Q+A - How Europe will stress-test its banks

BRUSSELS (Reuters) - 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?

Originally, EU regulators planned to test just 25 large, cross-border banks, including Germany's Deutsche Bank (DBKGn.DE) and Commerzbank (CBKG.DE), France's BNP Paribas (BNPP.PA) and Credit Agricole (CAGR.PA), and Britain's Royal Bank of Scotland (RBS.L), HSBC (HSBA.L), Barclays (BARC.L) and Lloyds (LLOY.L).

But the EU executive and the European Central Bank pressed countries for a major increase in the number of banks, and a total of around 100 or more is now likely to be tested. A comprehensive list has not yet been released.

The tests are expected to cover banks holding about half or more of banking assets in each country. This could mean, for example, that Germany tests 15 banks instead of the three originally planned.

The expanded tests will probably include most or all of Germany's eight regional landesbanks, and some of Spain's 45 cajas, which are unlisted savings banks.

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 are expected to be released for individual banks, although the degree of public disclosure remains unclear.

European countries decide on the scenarios to be used in testing, under the supervision of the ECB and the EU executive. Many details of the scenarios have not be announced, partly since they seem still to be under discussion for smaller banks.

The European Commission wants a "sovereign debt shock" to be among the scenarios that are tested; this could include the failure of a country such as Greece to repay debts. Countries such as Germany have been reluctant to put their banks through extremely harsh scenarios.

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 around July 23, French Economy Minister Christine Lagarde said on Sunday.

WHAT ARE THE TESTS LIKELY TO SHOW?

Testing of the original 25 big banks appears already to have been completed, and the results are not expected to reveal serious problems; these banks have generally strengthened themselves since the global financial 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 "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."

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 are likely to 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.

However, there is a danger that if the scenarios appear 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.

Once the results are out, investors will want to see that national governments are willing and able to act quickly to resolve any problems that have been uncovered.

ECB officials have urged countries to make sure they have emergency financial safety nets in place to prevent any disorderly failures of banks that fail to meet the 6 percent capital benchmark in the tests. Governments say they have already created these safety nets 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.

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.

(Writing by John O'Donnell; Editing by Andrew Torchia)