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* Bank shares, debt expected to rise after no major failures
* Italian banks the biggest losers, Monte Paschi hiresadvisors
* U.S. tests still seen as more credible; regular testingneeded
* Chances of Lloyds restarting dividend called into question
By Simon Jessop and Sudip Kar-Gupta
LONDON, Oct 26 (Reuters) - Investors gave a cautiousthumbs-up to the European Central Bank's (ECB) health check ofeuro zone banks on Sunday describing it as a step in the rightdirection rather than the final word on the state of the bloc'sfinancial system.
The number of banks that failed the test and the size oftheir capital shortfall were in line with expectations afternews leaked on Friday that 25 lenders would flunk the year-longreview.
With no major bank caught short and a relatively smallcapital hole to fill, markets were expected to take the resultsin their stride although Italian bonds and bank shares couldcome under pressure on Monday after Italy dominated the loserslist with 9 lenders failing the tests.
"I think stocks, broadly speaking, will have an up daytomorrow. While there were no major surprises in terms of whopassed and who failed, there was still an element of uncertaintyand so it's positive for the market that we get this exercise,which has been dragging on for year, behind us," said PhilippeBodereau, head of global banking at PIMCO.
"It's meaningfully positive for market sentiment."
Twelve of the 25 failing banks have already covered theircapital shortfalls after raising a collective 15 billion eurosthis year and of the remaining 10 billion euros, nearly a thirdof that should be raised via restructuring plans already inplace for Greek lenders Eurobank, Piraeus and National Bank of Greece.
Monte dei Paschi, Italy's third-largest bank, wasthe biggest loser, with a capital hole of 2.1 billion eurosstill to fill, prompting it to hire Citigroup and UBS to adviseon strategic options, according to a source familiar with thematter.
With capital shortfalls largely concentrated in banks inItaly, Greece and Cyprus the results were reassuring forinvestors in bank shares and junior bonds, which might have beenat risk of losses if the failures had been bigger and morewidespread.
"It makes me more confident about buying sub-ordinate bankdebt and bank equity. It removes uncertainty around the bankingsystem capitalization and encourages investors to buy equity andlower-rated debt," said Louis Gargour, chief investment officerat LNG Capital.
Germany's Deutsche Bank was one of the bigwinners, passing the stress tests even before this year'scapital raising of 8.5 billion euros was taken into account.
Britian's Lloyds Banking Group, meanwhile, could bein for a drop on Monday after it only narrowly passed the tests,putting a question mark over its ability to re-start dividends.
GETTING UNDER THE SKIN
The ECB was under pressure to do a thorough purge of banks'balance sheets after previous regional stress tests failed tospot problems, giving Ireland's banks the thumbs up monthsbefore they keeled over.
Investors praised the ECB for unveiling some skeletons,including identifying an extra 136 billion euros innon-performing loans, but said the tests still lacked thecredibility of similar examinations in the United States becauseof the political sensitivities of dealing with individualcountries and because the ECB is still getting to grips with itsnew status as a banking supervisor.
"The US regulators have much more of a handle on the trueposition of the institutions they regulate day-to-day. They havepeople on the ground within the institutions themselves. The ECBdoesn't actually take up its euro zone regulatory role untilNov. 4," said Barney Reynolds, global head of financialinstitutions advisory practice at Shearman & Sterling.
"I don't think it's regarded as an entirely apoliticalexercise internationally but on the other hand it's the firsttime a transnational body has, in a credible way, got under theskin of some of these figures."
The ECB tests are seen as crucial to restoring confidence inthe region's banks in the wake of the 2007-09 financial crisisand reviving the flow of credit to the euro zone economy.
But investors said Europe needed several years of crediblestress tests if they really wanted investors to pour money backinto banks in peripheral countries such as Ireland, Spain andItaly.
"This is a step in the right direction, but this is sort oflike a baby step. We need to see a couple of years of good testresults for those countries and those banks before we even thinkabout it," said Joe Urciuoli, head of credit research atSpectrum Asset Management. ($1 = 0.7893 Euros) (Additional reporting by Clare Hutchison, Nishant Kumar andCarolyn Cohn in London and Carmel Crimmins in Dublin.)
