By Eva Taylor
FRANKFURT (Reuters) - The European Central Bank will reveal more detail on Monday on how it plans to go about checking that top euro zone banks have the risks on their balance sheets under control.
The ECB's asset quality review, or AQR, is part of a broader examination that also includes a stress test to see how banks hold up under shock scenarios, to avoid nasty surprises once the ECB takes up responsibility for supervising them from November.
It aims to encourage banks to recognize losses on loans or investments that have soured over time, allowing them to regain investors' trust and free up capacity to grant new loans to help along the euro zone's fragile economic recovery.
"The devil will be in the detail and the risks of lowest common denominator and compromise in such a multilateral process are legion," said Morgan Stanley's Huw van Steenis.
"This is why the market still has many doubts on how cathartic a process the AQR and stress tests will be."
The ECB will address at least some of such doubts on Monday by laying out, for example, how it will define when a loan has turned bad and what the next steps will be.
On Friday, the European Banking Authority (EBA) set out key parameters for the stress tests it coordinates, which imply that the probe will be tougher than previous ones.
The two reviews will eventually feed into each other and their timings will overlap somewhat, but the overall result -spelling out the size of any capital shortfall - will only be published in October.
Analysts have estimated the tests will show the banks need up to 100 billion euros of fresh capital.
Over the past couple of months, the ECB has collected vast streams of data from the 128 banks that are taking part in the exercise, and a deadline for some lenders to deliver extensive detail on their trading books and risk models is approaching.
National supervisors have also identified particularly risky portfolios they would like included in the in-depth review, which the ECB now needs to review and approve.
In Germany, for example, shipping is likely to be looked at closely. The country was a global leader in ship lending before the financial crisis struck and the global economic downturn crimped trade flows, wiping out the profits that shippers need to pay off their loans.
Over the next couple of months, ECB inspectors will make sure the lenders have set aside sufficient capital for possible loan losses, check for data accuracy and run on-site reviews - the most complex part of the assessment.
Banks and investors are keen to find out how the ECB will go about this stage, which portfolios and assets will be looked at, and how the ECB defines certain key criteria, such as when a loan has gone bad.
Morgan Stanley sees Italy, the Netherlands and Austria in focus when it comes to non-performing loans, arguing that in Italy these continue to grow with no slowdown seen.
Italian lenders have been hard hit by writedowns on soured loans as the country's deepest recession in 60 years takes its toll on households and businesses.
Federico Ghizzoni, head of Italy's top lender UniCredit
(Editing by Catherine Evans)