* Test includes surge in unemployment and economic contraction
* Includes average fall of a fifth in property prices
* Results of test due in October
By Huw Jones
LONDON, April 29 European banks must show they can survive simultaneous routs in bonds, property and stocks in the toughest test to date by regulators aiming to restore confidence in an industry that had to be rescued by taxpayers in the financial crisis.
The European Banking Authority (EBA) said on Tuesday it would gauge the resilience of 124 banks from the 28-country European Union to see if they would still have enough capital after facing a toxic cocktail of theoretical shocks.
The EU watchdog set out "scenarios" banks such as Deutsche Bank, BNP Paribas and Barclays face in a test whose results will be published in October, raising hopes among policymakers that banks can finally turn a corner and lend more to the economy.
Over a three-year "stress test" period - a year longer than in the previous exercise - banks must show they can cope with a cumulative loss of 2.1 percent in economic output, much worse than the 0.4 percent decline in the last test.
Such a poor economic performance would push up unemployment to 13 percent and send house prices down 20 percent on average, triggering defaults on loans held by banks on trading books, the EBA said.
Separately, European insurers are also being tested by their regulator, as policymakers seek to address market criticism that the EU has not been as robust in its response to the financial crisis as the United States.
European banks such as UniCredit are already bolstering their capital to avoid the humiliation of failing the test, and before the European Central Bank (ECB) becomes their supervisor from November as part of a new euro zone banking union to intensify scrutiny of lenders.
Previous tests failed to convince markets and this time round the ECB is reviewing the balance sheets of the top euro zone banks to ensure the stress test is based on reliable numbers in the first place.
"The exercise's full transparency will be key to its credibility," EBA Chairman Andrea Enria said in a statement outlining the mix of shocks banks would face in the stress test.
"It will show how efforts recently undertaken by EU banks are already bearing fruit and it will provide a common framework for the next steps to be taken by supervisors and banks."
Banks that fail the test will be given time to plug capital holes by raising money from investors, scrapping dividends or selling assets.
Although the European economy is improving after several years of fallout from a banking and euro zone debt crisis since 2007, regulators opted for their toughest test yet after the failure of each of the previous three exercises to convince markets that banks have enough capital.
The EBA had already said the test would cover three years from January 2014, during which banks would have to maintain core capital equivalent to at least 5.5 percent of their risk-weighted assets to pass, a higher threshold than in the previous test.
The impact of the theoretical economic slowdown will be felt in six shocks hitting all assets held on banks' trading books, compared with two shocks in the prior test.
This time round banks cannot include planned measures to boost capital after the December 2013 cut off date for the test.
Banks will also have to show that while their assets are being pummelled, they can manage liabilities, meaning they can foot the higher funding costs such distressed markets would bring despite the test's cap on income from interest and trading.
Experiences from the recent past are also being included in the test, such as spikes in market interest rates, and turmoil in central and eastern European currencies in the wake of recent foreign exchange crises, such as in Hungary.
The stress test includes national variations in how the different assets react to the economic downturns.
For example, the gap between expected house prices and the "adverse" scenarios banks are tested against varies massively, with banks in Britain, Sweden and Finland tested against the biggest departures from expectations and banks in Spain and Portugal, which have already suffered massively property slumps, tested against the smallest slumps.
Tests against a commercial property collapse are most severe in the Britain, Sweden and Denmark and least severe in Austria, Portugal and Spain.
The test will also set tougher criteria on government debt holdings. The bulk of sovereign debt held by lenders is in the so-called available for sale (AFS) category in trading books, and some national regulators allow banks to ignore the impact of market slides on this category in real life.
Despite opposition from some regulators, the EBA test will impose a common phase-out of this protection where it exists, so that by the third year, at least 60 percent of AFS would be unshielded.
The watchdog hopes the test results and data will be detailed enough so that analysts can replicate it with their own computer models as a cross check. (Additional reporting by Laura Noonan; Editing by Mark Potter)