* Test includes surge in unemployment and economiccontraction
* Includes average fall of a fifth in property prices
* Results of test due in October
By Huw Jones
LONDON, April 29 (Reuters) - European banks must show theycan survive simultaneous routs in bonds, property and stocks inthe toughest test to date 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 "scenarios" banks such as DeutscheBank, BNP Paribas and Barclays face in a test whose results willbe published in October, raising hopes among policymakers thatbanks can finally turn a corner and lend more to the economy.
Over a three-year "stress test" period - a year longer thanin the 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 on trading books, theEBA said.
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 already bolsteringtheir capital to avoid the humiliation of failing the test, andbefore the European Central Bank (ECB) becomes their supervisorfrom November as part of a new euro zone banking union tointensify scrutiny of lenders.
Previous tests failed to convince markets and this timeround the ECB is reviewing the balance sheets of the top eurozone banks to ensure the stress test is based on reliablenumbers in the first place.
"The exercise's full transparency will be key to itscredibility," EBA Chairman Andrea Enria said in a statementoutlining the mix of shocks banks would face in the stress test.
"It will show how efforts recently undertaken by EU banksare already bearing fruit and it will provide a common frameworkfor the next steps to be taken by supervisors and banks."
Banks that fail the test will be given time to plug capitalholes by raising money from investors, scrapping dividends orselling assets.
HIGHER THRESHOLD
Although the European economy is improving after severalyears of fallout from a banking and euro zone debt crisis since2007, 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 banks would have to maintaincore capital equivalent to at least 5.5 percent of theirrisk-weighted assets to pass, a higher threshold than in theprevious test.
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 liabilities, meaning they canfoot 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.
Tests against a commercial property collapse are most severein the Britain, Sweden and Denmark and least severe in Austria,Portugal and Spain.
The test will also set tougher criteria on government debtholdings. The bulk of sovereign debt held by lenders is in theso-called available for sale (AFS) category in trading books,and some national regulators allow banks to ignore the impact ofmarket slides on this category in real life.
Despite opposition from some regulators, the EBA test willimpose a common phase-out of this protection where it exists, sothat by the third year, at least 60 percent of AFS would beunshielded.
The watchdog hopes the test results and data will bedetailed enough so that analysts can replicate it with their owncomputer models as a cross check. (Additional reporting by Laura Noonan; Editing by Mark Potter)
Barclays (BARC)
