Euro zone banks to clean house ahead of ECB review

* Banks expected to use year-end deadline to tidy up balance sheets

* Equity raising more likely next year with more clarity on stress tests

* Banks' capital buffers could be weakened after balance sheet review

By Lionel Laurent and Helene Durand

PARIS/LONDON, Oct (KOSDAQ: 039200.KQ - news) 24 (Reuters/IFR) - Euro zone banks are expected to issue more debt, increase loan provisions and speed up asset sales in the next couple of months as they knock their balance sheets into shape ahead of the European Central Bank's (ECB) sector health-check next year.

The ECB will take a snapshot of loans and other assets, including holdings of government debt, from the balance sheets of 128 banks at the end of this year and scrutinise their riskiness before it takes over as the bloc's banking supervisor late next year.

The starting point for the ECB's Asset Quality Review (AQR) gives the euro zone's banks less than 10 weeks to burnish their books, and small to mid-sized lenders in Italy, Spain and Portugal are considered most likely to take pre-emptive action.

"Banks will want to take corrective measures before the end of the year. It's far better not to be singled out by the AQR as having had a problem and fixed it in 2014; it's better to avoid that and do it now," said Mike Harrison, a banks analyst at Barclays (LSE: BARC.L - news) .

The most straightforward way of reducing the perceived riskiness of their books would be for banks to set aside more money to cover potential future loan losses, which probably implies taking a hit to fourth-quarter earnings.

"The earnings risk element of the AQR means it could take longer for the earnings cycles at many banks to normalise," said Harrison.

Eurozone banks have already shrunk their balance sheets by 2.9 trillion euros ($4 trillion) since May 2012 - by renewing fewer loans, repurchase and derivatives contracts and selling non-core businesses - according to data from the ECB.

Lenders could bring forward asset sales, including loan books, equity stakes and subsidiaries, before year-end.

"Now that we have the wording and that we know the rules of the game, I believe that some banks will feel like they have some room for manoeuvre," said Khalid Krim, Managing Director, Head (Other OTC: HEDYY - news) of European Capital Solutions at Morgan Stanley (Xetra: 885836 - news) .

"Concerning deleveraging or asset sales, we can realistically expect to see an acceleration of the timing."

Bankers said they would be careful, however, not to sell at such a pace that they had to accept poor pricing.

NEVER NEVER LAND

As part of the balance sheet review, the ECB will ask banks to maintain an 8 percent capital buffer.

While the ECB currently estimates Europe's largest banks on average have a core capital ratio of around 10 percent, those numbers could be recalibrated after the AQR, and some banks may fall below the threshold.

Capital (OTC BB: CGHC - news) ratios could also come under pressure when the ECB, along with the European Banking Authority, stress-tests the banks' books next year before taking over as supervisor in November.

A Morgan Stanley survey of investors showed between five and 10 of the banks to be tested by the ECB are expected to fail the tests and could be forced to raise up to 50 billion euros.

To keep capital buffers above 8 percent, euro zone banks will raise capital by issuing debt and equity, or in some cases by buying back their subordinated debt at discounted prices.

"Banks have time between now and November next year to go out and pre-raise some capital ahead of the conclusion of the stress tests," said Neil Williamson, head of EMEA credit research at Aberdeen. "We expect the large majority of banks to do that."

Strong prices for debt, as fears subside of an imminent cut in the supply of cheap money from the U.S. Federal Reserve, have also meant conditions are good for banks to issue debt; Italian banks including Banca Popolare di Milano (Milan: PMI.MI - news) and Intesa Sanpaolo have recently sold bonds.

"I think there will be an impetus to get things done before (this) year end, not least because markets are on fire," said Williamson.

Some banks could follow BBVA (Madrid: BBVA.MC - news) , Spain's second-largest bank, which in May was able to indirectly boost its core tier one capital, the central measure of a bank's financial strength, by issuing $1.5 billion in Additional Tier 1 paper.

Banks may hold off issuing equity, the best way of boosting core capital, until next year when there is more clarity around the stress tests, bankers said.

The ECB has said it will issue a "single, comprehensive disclosure" on its balance sheet assessment and stress tests before it takes over the reins of the so-called Single Supervisory Mechanism (SSM) in November 2014.

Bankers said a 12-month period with no update from the ECB could see the European banking sector hit by rumours about capital weakness, hampering the euro zone's ability to ride the current brighter outlook for the global economy.

"The problem is while you are waiting for the SSM you are in Never Never Land," said one European banker.

"I am not saying there is an easy answer, but every month more that it takes is another month of inaction, driven by uncertainty."

"We are in a good news phase globally, and you would like to be on the back of that with as much certainty as possible for European banking."