UPDATE 1-Deflation, emerging market fears set scene for tough EU bank tests

* Scenarios for EU bank tests to be revealed on Tuesday

* Deflation, emerging market fears set to feature in tests

* Regulators aim to avoid optimistic scenarios of past tests

* Banks worried about sovereign debt treatment, GDP outlook

(Adds Bloomberg report, BBVA comments)

LONDON, April 28 (Reuters) - Fears of euro zone deflation, emerging markets turmoil and a determination not to repeat past mistakes mean European regulators are likely to come up with the toughest set of tests for the region's banks that they have ever faced.

The European Banking Authority (EBA) will on Tuesday reveal the crisis scenarios that banks will have to prove they can withstand without resorting to the kind of taxpayer bailouts that all but bankrupted some countries in the 2008-2012 crisis.

Banks that fall short of capital under the imagined scenarios will have to produce a plan to boost their reserves by raising fresh funds from investors, selling assets or hanging on to profits instead of paying dividends.

Banks have already raised billions in capital and made other reforms ahead of the tests, which regulators hope will finally banish any investor doubts about the industry and allow it to refocus on lending to boost growth.

The European economy has rallied since the last round of bank stress tests three years ago and sharply lower borrowing rates for countries such as Greece - which can now borrow five year money at an interest rate below 5 percent against the 20 percent it was paying when the 2011 tests were done - support the idea that the worst of the euro zone crisis has passed.

But with widespread criticism heaped on 2010 and 2011 stress tests for being too soft, and new risks on the horizon, regulators are likely to set tougher conditions all the same.

The scenarios will include testing banks against economic shocks outside Europe, a plunge in commercial property markets and also volatility in central and eastern currencies, according to a draft EBA statement quoted by Bloomberg.

The EBA declined to comment.

"The key is that the scenario is at least as deep and dark as the great recession, the financial crisis of 2008/2009," said Mark Zandi, Philadelphia-based chief economist at Moody's Analytics. "You can easily conceive a scenario as severe as what we went through."


Analysts view economic growth as the most significant factor in the stress tests, with losses on banks' mortgages and business loans primarily driven by GDP projections, as well as assumptions around unemployment.

Figures leaked ahead of Tuesday's announcement show regulators are taking a tougher line on economic growth than in 2011, when 18 of the EU's 27 countries at that time posted weaker growth than the "adverse" case they were tested against for 2012.

The most dramatic miss was Greece, where an adverse scenario of a 1.2 percent contraction in real gross domestic product (GDP) proved far more optimistic than the 7 percent contraction that actually occurred.

In Spain, there were initial reports that the latest tests would assess banks against a fall in economic output of as much as 6 percent over the next three years, which would be much worse than during the recent recession, though several banking sources said the figure would now likely be lower.

"With this type of noisy discussion, it's unfortunate that it has come out and gives the wrong impression there is a pull and tug, that everyone is asking 'what about me?', when I think it's a reasonable discussion like one that occurs in any European Central Bank board meeting," said Jose Manuel Gonzalez-Paramo, the board member responsible for regulation at Spanish bank BBVA in an interview..

"In the end you come to something reasonable," he added.

However, banks and financial markets may have a different view of what is "reasonable".

One source with knowledge of the scenarios said there was a case for applying tougher scenarios for countries that had not yet had major crises, since those nations had further to fall - an idea that would be contested by countries such as Germany.

"A way of fudging it is to be too generous with growth forecasts for the periphery," said Colin McLean, chief executive at Edinburgh-based SVM Asset Management, referring to countries now emerging from deep recessions. "(The market will accept it) as long as the overall GDP assumption is more stringent than the last time and looks like it's in line with the U.S."

The last version of the U.S. stress tests set the adverse scenario for domestic GDP at as much as 4.7 percentage points worse than the expected scenario for one quarter, though the average gap was closer to 2 percentage points. The EU tests have a gap of between 1.5 percentage points and 2.2 percentage points between the base and the adverse cases.


The treatment of others issues, such as government bonds, will also be important, analysts and bankers said.

The 2011 tests were criticised for not appropriately measuring the risk of banks' government bond holdings, because they did not test whether banks could withstand a sovereign default similar to the one Greece ultimately enacted.

Neil Williamson, head of EMEA credit research at Aberdeen Asset Management, said another new factor in this year's tests was the deflationary environment the euro zone could be facing.

Annualised inflation in the euro zone stood at just 0.5 percent in March, its lowest level since 2009, and fears about deflation - where prices fall - are rife.

Williamson said deflation would hit borrowers' ability to make loan repayments to banks. New lending would also likely fall as consumers would be reluctant to borrow to fund the purchase of an asset that would be cheaper in the future.

"It's clear that deflation is going to be a risk overall at a macro level, but whether they actually push that far enough (is unclear) ... I suspect they will focus more on GDP," said SVM Asset Management's McLean.

In previous stress tests, banks used expected earnings from activities in emerging markets to cushion the blow of an imagined recession in Europe. But recent crises engulfing Russia and Ukraine make this less plausible now, and some banks even expect to be tested against specific emerging market stresses.

"What's going on in the emerging markets is a real threat to the developed world," said Moody's Analytics' Zandi. "Many of the high-flying economies are coming back to earth."

An interest rate test - or how banks would survive if low interest rates continue to squeeze margins - is another scenario Aberdeen's Williamson expects to see included.


While the EBA's latest information on the stress tests is likely to give investors and analysts some insights into how tough the tests are going to be, it is unlikely to allow them to draw any conclusions about their likely outcome.

"I strongly doubt we will get enough detail from the announcement on scenarios for the market to be able to reverse engineer the tests," said one analyst who asked not to be named.

Working out which banks will pass and fail, and by what margin, is not everyone's objective anyway. "What we're looking for is relevance of the scenarios, do they address what we believe is the risk on the ground?" said Aberdeen's Williamson.

Investor views of those risks have shifted hugely since the last tests were done, he said, pointing out that investors were very worried about "tail risk" - or low probability negative events - back in 2011, but are now so confident in the state of European banking that they're willing to accept an interest rate of 4.5 percent from National Bank of Greece.

That begs the question of how much attention investors will pay to the scenarios used in the EBA tests.

"It's quite staggering how far we've come," Williamson said. "Investors will increasingly come to ignore these scenarios."

(Additional reporting by Sarah White and Jesus Aguado in Madrid, Eva Taylor at Frankfurt and Huw Jones in London; Editing by Mark Potter)