* Regulators may check on risky business models
* Want to move beyond only policing capital levels
* To explore how banks will wean selves off cheap ECB funding
By Huw Jones
LONDON, March 20 (Reuters) - European Union regulators may extend the scope of next year's bank stress tests to check whether business models are too risky or vulnerable, a senior source familiar with the matter said.
The European Banking Authority (EBA), made up of financial regulators from the bloc's 27-member countries, is completing this year's stress test which obliged 31 lenders to plug a 115 billion euros hole to bring up their core capital level to 9 percent of risk weighted assets by the end of June.
The aim is to help restore investor confidence in a sector which the European Central Bank has flooded with a trillion euros of three-year loans to meet funding demands as many investors stay on the sidelines.
The EBA is now turning its attention to next year's test and has already held a "brainstorming" session to explore ideas.
"The key point is not to focus that much on pass/fail exercises or more capital. The point is to understand how banks are changing their business model, how they are deleveraging and adapting to the new rules," the source said.
"They are having a lot of support from the ECB -- it's rather cheap," the source added.
The test could look at how business models were evolving after many lenders have dumped assets to lessen the need for capital, and whether they can wean themselves off ECB funding when it has to be paid back.
Lenders' timetables for repaying funds will be closely watched by regulators.
But supervisors want the stress test, which is likely to be an annual event, to develop into a tool to identify and measure risks, vulnerabilities and sustainability in a bank's model, the source said.
An EBA spokeswoman said no final decisions have been taken as the discussions on next year's test were at a preliminary stage.
Simon Gleeson, a financial services partner at law firm Clifford Chance, said the ambition to test business models was laudable but would be difficult in practice.
"I suspect we are starting to see really serious powder and shot being devoted to whether one business model is superior to others," Gleeson said, adding the EBA risked ending up in politically hot water if it favoured a particular model.
Bank business models have become a hot issue after taxpayers had to stump up 3 trillion euros since the financial crisis to shore up the sector.
France and Germany in the past have vigorously defended their universal banking model which houses deposit-taking and investment banking operations under the same roof.
Britain is pushing ahead with splitting off riskier investment banking and ring-fencing the retail arms of its domestic lenders with more capital.
The industry is watching a high-level EU group set up by the bloc's financial services chief Michel Barnier to report by the end of the summer on whether structural changes are needed to EU banking business models.
Britain's Financial Services Authority has already begun to look at business models more closely to check whether they rely on high profitability in a few products.
Margaret Cole, the FSA's top enforcer who steps down this month, told Reuters last year the watchdog may delay authorisation for a financial firm if its business model relies on a "novel" product with a suspect design.
The FSA is also drawing lessons from the forced nationalisation of Northern Rock bank at the height of the financial crisis due to its over-reliance on wholesale funding markets which dried up overnight.