* Prolonged scrutiny of banks will create more uncertainty
* Market jitters could ramp up cost of funding
* Delays expected as ECB/EBA timetable seen as unrealistic
By Aimee Donnellan and Helene Durand
LONDON, Oct 15 (IFR) - The looming ECB review of bank health in the eurozone is unnerving lenders and investors alike, and risks undoing the relative calm in the bond markets over the past year.
With the European Central Bank set to assume supervision of eurozone banks in November 2014, there are concerns on all sides about both the timing and substance of the tests - and some fear the exercise will expose a very large capital hole that will have to be quickly mended.
"With the stated objectives, I think it's intractable," said Adrian Docherty, head of banking advisory at BNP Paribas.
"The outcome is bound to be a fudge, though I don't think that will damage ECB credibility. The risk is that things will drift on, becoming increasingly painful and perhaps counterproductive. We don't want this to be 'death by consultants'."
Scrambling to get to grips with Europe's largest bank balance sheets, the ECB will carry out what it calls an asset quality review (AQR) before stress testing the institutions with the European Banking Authority.
But the path from here to there looks more and more like a minefield as the ECB has yet to give banks guidance on how assets will be examined, whether half or full-year results will matter, and what types of loans will be examined - all of which will be crucial in determining whether a bank passes its test or not.
The legal and regulatory agreement for the ECB to take the reins of Europe's banks has already been delayed for roughly three months and was only signed today (October 15). Meanwhile, the ECB is set to present the methodology for the bank assessment by the end of October.
From the time the ECB gets the official nod that it will be responsible for Europe's banks, it will only have one year to carry out the AQR and stress tests before the November 2014 takeover - and already the delays seem to have shaken some investor confidence, raising the possibility of more volatility in the meantime.
Even if the banks welcome additional time to get their balance sheets in order before next November, some market participants believe the delay will shine an unwelcome spotlight on Europe's weakest banks.
"Although certain countries may welcome additional time to get their balance sheets in order, any delays from banks will be taken as negative and seem like they are scared about what they might find," said Robert Montague, a senior financials analyst at ECM Asset Management.
WAIT AND DON'T SEE
Looking at the road ahead, it's easy to see why banks are anxious.
Although banks now have a timeline for the release date of ECB methodology, the central bank's inability to give lenders an earlier heads-up on the review criteria - combined with the delay in signing the agreement - means the whole process is being dragged out over an even longer period.
Moreover, while the review is expected to highlight capital holes in bank balance sheets, politicians have yet to agree on where the funds to fill those holes will come from.
NOT THE BEST TIME
Investors are already noting that the complicated process comes at a time when Europe's banks have been able to enjoy a period of relative stability coming out of the eurozone crisis.
There has been renewed investor appetite for their debt over the past year, with even weak lenders able to beef up their capital via contingent convertibles (CoCos).
And the cost of insuring against European bank debt default has decreased materially since 2011. The senior and subordinated indices have tightened by 220bp and 400bp respectively.
"We have seen European bank spreads decrease a lot over recent months and any delay in the AQR and stress tests could be negative," said Vinod Vasan, global head of financial institutions group, debt capital markets at Deutsche Bank.
And while many expect the banks of Greece, Portugal, Ireland and Spain to come out worst in the eventual stress tests, others in the market are looking elsewhere.
A treasurer at one of Europe's weakest banks said that much of the market is focusing on France and Italy.
Recent bitter experience in Europe underscores the importance of making sure the tests are carried out properly so that investors do have that knowledge.
In 2011, the European Banking Authority (EBA) allowed banks like Dexia, Bankia and SNS Reaal to glide through examinations.
All of them later failed and - in the case of SNS - bondholders ended up getting bailed in.
"Investors need to know a bank's solvency situation," the treasurer said. "If not it would be difficult to invest in any bail-inable security." (Reporting by Aimee Donnellan and Helene Durand; Editing by Alex Chambers, Marc Carnegie and Julian Baker)