EU watchdog sets out initial terms of bank health check

* Stress test to cover three years from December 2013

* Core (Frankfurt: LJ1.F - news) capital must be above 5.5 percent for bank to pass

* Details of actual stress scenarios due in April or May

By Huw Jones

LONDON, Jan 31 (Reuters) - European Union banks face their toughest probe yet in a bid to weed out the sector's weaklings, the bloc's chief watchdog said on Friday, announcing stress tests intended to help draw a line under the financial crisis.

More than half a decade since the start of the 2008-2009 credit crunch, and despite more than 1 trillion euros ($1.4 trillion) of state support, confidence in the sector remains fragile and the EU's latest health checks are intended to settle any lingering doubts over its finances.

The European Banking Authority (EBA), the EU watchdog coordinating the tests, said on Friday that to pass, banks must have a core capital ratio of above 5.5 percent during the three-year stressed scenario, including above 8 percent at the starting point.

This reflects the amount of capital reserves banks have to put aside to cover unpaid loans or market bets that go wrong. It represents a significantly higher bar than in previous tests or before the crisis, when it was typically about 2 percent.

The theoretical stresses lenders will face, such as a market meltdown, won't be published until April or May. The threshold for the 2011 test was 5 percent and some lenders that were above this level had to be rescued later in EU bailouts.

The 2014 tests will apply to 124 banks from across the EU, accounting for roughly 30 trillion euros in assets or about 80 percent of the bloc's banking sector.

This is up from 91 in the previous exercise and includes 104 from the euro zone, including leading lenders such as Deutsche Bank, Santander, BNP Paribas (Milan: BNP.MI - news) and Monte dei Paschi (Milan: BMPS.MI - news) .

The EBA also mapped out a timeline and common methodology that must be applied to all banks, but some national supervisors will add additional risks to be tested.

Germany, for example, is likely to also test for exposure to the shipping business, while Britain may want to add an extra focus on the property sector.

The test will cover three years to December 2016. To be eligible for inclusion, capital must comply with requirements under the global Basel III accord for each December in the test. Basel is being phased in over six years with the rules gradually tightening over that time.

The outcomes of prior balance sheet reviews, due to be completed in June, and the stress test itself, which starts in May, will be combined into a single result for each lender in October, spelling out the size of any capital shortfall.

Any extra shortfall due to a national add-on or bespoke test would be published separately by the national supervisor to avoid harming comparability of the common EU test results.

Analysts have estimated the tests could show a total shortfall of up to 100 billion euros.

ECB CREDIBILITY

The EBA has yet to decide how much time a bank would have to plug a shortfall after the results are published, though policymakers insist taxpayers are the last stop.

There is also still debate over how to treat bank holdings of government debt in the so-called "available for sale" category. Some supervisors may apply a more lenient treatment than others, but the results in October will make clear what treatment was applied so analysts can run their own tests.

After the failure of past tests to root out problems, the stakes are higher this time as the European Central Bank (ECB) is putting its credibility on the line.

Under a new banking union for the single currency area, the ECB will directly supervise 130 euro zone lenders from November.

To avoid embarrassments down the line, the ECB is handling the balance sheet review for euro zone lenders and their stress tests itself, using new powers to by-pass protective national supervisors and challenge suspect data from a bank directly.

"This is the game changer," an EU regulatory official said.

The EBA does not have the power to directly challenge lenders over data, a key flaw in previous tests.

Central bankers say a balance sheet review ahead of the stress tests, to be carried out for the first time, along with the use of outside consultants, will make the exercise more rigorous.

Regulators say increased credibility this time round is clear from the way banks have already been scrambling to bolster their capital ratios, mainly by dumping loans, known as deleveraging, to avoid the humiliation of failing the test.

This deleveraging could pick up again after the test results are announced in October and supervisors will press lenders to raise new capital rather than ditch loans, people familiar with ECB thinking said.

Banks will be under pressure to fill capital holes even before the test results are announced, and tell markets in June if the initial review uncovers any major shortfall.