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* IMF: nearly 3/4 of euro zone banks need to alter businessmodel
* Expectations for a "big bang" style revamp not high inEurope
* Market expects a handful of failures from Europe's stresstests
* Rising bad debts still clogging bank balance sheets
* Uncertain outlook and high rates curb firms' demand forcredit
By Padraic Halpin and John O'Donnell
DUBLIN/FRANKFURT, Oct 23 (Reuters) - If the European CentralBank really wants to kick-start the euro zone economy, it shouldensure the bloc's banks are up to the task of lending.
The International Monetary Fund has estimated that nearlythree-quarters of euro zone banks need to significantly changetheir business models before they will be able to meet thedemand for credit when the economy recovers.
This week's stress test of Europe's largest banks gives theECB an opportunity to overhaul the sector, closing strugglingbanks and ensuring the ones left standing can sell loansprofitably.
But expectations for a "big bang"-style restructuring of thebanking sector are low, given the political sensitivities atplay, and instead the market is factoring in just a handful offailures out of the 130 banks set to be tested, with a fewmid-sized banks in southern European countries such as Italy andGreece seen to be most at risk.
"In testing banks, the ECB is like a cat approaching a birdvery slowly and not wanting to scare him off," said Jan PieterKrahnen of Frankfurt's Goethe University.
Instead of triggering an overhaul of the sector to get theeuro zone economy moving, the ECB is throwing money at theproblem, cutting interest rates to record lows and offeringbanks cheap loans if they lend more to businesses.
So far, the results have not been encouraging. Last month,banks took up just 82.6 billion euros last month of the 400billion the ECB has put on offer, and a Reuters consensusforecast is that they will take up another 175 billion at thenext tender in December, which still leave them about 140billion short of the maximum.
Lenders say the demand just isn't there from corporateborrowers, but that is only one part of the story.
The banks have also been avoiding lending, particularly insouthern Europe, where arrears are still climbing from thecredit binge that precipitated Europe's financial crisis,clogging up the system and curbing banks' ability to offer freshcredit.
The fact that bad debts are still rising in countries suchas Italy and Spain, six years after the collapse of LehmanBrothers sent the global financial system into a tailspin,reflects a reluctance to tackle the problem.
In Spain, for instance, the tally of bank loans tumbled fromalmost 1.9 trillion euros in 2008 to less than 1.4 trillion now.Meanwhile the amount of credit deemed at risk -- where nothinghas been repaid for three months -- has trebled to 184 billioneuros, almost one fifth of Spain's annual economic output.
Banks and governments in Europe have often preferred tosweep such problems under the carpet, hoping that a resumptionof economic growth will resolve them, or inflation will make thedebts less onerous. But the economic outlook has worsened, andprices are barely rising at all.
"Non-performing loans will be there for a long, long time,"said Bridget Gandy of Fitch ratings agency. "We are talkingabout huge amounts of money. In a period of slow economicgrowth, that's going to drag and drag."
RATES TOUGH TO SWALLOW
Even without the legacy of bad debt, new internationalregulations also make it more expensive to lend money, and bankshave been reluctant to take on more risk while the ECB auditsand stress tests their balance sheets this year.
Although the ECB funding is cheap, making fresh loans stillrequires banks to find additional capital, which they may not bewilling to do.
In Greece, for instance, some small companies are beingoffered borrowing rates at up to four times the average cost ofborrowing in the euro zone.
"We have been facing borrowing rates of 8 to 11 percent,which is tough for a small business to swallow," said VassilisKorkidis of Greece's Confederation of Hellenic Commerce. "As aresult, some are simply avoiding bank borrowing."
"About eight out of 10 loan applications are being turneddown. Banks ask for guarantees, collateral that far exceeds theamount of money they are willing to lend."
In the meantime, around 130,000 small and medium-sized firmshave closed in Greece since the onset of the financial crisis.
Part of the problem for banks in Greece, Spain and Italy isthat they still face a higher cost of funding to peers innorthern Europe whose economies and governments are seen as morecreditworthy.
Italian banks have to pay on average 1.1 percentage pointsmore to attract funds than German banks do, which they have topass on to borrowers via higher lending rates.
Europe's stress tests are meant to help lower banks' cost offunding by ensuring that lenders that are not adequatelyprotected against future losses are either be reinforced,restructured or shut down, thus reassuring investors.
But the reluctance to lend may persist even after the tests,and Britain provides a hint of what to expect.
It was the first country in Europe to shake out itsfinancial system in 2008, pumping tens of billions of euros intotwo of its largest lenders, Royal Bank of Scotland andLloyds, and instructing peers to reinforce capitaldefences.
Yet this did nothing to stop the overall tumble in lending.Having grown in the run-up to the crash at the fastest pacesince the 1980s, when British comedian Harry Enfield's releasedhis hit 'Loadsamoney', lending has been falling since mid-2010.
"The fact that banks have built up capital doesn't mean thatthe risks are lower," said Marcel Fratzscher, president of theGerman Institute for Economic Research.
"We may get the lost decade, as happened in Japan, with thebanks relying on the ECB for finance but not lending. Thisperiod of stagnation may last longer than the great recession."
CONFIDENCE YET TO RETURN
It is not all the fault of banks. With even large economiessuch as Germany and France spluttering, many businesses in theeuro zone are simply reluctant to borrow.
In Italy, struggling to climb out of its third recession insix years, the chief executive of Unicredit said thismonth that he had taken to personally calling customers toencourage them to apply for loans.
Federico Ghizzoni said businesses in Italy had requested orexpressed interest in taking loans amounting to just over halfof the 7.75 billion euros that his bank borrowed via the ECB'sfour-year loan programme in September.
With consumer spending stagnant and the first signs ofdeflation lurking, companies are putting off investments."Machinery that once had an average life span of eight or nineyears may now be kept and not replaced for 15-20 years," hesaid.
But even in Ireland, the euro zone's fastest growingeconomy, lending to companies fell at an annual rate of 11.8percent in August, the fastest decline in three years.
Banks such as Bank of Ireland and Allied IrishBanks have ramped up loans to small and medium-sizedbusinesses, but they are starting from a low base and noteveryone is feeling confident about the recovery.
"We will probably look back in three years, as businesspractitioners, and say that was a 10-year recession," said LarryMurrin, president of the Irish business and employers'confederation and CEO of major food exporter Dawn Farm Foods.
"We're now at a phase where we're seeing tangible positivenews, very encouraging -- but business needs to see five, sixquarters of sustained growth before confidence returns."
Yet others are frustrated at their lack of traction with thebanks.
"I won an absolutely incredible contract, an opportunity tostrengthen the business beyond description, but I couldn't fundit because nobody would give me the money," said the head of aDublin-based environmental services company, who was refused aloan from five lenders this year. "That flattened me." ($1 = 0.7818 Euros) (Additional reporting by Silvia Aloisi in Milan, GeorgeGeorgiopoulos in Athens, Sarah White and Jesus Aguado in Madridand Axel Bugge in Lisbon; Editing by Carmel Crimmins and KevinLiffey)
