The European Union's banking watchdog will test lenders' ability to withstand a sharp economic contraction this year as part of its health check of the bloc's banking industry in the wake of the financial crisis.

The European Banking Authority's (EBA) severe scenario includes a 0.5 percent economic contraction in the euro area in 2011 and a 15 percent drop in European shares, German newspaper Handelsblatt reported on Tuesday, citing documents from the regulator.

For the first time, the scenario in the current "stress tests" being run over the coming months will also take account of a rise of 75 basis points in long-term yields for euro-zone government bonds and a sharp decline in the real estate market, the paper said.

The EBA, launched in January with powers to impose binding standards on member states, is being watched to see how credible this year's test will be in restoring confidence into a sector that still depends on government support in some cases.

Increased tensions in wholesale funding markets, leading to a 125 basis point increase in short-term interbank financing costs, will be simulated as well, the paper said.

The test will also include a scenario that foresees euro-zone GDP contracting by another 0.2 percent in 2012, Handelsblatt reported.

As expected, the test will not include assets held in lenders' bank books, allowing periphery sovereign bonds classified as held until maturity to escape the same writedowns impacting their trading book under the test's scenario.

EBA Chairman Andrea Enria told Reuters last week that this year's test would be much tougher and that the new authority's own credibility depended in part on a successful outcome.

Last year 91 banks were tested and only seven failed, none of them from Ireland whose banking sector the EU and International Monetary Fund had to bail out later.

Since Europe's banks were found in need of a paltry 3.5 billion euros ($4.90 billion) in fresh capital, the stress test was widely viewed as far too lax, mainly since it did not look at the bank book.

On Monday, Moody's highlighted euro zone risks when it downgraded Greece by three notches to "B1", on par with frontier sovereigns such as Vietnam, Bolivia and Albania. It said the likelihood of a Greek default or voluntary distressed debt exchange had risen.

Final criteria for the stress test are due to be published on Friday, March 18.