Seven European banks are not strong enough to withstand another recession and would face a capital shortfall of 3.5 billion euros ($4.5 billion), far less than expected, stoking fears the keenly-awaited stress tests were too soft.

While the modest findings cast doubt on the credibility of the bank tests -- released on Friday in a bid to restore investor confidence -- with the European economy apparently improving fast, some analysts said that may not matter.

Five of Spain's smaller regional lenders, known as cajas, failed the test and their recapitalization will almost complete a state-funded drive to consolidate the country's network of its unlisted savings banks.

They need 1.8 billion euros, the Bank of Spain said.

Banks in Germany and Greece were also seen as weak spots and in need of restructuring, but state-owned Hypo Real Estate was the only German lender to flunk and state-controlled ATEbank was the only Greek bank to fail.

Analysts had expected five to 10 banks to fail the test, but estimated the capital shortfall could be over 30 billion euros. As expected, no big banks failed the health check.

Arguably the failure here is not the banks concerned, but the test itself. There is little evidence that the tests have been applied consistently and there is a distinct lack of credibility, making this a wasted opportunity, said Richard Cranfield, Chairman Global Corporate Group at Allen & Overy.

The Committee of European Bank Supervisors (CEBS), a previously little known group with 25 staff at a small London office that coordinated the process, said its test was more severe than the U.S. process.

Europe tested how 91 banks would cope with another recession and losses on government debt after the Greek crisis hit markets and raised fears the euro zone could unravel.

It aimed to repeat a health check on U.S. banks last year that helped restore investor confidence and underpinned a recovery by bank shares.

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

The euro fell against the dollar as some investors cast doubt on whether stress tests were tough enough but German government bond futures fell on relief that they threw up no nasty surprises.

European bank shares ended up on the week, before the results were announced, and the cost of insuring the debt of most European banks fell afterwards.

Despite questions about transparency and how the Euro stress tests don't measure up to the U.S. tests last year, I think these tests will start to put these euro zone concerns behind us, said Chris Rupkey, chief financial economist at Bank of Tokyo/Mitsubishi UFJ in New York.

There might be some initial disappointment leading to some selling on Monday when European markets reopen, but the market will soon get over it.

GOVERNMENT BONDS DISCLOSURE

Under the most severe scenario banks were tested on how they would cope with a moderate recession this year and next, with additional losses on government bonds thrown in.

As part of the process many of the banks revealed all of their sovereign debt holdings, but some dodged full disclosure, raising further question marks.

Any bank whose Tier 1 capital ratio falls below 6 percent by the end of 2011 failed the test, and would be expected to raise funds to make up the capital shortfall.

Of most concern to investors was that government bond losses were only applied to trading books, and not hold to maturity bonds, as the test did not consider there was a risk of any sovereign default.

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.

SPAIN, GERMANY IN SPOTLIGHT

The hunt for weak spots in European banking has focused on Spain's regional savings banks, 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 Spanish banks to flunk were Banca Civica, Diada, Espiga, Unnim and Cajasur. The worst case scenario included a 28 percent fall in Spanish house prices during 2010-11.

Banks that came close to failing with a Tier 1 ratio of less than 7 percent under the most stressed scenario included Germany's Deutsche Postbank, Greece's Piraeus, Allied Irish Banks, Italy's UBI Banca and Spain's Bankinter.

The banks that have scraped through may have more of a challenge on their hands and they may be the ones the market focuses on, said Cranfield.

Last year's U.S. bank test helped draw a line under worries about the sector there and Europe's attempt to match it has faced splits in the 27-nation EU about how to model the test and how much to divulge.

European banks have also already raised about 300 billion euros since the start of the crisis, whereas the U.S. tests kick-started the fundraising.

Banks in Ireland, Greece, Spain and Germany have also already received funds or are in the process of doing so, possibly pre-emptively to help them pass the test.

($1=.7766 Euro)

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

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