UPDATE 2-EU states to rescue bank test failures-draft paper
* Report prepares stress-test response for ministers meeting
* Lenders that almost fail to be put on watch list - doc
* Failed banks to get six months to repair finances
* Governments to stand ready should capital search fail
* Markets worry over test failure pressures on euro zone
(Adds market reaction, more detail)
By John O'Donnell
BRUSSELS, July 8 (Reuters) - European countries will support banks that fail stress tests if those lenders cannot raise capital from investors within six months, according to a draft EU document seen by Reuters.
The paper, being prepared for EU finance ministers to approve on Tuesday, is an about-face from promises by G20 policymakers in the wake of the financial crisis that taxpayers would never have to bail out banks again.
The European Banking Authority is due to announce next week the results of its latest stress tests of the region's top lenders -- 91 in all -- in another attempt to reassure investors that European banks have been rebuilt against future shocks.
This latest round of tests has been touted as being more rigorous than previous attempts in which few banks failed, and finance ministers' officials are drawing up plans for how to deal with the fallout.
Lenders that nearly fail the tests will be put on a critical watch list in case they deteriorate further, the document says. Those banks will be given until the end of September to repair their finances and will then have a further three months to implement it.
News that EU governments appear serious about supporting banks that fail to maintain core capital of 5 percent in the face of several theoretical markets shocks lifted Bund futures FGBLc1 and UK gilts.
"In essence that puts even more pressure on the periphery (euro zone countries) to come up with measures, not only to shore up their budgets, but to support their banking sectors, which they can ill-afford to do," said Marc Ostwald, strategist at Monument Securities.
"It's basically a charge to safety on the back of this. This is a market which is living in mortal fear of anything to do with the euro zone and anything that puts the banking sector under more stress," Ostwald said.
The Italian/German 10-year yield spread IT10YT=TWEB DE10YT=TWEB hit fresh euro era highs amid fears that already fiscally stretched countries like Italy may have to dig into their pockets to bail out banks that fail the test as well.
PRIVATE SECTOR FIRST
According to the document, capital-raising plans should first be based on "private-sector measures, including ... retained earnings ... raising additional common equity or high quality hybrid instruments from private investors, assets sales, mergers."
But if the search for private capital leads nowhere, then governments should be ready to step in.
Officials do, however, make provision for "the extreme case" if efforts to rehabilitate a bank fail and it threatens wider stability, recommending "a process of orderly restructuring and resolution."
The number of banks declared by the EBA to have failed will either encourage investors that Europe is now coming clean with its banking problems, or if the tests are deemed too lax again, they will hurt the EU's already battered credibility.
Previous stress tests are widely dismissed as too lax -- all Irish banks passed last year's test just months before the EU and International Monetary Fund had to bail them and the country out.
In the document, dated July 7, officials write that banks that miss the 5 percent capital pass mark will be given until the end of September at the latest to submit recapitalisation plans, with a further three months to implement "private-sector measures."
"If the relevant banks are unable to implement a credible capital plan by the specified deadlines the [government] stands ready to take necessary measures to maintain financial stability," officials write in the document seen by Reuters.
The new checks will measure how well the core capital that banks rely on to absorb losses such as unpaid loans holds up when exposed to an economic dip or fall in property prices.
They also gauge the impact on banks should government bonds they own, issued by states such as Greece, lose value.
Those banks that come uncomfortably close to the 5 percent threshold will also be singled out for special attention.
"Banks where the (core tier 1) ratio is above but close to the 5 percent benchmark under the stress scenario will be subject to reinforced prudential scrutiny so as to ensure that there is no unexpected deterioration in their capital position."
(Additional reporting by Ana Nicolaci da Costa and Huw Jones in London; editing by Sophie Walker)
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