UPDATE 2-EU watchdog sets out initial terms of bank health check
* Stress test to cover three years from December 2013
* Core capital must be above 5.5 percent for bank to pass
* Details of actual stress scenarios due in April or May
* French banking source says ECB already strutting its stuff
* Critics say treatment of sovereign debt still too feeble
By Huw Jones
LONDON, Jan 31 (Reuters) - European Union banks face their toughest probe yet in a bid to weed out the sector's weaklings, the bloc's chief watchdog said on Friday, announcing stress tests intended to help draw a line under the financial crisis.
More than half a decade since the start of the 2008-2009 credit crunch, and despite more than 1 trillion euros ($1.4 trillion) of state support, confidence in the sector remains fragile and the EU's latest health checks are intended to settle any lingering doubts over its finances.
The European Banking Authority (EBA), the EU watchdog coordinating the tests, said on Friday that to pass, banks must have a core capital ratio of above 5.5 percent during the three-year stressed scenario, including above 8 percent at the starting point.
This reflects the amount of capital reserves banks have to put aside to cover unpaid loans or market bets that go wrong and represents a higher bar than in previous tests or before the crisis, when it was typically about 2 percent.
For the banking sector as a whole a key issue is whether the tests will force another round of multi-billion euro capital-raisings via share issues, but the answer to that question won't emerge until later in the process.
Some banks like Deutsche Bank and Monte dei Paschi have moved early to bolster their balance sheets but there may be more to come. The Bank of Italy for instance has said some smaller Italian lenders may need 1.2 billion euros in total.
Analysts have estimated the tests could show a total shortfall of up to 100 billion euros.
The 2014 tests will apply to 124 banks across the EU, such as leading lenders BNP Paribas, accounting for roughly 30 trillion euros in assets. The stresses being tested will be revealed in April or May.
"The more rigorous the better," said Francisco Gonzalez, chairman of Spanish bank BBVA. Angel Ron, chairman of rival Banco Popular, said the 5.5 percent threshold is demanding but his bank was is "very well prepared".
The EBA is mapping out a timeline and common methodology that must be applied to all banks, but some national supervisors will add additional risks to be tested. Germany, for example, is likely to also test for exposure to the shipping business, to which some of its banks lent heavily.
The Bank of England said its own stress test of eight banks, including Barclays, HSBC and RBS, will run alongside the common EU test, dashing any hopes among lenders it would be a substitute.
The outcomes of prior balance sheet or asset quality reviews (AQR), due to be completed in June, and the stress test itself, which starts in May, will be combined into a single result for each lender in October, spelling out the size of any capital shortfall.
The German banking lobby said extra national tests would muddy the picture, but the EBA said they would be reported separately from the common EU test to make comparisons valid.
The EBA has yet to decide how much time a bank would have to plug a shortfall after the results are published, though policymakers insist taxpayers are the last resort.
There is also debate over how to treat bank holdings of government debt in the so-called "available for sale" category. Some supervisors may apply a more lenient treatment than others, but the results in October will make clear what treatment was applied so analysts can run their own tests.
Professor Hans-Peter Burghof of Hohenheim University in Germany said the treatment of sovereign debt was too feeble, echoing criticism of past exercises. "The stress test is a very blunt tool and because of that it is unrealistic to hope that confidence in European banks will come back," he said.
After the failure of past tests to root out problems, the stakes are higher this time as the European Central Bank (ECB) is putting its credibility on the line. Under a new banking union for the single currency area, the ECB will directly supervise 130 euro zone lenders from November.
To avoid embarrassments down the line, the ECB is handling the balance sheet review for euro zone lenders and their stress tests itself, using new powers to by-pass protective national supervisors and challenge suspect data from a bank directly.
"This is the game changer," an EU regulatory official said.
A French banking source said the ECB was already "strutting its stuff" by asking for millions of pieces of data to check exposures line by line.
Central bankers say a balance sheet review ahead of the stress tests, to be carried out for the first time, along with the use of outside consultants, makes the test more rigorous.
Regulators say increased credibility this time round is clear from the way banks have already been scrambling to bolster their capital ratios, mainly by dumping loans, known as deleveraging, to avoid the humiliation of failing the test.
This deleveraging could pick up again after the test results are announced and supervisors will press lenders to raise new capital rather than just ditch loans, people familiar with ECB thinking said.
Banks will be under pressure to fill capital holes even before the test results are announced, and to tell markets in June if the initial review uncovers any major shortfall.
Regulators say stopping leaks will be challenging as lenders may be tempted to reassure investors who face having to wait months before the formal result.
"It's a shame that the AQR and the stress tests will take so long, as it's not good to have any uncertainties hanging over the sector," said Emilio Botin, chairman of Spain's Santander . "Although I don't have any doubts about Spain."