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By Mia Shanley
STOCKHOLM (Reuters) - Sweden's big banks could find their reputation for capital strength increasingly under threat due to pressure from regulators who fear they are more vulnerable to risky loans than appears on paper.
Regulators have just told Nordic rival Danske Bank <DANSKE.CO> to change the way it works out its capital needs and to beef up its buffers against bad debts.
The events in Denmark show that regulators are looking closely at how banks implement capital rules brought in since the financial crisis to see if they are underestimating risks.
In Sweden, central bank governor Stefan Ingves has already pushed for the country's banks to set aside more capital for potential losses on home loans.
Banks' assessments of how likely a loan is to turn sour - known as "risk weights" - are often based on past records of credit losses.
"Are historical risk weights reasonable to predict future losses? Probably not," said Sean Cotten, Stockholm-based associate director for Standard & Poor's. "History is not a perfect picture of the future, especially when you are talking about tail risks."
All banks have had to build capital after the financial crisis to meet new international standards to make them safer.
The Swedish banks were ahead of the game partly because they had already had to beef up reserves after a property crash in the early nineties followed by turmoil in the Baltics in 2009.
The country's four biggest lenders, Nordea <NDA.ST>, Handelsbanken <SHBa.ST>, Swedbank <SWEDa.ST> and SEB <SEBa.ST>, have 13 percent to 18 percent core tier one capital ratios - a measure of financial strength - comfortably above the 9 percent demanded by European regulators.
This financial muscle has helped their shares more than double since 2008, while EuroStoxx 600 Bank <.SX7P> index is down 14 percent.
And they trade on a price-to-book ratio of between 1.3 to 1.7, substantially above a pan-European sector average of 0.8 according to Thomson Reuters data.
WHAT LIES BENEATH
But now regulators are focused more on what lies behind their solid headline capital ratios and this shows that Swedish banks have assigned some of the lowest risks to their mortgage portfolios in Europe.
This has upset Swedish authorities because the country's households are now among Europe's most heavily indebted, with debts of around 170 percent of output, higher than Germany's 91 percent and France's 94 percent.
As a result, a new property crisis in Sweden could have far more devastating effects with less of the population able to tap government benefits following two terms of center-right rule.
"A similar scenario today would result in higher losses," Cotten at S&P said.
Against this backdrop, Sweden's regulator has set a floor of 15 percent for banks' risk weights - a first in Europe.
But the International Monetary Fund, which estimates Europe's risk weights are between 7 percent to 27 percent, said in May that Sweden's should be even higher - towards 35 percent, a level that Norway is also considering.
Global regulators are focused too on whether banks need to change how they tot up their risks to determine the size of their capital buffers.
In Sweden, the level of risk banks assign to corporate loans is also falling fast, raising eyebrows.
Corporate loan risk weights - currently above 50 percent for Nordea and Swedbank - will fall as they move away from standard risk weightings assumed by regulators to tailor-made ones.
SEB and Handelsbanken, which use the tailor made method already, use 41 percent and 30 percent risk weights on corporate loans, respectively - below Europe's 50 percent average.
Sweden's regulator has said it could consider floors for risk weights on certain corporate loans, and sources say those could apply to loans to the commercial real estate sector.
The Nordic markets have been sheltered from the fallout from the financial crisis and euro zone debt turmoil that followed.
IMF data shows Sweden had the fifth best record for non-performing loans in the world for the decade from 2003 to 2012, with an average of just 0.82 percent.
Over the same period, an average of 2.26 percent of Britain's loans were non performing; in Germany the average was 3.62 percent.
Bjorn Wahlroos, chairman of the Nordic region's biggest bank Nordea <NDA.ST>, believes that the models that produce the banks' risk weights are based on very good statistical data but agrees they are not perfect.
"You have a higher probability of extreme outcomes than the normal distribution predicts," Wahlroos told Reuters. "For this reason, I think it's important to maintain excess capital."
But Swedish banks have a strong incentive to get risk-weighted assets down - it gives them more money for shareholders. All of them have boosted the percentage of profits they pay to shareholders.
Swedbank has said its risk-weighted assets could still fall as much as 50 billion crowns ($7.7 billion), freeing up several billion for shareholders.
"I am afraid what we are seeing is not sustainable," said Fridtjof Berents, an Arctic Securities analyst. "This is about banks' internal modeling and a tendency for a race to the bottom."
(Additional reporting by Laura Noonan and Huw Jones in London; Johan Ahlander in Stockholm. Editing by Alistair Scrutton and Jane Merriman)