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 is too strict and reveals unexpectedly large problems at some banks, it could backfire by undermining the very confidence it aims to bolster. Euro zone bank shares fell sharply after the ECB announcement.
Setting out its plans to scrutinise 128 top euro zone lenders, the ECB said it would use tougher new measures set out by Europe's regulator - the European Banking Authority (EBA) - in the asset quality review it will conduct next year.
"A single comprehensive assessment, uniformly applied to all significant banks, accounting for about 85 percent of the euro area banking system, is an important step forward for Europe and for the future of the euro area economy," ECB President Mario Draghi said.
"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," he said.
The ECB said it would conclude its assessment in October 2014 before assuming its supervisory role in November, although some policymakers have suggested that timing could slip.
If capital shortfalls are identified, banks will be required to make up for them, the ECB said. Draghi has said a "public backstop" must also be available.
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.
"The scope of the Comprehensive Assessment is more extensive than we expected," analysts at Citi said.
Shares in euro zone banks fell 2.5 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 3 percent weaker. Spain's Bankia led the decline, falling over 5 percent while Germany's Commerzbank, the only bank from the euro zone core to feature among the top 10 fallers, was down over 3 percent.
The Bundesbank and financial watchdog Bafin, which in Germany share banking supervision, said the country's banks were "already intensively preparing for the comprehensive assessment."
Detailing the measures in its review, the ECB said it would use the EBA's definition which classifies bank loans that are more than 90 days overdue as non-performing.
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, meaning banks do not have to hold extra capital to back these holdings.
However, following the euro zone crisis which led to a huge restructuring of Greek debt, the Bundesbank has been pushing for the varying degrees of risk attached to bonds issued by governments to be recognised eventually, although not necessarily in the forthcoming ECB assessment.
"We are all waiting to see whether Germany has got on top of its rumoured 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.
Much of the precise detail about the tests remains to be sketched in. Bafin head Elke Koenig said she did not expect much need for more capital in German banks.
The ECB wants a tough review so that it does not face surprises once it has taken charge, and to avoid repeating the mistakes of two earlier European-wide stress tests that 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.
"First of all, the private sector has to intervene," Ignazio Angeloni, director general for financial stability at the ECB, told a news conference. "Once markets know more and once risks are priced better, then investors are more ready to come in. We cannot rule out the possibility ... that that may not be sufficient immediately."
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.
Some ECB policymakers feel uncomfortable taking on the extra responsibility and have suggested spinning off bank supervision into a separate institution over the long term. But such a step would require a change of the EU treaty, which might take years.
($1 = 0.7260 euros)(Additional reporting by Jonathan Gould in Frankfurt and John O'Donnell in Brussels. Writing by Mike Peacock; editing by David Stamp)