this time as the European Central Bank (ECB)is putting its credibility on the line. Under a new bankingunion for the single currency area, the ECB will directlysupervise 130 euro zone lenders from November.
To avoid embarrassments down the line, the ECB is handlingthe balance sheet review for euro zone lenders and their stresstests itself, using new powers to by-pass protective nationalsupervisors and challenge suspect data from a bank directly.
"This is the game changer," an EU regulatory official said.
A French banking source said the ECB was already "struttingits stuff" by asking for millions of pieces of data to checkexposures line by line.
Central bankers say a balance sheet review ahead of thestress tests, to be carried out for the first time, along withthe use of outside consultants, makes the test more rigorous.
Regulators say increased credibility this time round isclear from the way banks have already been scrambling to bolstertheir capital ratios, mainly by dumping loans, known asdeleveraging, to avoid the humiliation of failing the test.
This deleveraging could pick up again after the test resultsare announced and supervisors will press lenders to raise newcapital rather than just ditch loans, people familiar with ECBthinking said.
Banks will be under pressure to fill capital holes evenbefore the test results are announced, and to tell markets inJune if the initial review uncovers any major shortfall.
Regulators say stopping leaks will be challenging as lendersmay be tempted to reassure investors who face having to waitmonths before the formal result.
"It's a shame that the AQR and the stress tests will take solong, as it's not good to have any uncertainties hanging overthe sector," said Emilio Botin, chairman of Spain's Santander. "Although I don't have any doubts about Spain."
