Europe faces moment of truth on banks, with flawed defences

* Sharp rise in banks buying own governments' bonds

* Cheap ECB loans gives banks windfall profit on state debt

* Politicians' attempts to break "doom loop" faltering

By John O'Donnell

BRUSSELS, Dec 13 (Reuters) - Europe's banks face a moment of truth next year when health checks will spell out the repairs they need. The trouble is that fixing them could require cash-strapped governments to borrow more, often from the very banks that need their help.

The European Union's efforts to break this "doom loop", in which frail banks and penurious states recycle the same money to prop each other up, are falling short.

Banks have ramped up buying in the past two years and enjoyed high payouts on government bonds bought with cheap European Central Bank loans. On the other side of the coin, states such as Italy and Spain increasingly lean on their banks by selling them debt.

Central bank strategists in Frankfurt are concerned this has laid the foundation for future shocks before the dust has settled on the worst financial storm in a generation.

"This is a vicious circle," said Andreas Dombret, board member of Germany's central bank, the Bundesbank. "Four years into the crisis, the link between governments and banks has become even stronger."

Italian banks' holdings of euro zone government debt rose from 247 billion euros ($340 billion) in November 2011 to 425 billion in October this year, ECB data shows, and Spanish banks' stockpile jumped by more than two thirds to 305 billion euros.

To prevent a future financial crisis, euro zone leaders want to hand supervision of banks to the ECB and establish an independent central agency to shut failing lenders.

But the cost of a clean-up will still be paid chiefly by the country where the bank is based, falling short of earlier pledges to break the vicious circle between bank and state. An EU meeting of leaders next week could cement that plan.

FREE LUNCH

The close ties between banking and politics are as old as lending itself, but the continued fragility of banks in Europe and governments' huge debt burdens as they grapple with recession could prove an explosive mix.

The intimacy of the relationship can be seen at Intesa Sanpaolo, Italy's largest retail bank.

Described by its former chief executive Corrado Passera as "part of the system", the bank has close ties with the political elite and stakes in central planks of the economy such as Telecom Italia and national airline Alitalia.

While at Intesa - he left two years ago to take a ministerial post in government - Passera masterminded the privatisation of Alitalia and lent it money. Recently, the bank extended the loss-making airline further credit.

As speculation mounted towards the end of 2011 that Italy faced possible default, this marriage was put to the test. Investors saw Intesa and the state as so intertwined that its share price tumbled over fears not for the bank but Italy.

In the country's darkest hour, Intesa bought tens of billions of euros of Italian bonds. From just above 59 billion euros at the end of 2011, the group's holding had shot up to almost 97 billion by September this year.

Intesa, whose chief executive recently said that regulation was behind their decision to invest, is not the only bank to have splurged on government bonds.

Even in Germany, held up as a paragon of economic virtue, banks are expected to do their bit for the nation.

Officials from its Bundesbank recently asked Deutsche Bank why it was slipping down the rankings of banks that buy German state debt, according to one person familiar with the matter. Deutsche, one of the leading banks selling German government debt to investors, declined comment.

For Italian banks, buying state bonds was not only to avert Italy's collapse. The difference between the return offered on the bonds and the low cost of borrowing from the ECB offered a "free lunch", as one banker described this carry trade.

If a bank had bought 100 million euros of three-year Italian bonds at the end of 2011, using cheap ECB loans known as LTRO, it would have paid less than 1 million euros a year for the credit, but earned about 4.5 million on the bonds - and seen their value rise - according to ThomsonReuters data.

PICKING UP THE TAB

While the ECB's credit succeeded in preventing a lending freeze and helped Italy and Spain to borrow, there is a growing feeling in Frankfurt that its generosity has been abused.

Some of the scheme's architects did not predict the extent to which bond buying would accelerate, a misjudgment one person involved described privately as a "mistake".

"I did not sense that this would be used to such a large extent," he said.

Frustration in Kaiserstrasse, the Frankfurt home of the ECB, was clear in the frank message delivered by ECB President Mario Draghi last week.

"If we are to do an operation similar to the LTRO, we're going to make sure this is being used for the economy," the Italian said. "And we'll make sure this operation is not going to be used for ... these carry-trade operations."

Neither will the central bank's flood of cheap credit wash away banks' past sins, to be laid bare in the ECB health checks next year.

Estimates for the cost of fixing banks in Italy vary, but the International Monetary Fund predicts that 20 Italian lenders may need up to 14 billion euros.

The case of Italy's scandal-ridden Monte dei Paschi di Siena provides a hint of how the problem may be addressed by Italy, where national debt is approaching 135 percent of economic output - the worst in the currency bloc behind Greece.

In order to shore up its withered finances, Monte dei Paschi, which had earlier stockpiled billions of euros of Italian government bonds, sold its own bonds to the government.

ZERO RISK?

Untying the knot between state and banks has been a long-running theme of the financial crisis.

When some of Ireland's banks were teetering on the brink of collapse, the state rushed to guarantee not just all savings but any bond sold by the banks, a monumental pledge that toppled the government and buckled the country's economy.

Three years on, Ireland has just become the first euro zone country to exit an international bailout, but at the cost of painful spending cuts.

The loop is further reinforced by EU law, which allows banks to treat state bonds as "zero risk", so they do not have to set aside capital to cover potential losses on them.

The rules are based on an agreement among central bankers and regulators from around the globe on the influential Basel committee in Switzerland. Many officials there say they never intended state debt to have blanket risk-free status.

It is unlikely to change soon. Draghi has said the ECB will not come up with new rules without international agreement.

Johannes Wassenberg of ratings agency Moody's fears this will create a new bubble: "If capital regulations treat government debt as risk free, this may encourage banks to channel a lot of liquidity into this asset," he said.

"This can lead to risks further down the road."

Such risks are illustrated by Cyprus, whose banks crumpled under the weight of losses on Greek government bonds and dragged down their own state's finances with them.

"We have learned the hard way that what is risk-free on paper or in theory is not so in practice," Cypriot Finance Minister Harris Georgiades told officials in Brussels.

But as long as banks can treat the bonds as such and make big profits on them, they remain unchastened.

"You have credit standards today that you have not seen since before the crisis," said Bernd Knobloch, a German banker. "The banks are earning good money. You have to dance as long as the music is playing."