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Crunch time for Europe's banking credibility

Europe's attempt to restore confidence in its banks comes to a head on Friday with widespread expectation that up to 10 lenders will fail the exam and have to raise capital.

Regulators have been looking at how banks would withstand another recession in an exercise similar to one in the United States last year which helped restore bank sector confidence.

Some 91 lenders from 20 of the EU's 27 countries are involved and results are due at 4pm on Friday.

A survey conducted by Goldman Sachs of 376 investors including hedge funds and long-only investors produced an average estimate of 10 banks needing some €38 billion in fresh capital. Banks in Spain, Germany and Greece are most likely to raise cash, it said. Other analysts looking at which banks might need new capital expect 5-10 banks to come up short on the tests, and some even fewer.

The test scenarios include a look at how they cope with a moderate recession this year and next, and the same scenario with additional losses on government bonds.

Any bank whose Tier 1 capital ratio falls below 6% by the end of 2011 will be regarded as failing the test, according to documents seen by Reuters on Wednesday. Banks would be expected to raise funds to make up the capital shortfall.

The EU cleared Spain and Portugal on Friday to extend state support measures for their banks until the end of 2010. Sweden, Germany, Austria, Latvia, Ireland, Denmark, the Netherlands, Poland, Slovenia and Greece have already secured EU approval to do so.

A stress test on U.S. banks early last year helped draw a line under worries about the sector there and turned around market sentiment, and European regulators are aiming to achieve the same.

But there have been clear splits in the 27-nation EU about how to model the test and how much to divulge, stoking worries that it will be less credible.

With the latest data showing signs of a strengthening recovery in Europe, banks could find themselves in a healthier position than expected. (Reuters)