By Laura Noonan
DUBLIN, March 10 (Reuters) - The European Central Bank's stance on how bad loans are defined will be one of the biggest revelations to the euro zone's largest banks when it details on Tuesday how it will test balance sheets, three sources with knowledge of the tests told Reuters.
The details will give the 128 banks being tested their most explicit insight to date on how their books will be examined by inspectors looking at whether they need billions of euros of extra capital to strengthen balance sheets. Estimates of the capital shortfall range from 280 billion euros ($388.13 billion)to as much as 770 billion.
The tests are being carried out to restore investor confidence in the banks and clean up any problems left over from the financial crisis before the ECB becomes their supervisor in November.
As well as the initial review on whether banks' assets are correctly valued now, banks will also be subjected to a stress test looking at whether they need more capital to deal with future crises.
A document detailing the tests' methodology has been in circulation amongst national supervisors and consultants for several weeks. Recipients have signed non-disclosure agreements and face penalties for any breaches.
"It will terrify them, even though they've got a reasonable idea of what's coming," one source with knowledge of the guidelines told Reuters, pointing to the very prescriptive approach laid out over nearly 300 pages.
The ECB declined to comment.
The three sources said the most closely-watched areas in Tuesday's announcement would be the ECB's view of when loans become impaired, and the way 'hard to value assets' are treated.
For loan losses, the guidelines include a simple rule that any loan more than 90 days overdue is non-performing and a more complex one that sets out the other triggers that suggest full repayment is unlikely, two of the sources said.
A third source said that while the ECB's decision on impairment triggers was "reasonable" some banks would still fall short of it since not all banks would use all the triggers on the ECB's list of definitions of indicators for impairment.
Triggers can include things like evidence that a corporate borrower is in distress and evidence that the value of the collateral underpinning a loan has fallen. "Triggers can be subjective," the second source said.
If a loan's status is changed from performing to non-performing, it would have a higher probability of default, some thing that would force a bank to set aside more capital to provide for higher likely losses.
Banks' estimates on loan losses will be pitted against 'challenger models' created by external auditors - carrying out the tests on behalf of supervisors - an approach first tried in Ireland's balance sheet assessment in late 2013, two of the sources said.
Previous rounds of bank tests have tested the models in use by the banks rather than creating brand new ones.
The rules also require that new valuations must be done for any collateral that had not been valued within a year of January 2014, two of the sources said.
Beyond loans, the ECB's treatment of 'Level 3 assets', a broad group of assets that are difficult to value, will also be closely watched. Those Level 3 assets include derivatives and also include assets such as real estate holdings banks have acquired through foreclosures, their participations in private equity deals and special investment vehicles.
The ECB has taken care to prevent any leaks. Recipients of details of the review face fines of 100,000 euros for leaks and copies have been water-marked with the name of its owner, the sources said.
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