ECB review makes investors wary of weaker banks

* ECB's review threatens broad bank rally

* Italian, Spanish lenders seen as vulnerable

* Nordic banks, HSBC to benefit from stronger balance sheets

By Francesco Canepa

LONDON, Oct 28 (Reuters) - A four-month, largelyindiscriminate rally in Europe's banking shares is under threat,as the European Central Bank's asset quality review lays barethe shortfalls of weaker institutions.

The wider-than-expected review into banks' balance sheetsthrows investors' spotlight onto lenders with problematic loanbooks, large exposures to sovereign bonds and rely on centralbank funding, such as Spain's Banco Sabadell andItaly's Banco Popolare.

While details of the review are still unknown, the risk thatsome weaker banks will have to raise more capital means they maybe axed from investor portfolios.

Shares in Sabadell, Banco Popolare and UniCredit have fallen between 3 and 5 percent over the past five tradingdays, compared with a 1 percent drop for the sector. The ECBunveiled parameters of the review on Oct. 23. Its results aredue to be published in October 2014.

These three stocks rose roughly 30 percent, or three timesas fast as the sector since late July, so they no longer lookparticularly cheap compared to peers with stronger balancesheets, such as France's BNP Paribas, Sweden's SvenskaHandelsbanken (SHB) or London-listed HSBC.

"The opportunities right now are in the banks with thestrongest balance sheets, which are best placed to generatecapital in the (next) 12-18 months," Neil Wilkinson, Europeanequities fund manager, Royal London Asset Management, said.

"After a period where southern European banks have done verywell...my focus is back on the fundamentals and northern Europeagain."

Stocks such as Spain's Sabadell and Popular andItaly's UniCredit and Intesa Sanpaolo have reducedtheir hefty price-to-book discounts to SHB by 20-30 percentsince June, Datastream data showed, despite still having muchweaker balance sheets than the Swedish bank.

Positioning by speculative investors also shows a marketbias in favour of southern European banks, meaning any bad newsfrom the review could have a big impact on their share prices.

Short interest - a measure of how many shares are out onloan to speculators hoping to sell them and buy them back morecheaply - in SHB is higher than in Intesa and UniCredit, Markitdata showed.

A Barclays Capital study shows Sabadell, Popular, UniCreditand Intesa Sanpaolo are among the most vulnerable if the ECBrequires them to increase their coverage ratio, a cash bufferbanks must keep to cover potential losses.

SHB, HSBC, BNP Paribas and Switzerland's UBS and CreditSuisse, by contrast, are highlighted among the most solid.

"It's very difficult to understand what skeletons banks havein their closets," said James Butterfill, head of global equitystrategy at Coutts.

"(But) if you buy these European banks individually, someseem much better capitalised than others," added Butterfill, whoowns shares in BNP Paribas and UBS.

Given that some of the weakest banks are in southern Europeand financial stocks have a higher relative weight in southernEuropean indexes, the recent outperformance of Italy's FTSE MIB and Spain's Ibex over northern indices couldunwind as the review approaches.

DERIVATIVES

Banks with large derivative holdings, including DeutscheBank, may also feel the heat after the ECB's surprisedecision to review the value of the least liquid assets, thoseincluded in the 'level 3' accounting category.

Level 3 assets, which include complex derivatives tradeddirectly between investors, are thinly traded and thereforedifficult to value, meaning there could be scope for surpriseswhen the ECB makes its own assessment of their value.

"If the regulator is looking at stuff like level 3 assetsrather than just the loan book there's potential pressure onsome of the names," Benjie Creelan-Sandford, an analyst atMacquarie Research, said.

German lender Commerzbank's exposure to level 3 assets istwice as big as its tangible book, with Deutsche Bank andPortugal's Banco PBI and BCP all well abovethe 100 percent mark, according to Macquarie.

A writedown of the value of these assets would thus have asignificant impact on the bank's overall capital position.

In this context, some analysts advocated avoiding euro zonebanks altogether and focusing on lenders that would not beaffected by the review, such as HSBC and Scandinavian lenders.

"You absolutely want to be hiding out in a bank wherethere's no risk of anything negative because they're not reallyin (the review)," Simon Maughan, head of research at OlivetreeFinancial Group, said.