By Eva Taylor and Jonathan Gould
FRANKFURT (Reuters) - The European Central Bank promised on Wednesday to put top euro zone banks through rigorous tests next year, staking its credibility on a review that aims to build confidence in the sector.
The ECB wants to unearth any risks hidden in balance sheets before supervision comes under its roof as part of a banking union designed to avoid a repeat of the euro debt crisis, which was exacerbated by massive bad property loans in countries such as Ireland and Spain.
However, some analysts say that if the review reveals unexpectedly large problems at some banks, it could undermine the very confidence it aims to bolster. Euro zone bank shares fell markedly after the ECB announcement.
Setting out its plans to scrutinize 128 top euro zone lenders, accounting for about 85 percent of the euro area banking system, the ECB said it would use tougher measures set out by Europe's regulator - the European Banking Authority (EBA) - in the asset quality review it will conduct next year.
"We expect that this assessment will strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets," ECB President Mario Draghi said.
The ECB said it would conclude its assessment in October 2014 before assuming its supervisory role in November, and Draghi told Reuters television there was no question of that timing slipping.
If capital shortfalls are identified, banks will be required to make up for them, the ECB said. But Draghi insisted a public backstop in the form of a common resolution mechanism for dealing with troubled banks must also be in place.
"The ECB thinks that a resolution mechanism is a very important pillar of our banking union. We still aim at having it in place by 2015," Draghi said.
A provisional list of banks to be reviewed includes 24 German lenders, 16 in Spain, 15 in Italy, 13 in France, seven in the Netherlands, five in Ireland and four each in Greece, Cyprus and Portugal.
Shares in euro zone banks <.SX7E> fell nearly 3 percent on concerns the tests could put them under pressure to plug capital holes, with Spanish lenders down 4 percent on average and Italian bank stocks down 3 percent. <.EU>
Detailing the measures in its review, the ECB said it would use the EBA's definition of non-performing loans as those more than 90 days overdue.
It will ask banks in its balance sheet review for an 8 percent capital buffer. That could have been higher but may still prove a challenge to some banks as they attempt to become crisis-proof.
The asset quality review will look across the piece at "sovereign and institutional holdings and corporate and retail exposures, and both the banking and trading books".
The EBA classifies sovereign debt as risk free, but following the euro zone crisis, which led to a huge restructuring of Greek debt, Germany's central bank has been pushing for varying degrees of risk attached to bonds issued by governments to be recognized eventually.
The Bundesbank and financial watchdog Bafin said the country's banks were "already intensively preparing for the comprehensive assessment". Bafin head Elke Koenig said she did not expect much need for more capital in German banks.
"We are all waiting to see whether Germany has got on top of its rumored problems in the banking sector," said Sharon Bowles, who chairs the influential committee in the European Parliament that shapes economic and financial policy.
"It seems clear that banking union has not disconnected banks from sovereigns. Bank disclosures over sovereign holdings will make that even clearer," she told Reuters.
The ECB wants a tough review to avoid unpleasant surprises once it has taken charge. Two earlier European-wide stress tests
failed to spot risks that led to the Irish and Spanish banking crises.
Wary of a lopsided banking union that could see it supervise euro zone banks without a common backstop in place, it has urged governments to agree on a strong single resolution mechanism (SRM) to salvage or wind down banks in trouble.
However, this second stage of the planned union is incomplete as politicians discuss how much of the costs should be shouldered by taxpayers. Plans for a third stage, a common deposit insurance scheme, have completely stalled.
"The ECB wants to have full responsibility for the assessment, but nothing to do with what has to be done following the assessment, namely the task of the resolution authority. The two things must be completely separated," Draghi said.
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 ($69 billion) to bolster their capital.
However, some banks may be unable to raise capital on their own, and the euro zone crisis has shown that sometimes even national governments cannot afford to stage rescues. In addition to Ireland, Spain - the bloc's fourth biggest economy - had to take international help to tackle its banking problems.
"The review should help ensure weak banks are dealt with, but without a central backstop there is still a direct link to the sovereign," said Neil Williamson, Head of EMEA Credit Research at Aberdeen Asset Management.
"It doesn't matter how stress tested and well capitalized you think peripheral bank ABC is, if you think the sovereign is going to need a PSI or will default then the bank is uninvestable."
(Additional reporting by Jonathan Gould in Frankfurt and John O'Donnell in Brussels, Helene Durand in London. Writing by Mike Peacock. Editing by David Stamp and Will Waterman)