UPDATE 3-EU pushes banks to quantify sovereign debt risks

(Adds detail on Greek bonds, German banking comment)

By Julien Toyer and Arno Schuetze

LUXEMBOURG/FRANKFURT June 21 (Reuters) - Europe's banks have been told to put a figure on potential losses from holdings in Greek and other sovereign debt to ensure a health check of lenders realistically reflects the deepening euro zone crisis.

Sources involved in the European Union stress test of 91 banks said regulators are "tightening the thumb screws" on lenders to spell out the impact of a government debt default -- but without having to make the politically unacceptable assumption in the test that a default can happen.

Test results will be published on July 13, the sources added.

Until now fallout from the sovereign debt crisis was focused on a bank's day-to-day trading book but most government bonds are held on a bank's core banking book.

The disconnect has become even starker as sovereign woes get worse, giving regulators a bigger headache as they try to avoid another stress test flop.

"Banking books are being stressed much more harshly than last year and than in the original draft of this year's stress test. That will help increase the credibility of the tests," an official in charge of the stress test at his bank said.

"That will result in factually putting countries like Greece on default status," the official added.

The test is aimed at shoring up investor confidence in the sector which is already being hit by the prospect of tougher regulation eating away into profitability.

After last year's test flopped -- Irish banks had to be bailed out after passing -- the fledgling European Banking Authority (EBA) which is conducting the health check, is staking its reputation on delivering a credible exercise this time round.

Europe has raised the bar for banks this year, demanding they hold more, better-quality capital to withstand a possible 2-year recession. They have to hold more than 5 percent of core Tier 1 capital to pass the exam, or raise capital.

TIGHTER THUMB SCREWS

A German regulatory source said the EBA had tightened the screws to draw up the "harshest version" of haircuts or losses on government debt.

The estimated banking book loss would be based on the probability of default (PD) and loss given default (LGD), as with estimates of credit risk for all banking book assets, sources said.

The probability of default is based on a sliding scale of credit ratings from Moody's and Standard & Poor's from June 1. Both the PD and LGD indicators have risen sharply for Greek bonds in recent weeks.

The EBA's tougher approach looks at how a bank would survive a four-notch rating downgrade to low rated government debt holdings -- a move that would take Greek bonds into default territory.

Germany's Landesbanks are seen as among the weaker lenders in Europe but are still expected to pass despite a toughening up of the banking book rules.

"We still assume that the Landesbanks will pass the EBA stress tests," a spokesman for the Association of German Public Sector Banks said.

More data on banking book fallout from the euro zone crisis will also help the EBA fulfil another aim -- giving markets enough detail so they can conduct their own tests to include scenarios such as the impact of government defaults.

The publication date for the stress test results will be formally announced "once the big decisions on Greece will be taken", an EU source said.

The EU decided this week to defer its next slice of funds to bail out the country until Greece takes more practical steps to cut public debt.

Euro zone ministers meet in early July for a progress report on Greece.

EU finance ministers discussed on Monday in Luxembourg the "backstop" measures their countries must have in place by the test publication date in the event a national bank fails, an EU diplomat said.

EBA Chairman Andrea Enria also briefed ministers on the tests so far and ministers will discuss the stress test results on July 12 on the eve of publication.

The EBA said no date has been set for publication of the tests. "We are still waiting for the data to be resubmitted at the end of June," an EBA spokeswoman said. (Reporting by Julien Toyer in Luxembourg, Arno Schuetze, Philipp Halstrick and Alexander Huebner in Frankfurt, Steve Slater and Huw Jones in London. Editing by Alexander Smith)