By Huw Jones

LONDON (Reuters) - Banks in the European Union are not fully prepared for a sweeping change in accounting rules from 2018 which will force them to increase by nearly a third the amount of money they set aside for bad loans, Europe's banking watchdog said.

The new rules require banks to put aside some money for loan defaults upfront when a loan is first approved. The aim of this is to strengthen banks and prevent the taxpayer bailouts that took place during the 2007-2009 financial crisis.

It will force banks to begin building defenses even before a loan turns sour. Under current book-keeping rules, banks do not account for bad loans until they have effectively defaulted. But the new accounting system, known as IFRS9, will also impact the banks' capital reserves.

The European Banking Authority (EBA) said on Thursday: "On the qualitative side, the report highlights that as of December 2015, when the exercise was launched, banks were, overall, still at an early stage of preparation for the implementation of IFRS 9, although larger banks seemed more advanced," the EBA said.

Many banks plan so-called parallel runs, where they apply the old and new accounting rules at the same time, but this testing may, in some cases, be more limited than originally envisaged, the EBA said.

"It should also be noted that at the time the exercise was carried-out, banks still needed to make some key accounting policy decisions."

Banks are under pressure to push ahead with preparations as the new rule, which is mandatory, involves changes to IT and accounting systems.

The EBA said its study of 50 lenders showed provisions rose an average 18 percent under the new rule and up to 30 percent for 86 percent of the banks that responded to the EBA's survey.

The watchdog said a bank's core capital buffer would decrease by an average of 59 basis points, and up to 75 basis points for nearly 80 percent of respondents.

"In limited cases the impact of IFRS 9 could be higher."

This week, French bank Credit Agricole <CAGR.PA> said switching to IFRS9 would affect its core equity capital ratio by 20 basis points.

The watchdog is now launching a second assessment of the impact of the new rule.

The Basel Committee of global banking regulators has proposed giving banks time to adjust to the capital hit after the new accounting rule comes into force in 2018.

The European Commission has proposed in an unpublished paper seen by Reuters a phase-in period lasting up to December 2023 "to mitigate the financial impact on institutions".

The EBA said on Thursday it would consider issuing guidance on any transitional arrangements.

The International Accounting Standards Board writes accounting rules which are applied in the EU and elsewhere in the world, apart from the United States.

The United States also reformed its accounting rule for provisioning, but went much further, forcing banks to provision in full from the day the loan is granted.

(Reporting by Huw Jones; Editing by Jane Merriman and Mark Potter)