Crunch time for Europe's banking credibility

Regulators have been looking at how banks would withstand another recession in an exercise similar to one in the United States last year which helped restore bank sector confidence.

Some 91 lenders from 20 countries have faced the so-called stress tests and the results are due at 1600 GMT.

The Committee of European Bank Supervisors (CEBS) said its test was more severe than the U.S. health check of its banks. The adverse scenario in Europe was a one in 20 years possibility, compared to a one in 7 years probability in the U.S. test, it said.

But the details of how the tests were run, which were released by the organizers early, fed market consternation that they may not have been rigorous enough.

(There are) concerns about the credibility of the stress tests, said Kathy Lien, director of currency research at GFT Forex in New York, as the euro edged lower against the dollar.

Some investors have been concerned that no possibility of a sovereign default among high-debt euro zone nations had been considered, potentially underestimating the risk banks could face.

Banks' holdings of government bonds were subjected to a 23.1 percent loss on their Greek debt, a 12.3 percent loss on Spanish bonds and a 4.7 percent loss on German debt, all based on 5-year bonds and their value at the end of 2009.

Ten banks are expected to fail and will need to raise about 38 billion euros ($48.93 billion), according to the average expectation from a survey conducted by Goldman Sachs.

It quizzed 376 investors, including hedge funds and long-only investors.

Banks in Spain, Germany and Greece are most likely to raise cash, it said.

Other analysts looking at which banks might need new capital expect 5-10 banks to come up short on the tests, although none of Europe's big names is expected to flunk.

It's like pulling an elastic band to see at what point it breaks. It depends how hard you pull, said Alessandro Frigerio, a fund manager with RMJ SGR in Milan. The stress tests serve above all to remove uncertainty, it's a kind of reassurance, transparency toward the market.

Several Spanish savings banks, including some that have been involved in recent mergers, have failed the tests, Spanish newspaper El Pais reported on Friday.

The test scenarios include a look at how they cope with a moderate recession this year and next, and the same scenario with additional losses on government bonds.

Any bank whose Tier 1 capital ratio falls below 6 percent by the end of 2011 will be regarded as failing the test, according to documents seen by Reuters on Wednesday. Banks would be expected to raise funds to make up the capital shortfall.

SPAIN, GERMANY IN SPOTLIGHT

The hunt for weak spots in European banking has focused on Spain's regional savings banks, known as cajas, as well as regional German lenders, known as landesbanks.

Spain and Germany have set up funds to help weak banks recapitalize and Spain wants more cajas to merge.

The EU cleared Spain and Portugal on Friday to extend state support measures for their banks until the end of 2010.

Sweden, Germany, Austria, Latvia, Ireland, Denmark, the Netherlands, Poland, Slovenia and Greece have already secured EU approval to do so.

Manfred Weber, the head of the Association of German Banks, told local radio he was confident that German banks all in all would perform well at the tests.

I also believe that the European banking system, two thirds of which are included in this test, will present a better picture than many expected before, he said.

European banks shares drifted 0.2 percent higher by 1430 GMT, marking time ahead of the test results despite a record jump in Germany's Ifo business sentiment index, the latest in encouraging signs for Europe including better results in recent sovereign debt auctions.

With the latest data showing signs of a strengthening recovery in Europe, banks could find themselves in a healthier position than expected.

A stress test on U.S. banks early last year helped draw a line under worries about the sector there. European regulators are aiming to achieve the same.

But there have been clear splits in the 27-nation EU about how to model the test and how much to divulge, stoking worries that it will be less credible.

The tests should have been done two years ago ... like the Americans did, full-on during the crisis, said Marc Renaud at fund manager Mandarine Gestion, who manages 980 million euros.

($1=.7766 Euro)

(Additional reporting by Natalie Harrison, Stephen Jewkes, Lionel Laurent, Elizabeth O'Leary and Kazunori Takada; Editing by Mike Peacock)