(Removes errant word in paragraph 4)
* ECB prepares for leading role in stress tests
* Second tier and peripheral banks to be hit hardest
* Gap between core and periphery to widen further
By Aimee Donnellan
LONDON, July 18 (IFR) - A European Central Bank led probe into the health of the region's banks is likely to uncover a host of non-performing loans that could be the final undoing of Europe's most vulnerable financial institutions.
Banks across Europe could face capital holes worth billions of euros once the ECB introduces a stricter and Europe-wide definition of non-performing loans (NPLs) and launches what is in effect an external audit of the sector.
"Banks will not be able to massage these numbers or hide NPLs. They will have to take it very seriously. This is the ECB, after all," said a senior DCM banker.
The ECB is currently preparing a comprehensive review before it undertakes the stress tests scheduled for March 2014.
Investors are attaching a lot of weight to the ECB's supervisory powers, as they believe that the central bank, like the Federal Reserve, will have no interest in conducting a half-hearted assessment.
To add to the credibility of the stress tests, bankers say the ECB may prevent regulators from evaluating their own country's institutions.
"Having a central process to what is essentially an external audit will certainly help its credibility. And if the ECB mixes the regulators up to ensure they are not assessing their own banks, the market will attach more weight to their results," said Neil Williamson, head of EMEA credit research at Aberdeen.
It may work out, for example, that a Portuguese regulator will be responsible for assessing a French bank. This should act as a deterrent to regulators overlooking weaknesses, bankers say.
"For a long time certain banks have been relying on favours from their university mates that are in top positions within their central banks. This has destroyed the credibility of previous tests," said one senior debt banker at a US bank.
STRONGEST ON TOP
"The stress tests are likely to highlight the gap between the strongest and the weakest banks in Europe, and in turn, investors are going to want a higher premium to take on the risk of some of these less fortunate institutions," said Robert Montague, a senior financials analyst at ECM Asset Management.
This will be an unfavourable outcome for European regulators who are desperately trying to create unity and nurse the weakest banks and countries back to health.
MORE BAD LOANS
The ECB certainly has a mammoth task ahead of it.
Non-performing loans are a cancer on a bank's balance sheet - reducing lending capacity, consuming capital and making investors more risk averse simply by their presence.
And data released over the past month shows that NPLs in Spanish and Italian banks are actually increasing.
Spanish banks' bad loans as a percentage of total lending rose to 10.9% in April from 10.5% in March, according to the Bank of Spain. That proportion is expected to increase further as a difficult economic outlook weighs on the capacity of households and companies to repay debts.
Similarly, NPLs in Italian banks grew by 22.4% to EUR135.7bn over the past year, according to data from the country's banking association ABI.
The figures should not come as a shock given widespread concerns about peripheral countries over the course of the crisis, but the combination of a clearer definition on NPLs and stronger regulatory oversight will hit hard.
"The stress tests are likely to uncover capital shortfalls in weaker banks," said Lee Tyrrell-Hendry, a macro credit analyst at RBS Markets.
"These shortfalls could be filled internally through deleveraging, de-risking, asset sales or rights issues, but for the mid-tier banks in the periphery we think there is a risk of bail-in of junior bondholders and equity holders."
Preparation for the tests already appears to be underway. This week Commerzbank sold EUR5bn of UK property loans, reducing its NPLs by EUR1.2bn, although the bank admitted that the sale had no notable impact on its Core Tier 1 capital ratio, which now stands at 8.4% - only just above the minimum 8% Basel III level that systemically important banks are required to hold.
The concern now is that NPLs are reaching crisis point in the weaker peripheral banks, and their underlying economies are showing few signs of growth. Last year, NPLs in peripheral banks reached EUR500bn, according to research from JP Morgan.
Now that the ECB's credibility is at stake, debt experts believe the upcoming stress tests need to be a lot more - for want of a better word - stressful.
The last set of stress tests was completed in July 2011 and only flunked eight European banks to expose a capital shortfall of a mere EUR2.5bn.
The European Banking Authority allowed banks like Dexia, Bankia and SNS Reaal to glide through examinations, only for major weaknesses to be later exposed.
And it failed to spot problems in Ireland, Spain and Cyprus, all of which led to painful government bailouts, and in some cases, bondholder bail-ins.
National regulators have been equally lax in their approach, which bankers and investors claim is partly a result of cosy relationships.
But that should change in just nine months' time, if the ECB manages to convince markets that the scrutiny of NPLs is not only more rigorous, but also truly free from national bias. (Reporting by Aimee Donnellan, editing by Alex Chambers and Julian Baker)