UPDATE 2-ECB to reveal strategy for bank health checks by end-March

Mon Feb 3, 2014 1:03pm EST

* ECB says to finish portfolio selection in mid-February

* AQR methodology will be finished in coming weeks

* ECB to apply EBA parameters for stress test

* Timeframe to boost capital buffers to depend on scenarios

By Eva Taylor and Jonathan Gould

FRANKFURT, Feb 3 (Reuters) - The European Central Bank kept the euro zone's top lenders on tenterhooks as it promised to reveal the strategy for its unprecedented review of bank balance sheets by the end of March, giving only scant detail on Monday.

The ECB's asset quality review, or AQR, is part of a broader examination that also includes a stress test to see how banks hold up under shock scenarios, to avoid nasty surprises once it starts supervising them from November.

The exercise aims to encourage banks to recognise losses on loans or investments that have soured over time, allowing them to regain investors' trust and free up capacity to grant new loans to help along the euro zone's fragile economic recovery.

By holding back details of the AQR, the ECB will keep banks on their toes.

"Firms' auditors don't send around the audit manuals to clients," said Stephen Smith, head of KPMG's AQR Task Force. "There's a danger that people might start to game you (if they know the details too far in advance)."

Confidence in the sector remains fragile despite more than 1 trillion euros ($1.4 trillion) of state support since the global financial crisis and the euro zone's debt problems underlined the risky relationship between over-indebted governments and the banks who buy many of their sovereign bonds.

The European Union's latest health checks are intended to settle any lingering doubts over its finances.

On Friday, the European Banking Authority (EBA) set out parameters for the stress tests and the ECB said it would apply them as well, aiming to give banks the stress test scenarios by the end of April.

Euro zone banks will get some time to meet the capital shortfalls highlighted by the scenarios, but the gaps from the baseline scenario in which banks must have a core capital ratio above 8 percent need to be addressed right away.

"A shortfall relative to the baseline scenario will require that capital be raised in the nearer term, whereas a shortfall arising from the adverse scenario may only require capital to be raised over a more extended period, on the basis of an agreed capital plan," the ECB said in a statement.

KPMG's Smith said a marked difference to previous rounds of stress tests was the ECB's clear intent to carefully examine banks' trading assets as well as their loan assets. "It confirms that the AQR will be looking at the darkest recesses of bank balance sheets," he added.

RECAPITALISATIONS

On the key question of valuing government bonds, the ECB said sovereign debt held in the available-for-sale and held-for-trading portfolios would be marked-to-market.

The ECB also said capital instruments that can automatically be converted into common equity tier 1 capital (CET1) "may be eligible for use to address a capital shortfall arising from the adverse stress test scenario, as long as the conversion trigger is set at 5.5 percent or above."

This could help the sector.

"We believe that this provision will significantly reduce the need for upfront recapitalisations across Europe, and consequently should be positive for both bank equity and subordinated debt in 2014," said Ciaran Callaghan, banks analysts with Dublin-based Merrion Capital.

The AQR and the stress tests will feed into each other and their timings will overlap somewhat, but the overall result -spelling out the size of any capital shortfall - will be published only in October.

Analysts have estimated the tests will show the banks need up to 100 billion euros ($135 billion) of fresh capital.

Over the past couple of months, the ECB has collected vast streams of data from the 128 banks that are taking part in the exercise and some lenders have to deliver extensive detail on their trading books and risk models by Feb. 7.

National supervisors have also identified particularly risky portfolios they would like included in the in-depth review, which the ECB will review and approve by mid-February.

The actual review of assets, collateral and provisioning in the selected portfolios will start in March.

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