* Asian shares extend rally after European bank tests
* Scepticism about tests’ credibility hangs over markets
* Sovereign risk disclosure seen outweighing doubts
* Markets likely to focus on banks that narrowly passed test
* Follow-up action by banks, regulators and governments key
By Bill Tarrant and Paul Taylor
SINGAPORE/PARIS, July 26 (Reuters) - Investors in Asia took some reassurance that European banks had passed “stress tests” on their ability to deal with a debt crisis, which has been a cloud over the global economic recovery.
But scepticism remained about the credibility of the tests because they showed a combined capital shortfall of the 91 banks put under the microscope that was much smaller than expected.
“On the surface, if anything, you have to take these tests with a pinch of salt,” said Jonathan Cavenagh, currency strategist at Westpac, Sydney. “Sovereign debt problems remain, funding constraints for their banks are still there and these have the potential to weigh on the euro.”
Asian shares rose on Monday when the worst fears about the tests were assuaged. The results were published on Friday during European hours, so Asian markets were reacting to the news for the first time.
The MSCI Asia Pacific Index .MIAPJ0000PUS was up 0.3 percent at 0345 gmt. It was still down more than 7 percent from its year-to-date high in mid-April, in part over concerns that debt defaults in the euro zone could derail the global recovery.
The euro EUR= rose slightly to $1.2922 at 0345 gmt from $1.2916 late in New York on Friday and $1.2888 late on Thursday.
Only seven of 91 banks failed -- five small Spanish banks, Germany’s state-rescued Hypo Real Estate and Greece’s ATEbank. No listed bank failed the tests. [ID:nN25160076]
Financial markets had expected a shortfall of 30 billion euros to 100 billion euros, although many European banks had already raised capital during the financial crisis.
“The market will likely rise initially and then move narrowly awaiting reaction in Europe with market players keeping an eye on currency moves,” said Hiroichi Nishi, general manager of equity marketing at Nikko Cordial Securities, in Tokyo.
Better-than-expected economic data and business confidence surveys suggesting the euro zone will avoid a double-dip recession despite fiscal austerity measures were also helping to revive investor confidence in Europe.
More than a dozen banks barely passed the tests, with just over the required 6 percent of Tier 1 capital in the most stressful scenario, and are likely to come under market scrutiny.
The stress test scenarios included how banks would cope with a double-dip recession, a 20-percent drop in stock markets and sharp rises in interest rates.
While the tests were widely criticised for being too lenient, the wealth of data disclosed by banks representing 65 percent of the continent’s banking assets, and the commitment of banks, regulators and governments to follow-up action, may well outweigh the scepticism.
Given the haggling among EU governments and regulators about the stress tests right up to the last moment, the degree of transparency was greater than had been expected a few weeks ago.
Sources familiar with the discussions said Germany fought hard behind closed doors to limit the extent of disclosure.
In the end, most banks -- except Deutsche Bank (DBKGn.DE) -- issued a detailed breakdown of their exposure to the sovereign debt of EU countries, enabling investors to run their own risk simulations to gauge a counterparty’s solidity.
That should help reopen the interbank lending market, which partially froze at the height of the euro zone debt crisis in May and has remained tight due to fears that banks have been hiding big exposures.
The EU authorities were chastised for refusing to test the impact of a debt default by Greece, but European Central Bank governing council member Christian Noyer defended the decision.
He said euro zone states “have put several hundreds of billions of euros on the table with the support of the IMF to make this hypothesis completely excluded”.
Spain, which spearheaded the drive for transparency, tested a larger part of its banking system and disclosed more data than any other country, hoping to clear away lingering market suspicion of its smaller banks’ solvency.
However, economist Nicolas Veron of the Bruegel think-tank said Madrid had underplayed the recapitalisation needs of the cajas, regional savings banks, although its bank resolution fund is well on the way to meeting those needs.
“The Spanish wanted to be seen as the most transparent and deserve praise for the catalyst role they played, but in the end they clearly understated what the cajas need,” he said in a telephone interview.
Veron said the success of the exercise would depend partly on whether European regulators adopt a more cooperative approach after the stress tests than they did before them.
"If this is the start of a beautiful friendship among EU supervisors, then that's not the same as if the united front crumbles next week and they start criticising each other again," he said. Graphic on biggest bank results: r.reuters.com/muj39m (Editing by Neil Fullick)