UPDATE 2-ECB, on new mission, sets out tougher bank health tests
* ECB to conclude assessment in Oct 2014
* Aims to improve transparency, boost confidence in sector
* Banks with capital shortfalls must fix them
FRANKFURT, Oct 23 (Reuters) - The European Central Bank vowed on Wednesday to submit the euro zone's top banks to a comprehensive batch of tests next year, staking its credibility on a review that aims to build confidence in the sector.
The ECB wants to unearth potential risks hidden in balance sheets before supervision is centralised under its roof from November 2014 as part of a European banking union drawn up in response to a debt crisis exacerbated by massive bad property loans in countries like Ireland and Spain.
Setting out its plans to scrutinise the 128 top euro zone lenders, the ECB said it would use tougher new measures set out by Europe's top 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 tasks 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 banks, 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 Bundesbank and Bafin, which in Germany share banking supervision, said German banks were "already intensively preparing for the comprehensive assessment".
Detailing the measures it will use in its review, the ECB said it would use the EBA's definition which says bank loans more than 90 days overdue are non-performing.
It will ask banks in its balance sheet review for an 8 percent capital buffer. The buffer could have been higher but may still prove a challenge to some banks as they reshuffle their balance sheets to make them crisis-proof.
An asset quality review will look at "sovereign and institutional holdings and corporate and retail exposures, and both the banking and trading books will be reviewed".
The Bundesbank has pushed to reflect the varying degrees of risk attached to bonds issued by different governments.
"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.
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 insurance scheme, have stalled.
"For the success of the exercise, the ex ante availability of backstops is critical," the ECB said, adding that capital shortfalls should be first and foremost made up with private sources of capital.
A Morgan Stanley survey of investors this month 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 ($68.87 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.