European Union banks face their toughest probe yet in a bid to weed out the sector's weaklings, the region's chief watchdog saidtoday, 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 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 per cent during the three-year stressed scenario, including above 8 per cent 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 and represents a higher bar than in previous tests or before the crisis, when it was typically about 2 per cent.

The 2014 tests will apply to 124 banks from across the EU, including leading lenders such as Deutsche Bank, BNP Paribas and Monte dei Paschi, accounting for roughly €30 trillion in assets or about 80 per cent of the region’s banking sector.

“The more rigorous the better,” said Francisco Gonzalez, chairman of Spanish bank BBVA. Angel Ron, chairman of rival Banco Popular, said the 5.5 per cent threshold is demanding but his bank was is “very well prepared”.

The EBA is mapping 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, to which some of its banks lent heavily.

The Bank of England said its own stress test of eight banks, including Barclays, HSBC and RBS, will run alongside the common EU test, dashing any hopes among lenders it would be a substitute.

The outcomes of prior balance sheet or asset quality reviews (AQR), 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.

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

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 and supervisors will press lenders to raise new capital rather than just 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.

Regulators say stopping leaks will be challenging as lenders may be tempted to reassure investors who face having to wait months before the formal result.

“It’s a shame that the AQR and the stress tests will take so long, as it’s not good to have any uncertainties hanging over the sector,” said Emilio Botin, chairman of Spain’s Santander . “Although I don’t have any doubts about Spain.” (Reuters)