In an effort to reassure financial markets about the health of the European Union's banking system, the bloc's countries will stress-test a large number of their banks and publish the results.

WHICH BANKS WILL BE TESTED?

Ninety-one banks comprising 65 percent of the European banking sector. They range from Germany's Deutsche Bank (DBKGn.DE) to Malta's Bank of Valletta BOV.MT. They include seven of Germany's eight regional landesbanks, the exception being tiny Saar LB. All of Spain's cajas, or unlisted savings banks, are included; the 45 institutions will be tested as if a planned wave of mergers, which will halve their number, has already been completed.

In each EU state, the sample includes enough banks, in descending order of size, to cover at least 50 percent of the national banking sector.

Originally, EU regulators planned to test just 25 large, cross-border banks, but the European Commission and the European Central Bank pressed countries for a big increase in the number.

HOW WILL THE TESTS WORK?

National supervisors, such as Germany's Bafin, will carry out the tests, which will be coordinated by the Committee of European Banking Supervisors, a London-based umbrella group for financial supervisors.

The tests will simulate how banks cope with financial pressures on their loans and other assets in a worsening recession. Results will be released for individual banks, although the degree of public disclosure remains unclear; details of what will be published are expected to be finalised on July 12-13, when EU finance ministers meet in Brussels.

The test scenario will assume a 3 percentage point deviation of the EU's gross domestic product from the EC's forecasts over a two-year horizon. It will also assume a sovereign risk shock in which some government bond prices would be marked down further from the depressed levels of early May. For example, a markdown of 16 to 17 percent would be applied to Greek debt, German banking sources said; this might be equivalent to a markdown of about 40 percent from current levels.

Banks will be tested on how their so-called Tier 1 capital, a key measure of financial strength, bears up. The ECB wants to see if the ratio of this capital to assets stays above a minimum benchmark of 6 percent of assets in the tests; although this is higher than the 4 percent legal minimum, it is lower than most bank shareholders are happy with. Deutsche Bank, for example, now has more than 11 percent.

WHEN WILL THE RESULTS BE RELEASED?

The outcome of the tests will be published on July 23.

WHAT ARE THE TESTS LIKELY TO SHOW?

For the original 25 big banks, the results are not expected to reveal serious problems; they have strengthened themselves since the global credit crisis of 2007-2009, and have retained their ability to raise funds from the private money markets. German sources told Reuters that Deutsche Bank, Commerzbank and BayernLB [BAYLB.UL] had already passed the tests.

There is much more concern about the possibility of serious balance sheet weaknesses being discovered among smaller, second- and third-tier banks, such as the landesbanks and the cajas. Few believe the state owners of Germany's landesbanks, for example, have revealed the full extent of their problems.

Many banks in Greece and Portugal have largely lost access to the private markets during their countries' sovereign debt crises, and are surviving on funding from the ECB.

However, officials from the ECB and EU governments have insisted that the stress tests will show the European banking system is fundamentally healthy. Lagarde said, You will see that banks in Europe are solid and healthy.

Many bankers and analysts think that to bolster the credibility of the tests without alarming markets, regulators will arrange to have the tests reveal isolated problems at some banks -- but that the problems will not be serious enough to threaten national banking systems.

WILL THEY REASSURE MARKETS?

Limited stress tests of a small number of European banks last year, the results of which were not released for individual institutions, failed to reassure the markets.

This time, the tests appear closer in scope, rigour and transparency to stress tests of U.S. banks undertaken during the global crisis. Those tests did succeed to some degree in easing investor worries.

But there is a danger that if the scenarios seem too soft on the banks, or if only partial results are made public, investors could view the tests merely as attempts to manipulate market opinion and hide deep-seated problems. In that case, the tests could actually increase market jitters.

Many details of the testing methodology have not been revealed, but it is vulnerable to criticism. For example, the sovereign risk shock that will be assumed is not a full-blown default by a euro zone member state. Some banks may be able to avoid recognising losses on bonds in the test scenario by saying they will be held to maturity, rather than marked to market.

Also, in contrast to U.S. banks during the global crisis, the main issue for many European banks is not the quality of their balance sheets but their access to affordable funding. Short-term interbank money rates have risen nearly 20 basis points in three months as the ECB has started to reduce the duration of the funding it provides, and as markets anticipate it may end unlimited supplies of funds in coming months. The stress tests will not directly address this issue.

Once the test results are out, investors will want to see national governments are willing and able to act quickly to resolve any problems that have been uncovered, if banks are unable by themselves to raise enough capital from the markets.

ECB officials have urged countries to make sure they have emergency financial safety nets in place to prevent any disorderly failures of banks that do not meet the 6 percent capital benchmark in the tests.

Given the complexities and uncertainties in bank balance sheets, it is possible that the markets will not be entirely reassured until economies around Europe return to strong, self-sustaining growth -- a process that could take one or two years in the region's weak southern periphery.

CAN GOVERNMENTS HANDLE PROBLEMS REVEALED BY THE TESTS?

The answer appears to be yes, although the process could be expensive, time-consuming and politically controversial.

Governments around the EU say they have already created financial safety nets for banks or are willing to take further action to protect their financial systems if necessary.

Spain, for example, set up its Fund for Orderly Bank Restructuring a year ago; it has initial capital of 9 billion euros and can theoretically borrow another 90 billion euros in debt markets with a state guarantee.

If a German bank fails to pass tests, the Bundesbank will ask it to access the capital markets or obtain funds from Germany's rescue fund Soffin, which still has 300 billion euros in funds, German financial sources have said.

Under an agreement with the International Monetary Fund, the Greek government has been preparing legislation to create a 10 billion euro support mechanism for banks in case their capital adequacy falls and they are unable to raise funds from markets.

If governments run out of national funds in recapitalising lenders, they will be able to access emergency loan facilities totalling 500 billion euros which the EU announced in May to support countries with sovereign debt problems, EU Economic and Monetary Affairs Commissioner Olli Rehn said on Monday.

Such loans could take weeks to arrange, but under a programme launched in May, the ECB can intervene immediately in capital markets to ease funding problems by buying the bonds of banks or countries which are in trouble. (Writing by John O'Donnell; Editing by Andrew Torchia)

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