* Tests include surge in unemployment and recession
* Also include average fall of a fifth in property prices
* Results of tests due in October (Adds market reaction, analyst comments)
By Huw Jones
LONDON, April 29 European banks must show they can survive simultaneous routs in bonds, property and stocks, in the toughest test so far 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 the scenarios which banks such as Deutsche Bank, BNP Paribas and Barclays could face, in tests whose results will be published in October, raising hopes among some policymakers that banks can finally turn a corner and lend more to the economy.
The benchmark STOXX Europe 600 banks index was up 1.5 percent at 1028 GMT, with almost all its members gaining ground. The biggest risers were Commerzbank, Nordea - which posted results - and SocGen.
"The granularity and relevance of the scenarios is much better than Europe's first two stress-test attempts, but the absence of widespread deflation is an elephant in the room," said Neil Williamson, head of EMEA credit research at Aberdeen Asset Management.
"To be fair, deflation in the Eurozone would have such dire consequences for both public and private finances, that to include it could have risked too big a jolt to the fledgling confidence returning to the Eurozone," Williamson said.
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, the EBA said.
From a macro-economic point of view, analysts say it is unlikely banks will significantly raise lending until the tests are done, and maybe not even then depending on what they show.
That has profound implications for the European Central Bank (ECB), which has said printing money or quantitative easing is possible if deflation becomes a real threat, something it currently doesn't expect.
ECB President Mario Draghi told German lawmakers on Monday that quantitative easing remained a way off. The bank tests could be one reason why.
The ECB is looking at buying corporate assets rather than government bonds, but there is neither the structure nor size of market to make that workable yet. If the ECB did buy government bonds with new money, most of it would flow to the banks, which might then not lend it on, so the impact would be muted.
Data released on Tuesday showed bank lending to euro zone companies and households fell 2.2 percent year-on-year in March.
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 tests, and before the ECB becomes their supervisor from November as part of a euro zone banking union.
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 test is based on reliable numbers in the first place. 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 subsequent euro zone debt crisis, 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 time banks would have to keep core capital equivalent to at least 5.5 percent of their risk-weighted assets, 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 their liabilities, meaning they can meet 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. (Additional reporting by Laura Noonan and Mike Peacock; Editing by Mark Potter and David Holmes)