* Concern grows over stress tests credibility
* Euro falls below $1.28, erases gains versus yen
* Sterling rallies 1 pct on economic data (Adds comment, detail, updates prices)
By Wanfeng Zhou
NEW YORK, July 23 (Reuters) - The euro fell against the dollar on Friday as doubts grew that the stress tests of European banks won't reveal the true health of financial institutions.
The Committee of European Banking Supervisors (CEBS) said losses on sovereign debt holdings were applied only to banks' trading books, not their banking books.
The euro briefly traded below $1.28 as the news fed skepticism the stress tests will not shed light on banks' capacity to withstand serious financial market turbulence.
"It appears that the worst may be true with regards to how bonds would be subjected to testing," said Win Thin, senior currency strategist at Brown Brothers Harriman.
In late morning trading, the euro was down 0.5 percent at $1.2825, after hitting a session low at $1.2794 on electronic trading platform EBS.
Official results of the tests on 91 top European banks are due around 12:00 pm (1600 GMT). They are being coordinated by the CEBS, a London-based body consisting of representatives of central banks and supervisors from the 27 EU nations.
Thin said the positions in the trading book is usually held for a limited amount of time and profits are determined by mark to market, while the banking book contains assets held for longer and profits are usually calculated on an accrual basis if held to maturity.
"We do not know of any analyst that thinks Greece can avoid a debt restructuring. Does it make sense to assume that they will be paid off at par if held to maturity? By leaving out stress tests on the banking book, then a true picture of bank balance sheets will clearly not be obtained," he said.
Earlier, the euro had gained after data showing an unexpected jump in German business sentiment in July to reach its highest level in three years.
The euro also erased gains versus the yen and was last at 111.97, down 0.1 percent on the day.
A report in Spanish newspaper El Pais that several of the country's 18 savings banks had failed the stress tests added to pressure on the single euro zone currency.
"A great deal of caution should be exercised by traders today as the results of the stress tests are made public," said Dan Cook, a senior market analyst at IG Markets, in Chicago.
"There is definitely the potential for a huge swing in either direction, followed by an equally enormous reversal as all of the information is digested."
The dollar was up 0.4 percent versus the yen at 87.31 yen, staying above 86.27 yen struck on trading platform EBS late last week, its weakest since December 2009.
The greenback was up 0.3 percent versus a currency basket at 82.879.
Sterling rose over 1 percent on the day to $1.5404, boosted by data showing Britain's economy grew almost twice as fast as expected in the second quarter of this year. (Additional reporting by Steven C. Johnson; Editing by W Simon )