* Dangers to over-reliance on ECB funding flagged* ECB and banks taking on more risk on balance sheets* Feb LTRO seen easing financial stress in money marketsBy Ana Nicolaci da CostaLONDON, Feb 1 European Central Bank liquidity has helped to lower the level of financial stress in the inter-bank market and improve sentiment towards risk, but analysts are beginning to flag the dangers of a banking system over-reliant on cheap central bank funding. The three-month spread between Libor rates and overnight index swap rates has narrowed since the ECB injected money in the financial system in December and is seen tightening further as the central bank is set to offer another round of three year loans this month. There is a widespread view that the ECB's liquidity operations have been successful in averting a credit crunch which would have accentuated the euro zone debt crisis. But there are concerns banks may get too comfortable and the ECB may struggle to wean them off cheap lending."The worry is this a temporary life-support or is this something that is going to be hard to reverse in future?" Richard McGuire, senior fixed income strategist at Rabobank said. Even with three-month euro zone Libor interbank lending rates at their lowest since March 2011 at 1.04943 percent , traders say banks have remained reluctant to lend to each other.
"We don't think that it actually tackles the root of the problem which is one of solvency and at its heart a lack of fiscal union in the euro zone," McGuire added. European leaders agreed to a pact of stricter budget discipline, a step towards tighter fiscal integration, helping to fuel risk appetite in financial markets already benefiting from ample ECB liquidity. The injection of nearly half a trillion euros of three-year ECB funding in December has seen the spread between three-month Libor rate and overnight Eonia rates - a measure of counterparty risk - tighten more than 20 basis points since December. The spread last stood at 69 bps, unchanged from the day prior.
Simon Smith, chief economist at FxPro expects that gap to narrow another 20 basis points after the second round of three-year funding this month. The ECB is expected to allot 325 billion euros in its second three-year refinancing tender due in late February so long as money markets remain stressed, a Reuters poll of traders showed this week. DAY OF RECKONING
The problem was how to wean the banks off such attractive funding conditions and what impact it could be having on the ECB's growing balance sheet, analysts said."If you give banks the easy option it sort of blunts the need to make the harder choices," Smith said. Given the ECB has eased its collateral requirements quite significantly, "from having a very liquid, stable balance sheet, the ECB has gone to having a very large and less stable balance sheet by nature of the risks that it is taking on in terms of the paper it is receiving."The ECB's long-term refinancing operations (LTRO) have allowed domestic banks to borrow at relatively attractive rates with the ECB to buy high-yielding bonds, making a profit but also increasing these banks' exposure to riskier sovereign debt."Banks become increasingly vulnerable to a turn in peripheral sentiment because they will be more heavily invested in peripheral bonds so any decline in the value of those bonds is going to hurt balance sheets an awful lot more if they have loaded up on them via the LTRO process," McGuire said. It also delayed the "day of reckoning" which will ultimately involve a solution that transfers some of the risks to Europe's paymaster Germany and other so-called "core" countries either via greater fiscal union or quantitative easing by the ECB, he added."At the moment this three-year (cash) is helping the carry trade. So banks are going out and buying a huge amount of government debt for anything under three years and using the ECB to fund it," a trader said. "It's great in the short-term ... but what happens in three years' time when the ECB stops that?"
* Traders step up bets that ECB action will depress rates* Eonia falling to new lows across curve, below depo rate* Timing of refi rate cut unclear, first cut priced by SeptBy William JamesLONDON, May 31 Bets that the European Central Bank will step in to relieve growing pressure in the euro zone financial markets have driven short-term money market rates to record lows as traders anticipate a cut in borrowing costs or another flood of cash. A fall to new lows across three-month to one-year rates on Tuesday suggested markets were preparing for fresh monetary easing from the ECB that would push the cost of overnight borrowing lower. Pressure has grown on the ECB to act to calm acute nervousness over whether Greece may have to leave the currency bloc, and whether Spain can afford to save its fragile banks."Whilst the situation in Europe prevails as it is, the market will continue to keep front-end rates pretty low and under pressure. They're definitely looking for something from the ECB," said Eric Wand, strategist at Lloyds Bank in London.
Hamstrung by a lack of trust between banks, the euro zone financial system is already on life support from the ECB. The central bank is currently lending just under 1 trillion euros to financial institutions to provide funding that banks can no longer source at an affordable rate in the market. That huge surplus of cash has pushed the Eonia overnight lending rate down to within a whisker of the 0.25 percent paid on deposits at the ECB. The daily Eonia fixing on Wednesday night was 0.33 percent. The deposit rate was once seen as a floor for Eonia, since there was no incentive to lend to a bank for a lower rate than that available at the ECB.
But traders looking to lend at a fixed Eonia rate for six months or longer are now willing to offer a rate below 0.25 percent, gambling that fresh easing would force rates down even further."With it being extremely unlikely that the daily Eonia fix will rise, traders have a good idea of any potential downside," said Kevin Pearce, senior broker at ICAP in London."But if the ECB does offer some new form of stimulus in the shape of rate cuts - which I think is unlikely at present - or new lending operations, it could push Eonias lower."
Six-month Eonia hit a record low of 0.22 percent on Thursday, while the one-year rate slipped as far as 0.204 percent. TOO SOON TO CUT? The ECB holds its next regular policy-setting meeting on June 6, but forward Eonia prices showed markets believe it was unlikely the ECB would act yet. A 25 basis point cut in the 1 percent main refinancing rate was only around 10-20 percent priced in for June, but the probability increased into July's meeting, analysts said. J. P. Morgan research said a cut was fully discounted by September. While there is no clear consensus on the timing of any ECB action, the sharper decline in long-dated rates shows that markets expect central bank support measures to remain in place for an extended period - a gloomy verdict on the region's chances of escaping its current crisis."Out to two years there's not much higher rates in sight. The ECB is seen more or less staying put at these levels or even lower," said Benjamin Schroeder, strategist at Commerzbank in Frankfurt.
* Italy daily repo volumes at highest since 2006* Negative rates in German, French repo boon for Italy* Stabler peripheral markets also helping Spain repoBy Emelia Sithole-MatariseLONDON, Feb 18 Daily volumes in short-term borrowing using Italian government bonds is at its highest since before the financial crisis, reflecting recovery in parts of euro zone money markets. According to data from repo index provider RepoFunds, volumes in the Italian repo market reached 69 billion euros on Friday, the highest since 2006 -- before the start of the global financial crisis the following year.
The RepoFunds index was launched in December by interdealer brokers ICAP and electronic trading platform MTS, and is based on electronically-executed repo trades that use a bond, bill or floating rate note issued by the relevant sovereign. Activity in the Italian market has picked up since the European Central Bank unveiled its yet to be tested bond buying scheme last September and lifted investor confidence that the region can contain its three-year-old debt crisis. The Italian repo market is also benefiting from investors looking for a return on their cash as it offers some return compared with near to below zero rates in the German or French repo markets, analysts said.
Chris Clark, an analyst with ICAP, said Italian bonds had been popular as collateral since the ECB outlined its bond purchase programme in September."Lending out short-dated cash against Italian collateral has been benefiting a good deal from German and French rates being negative... You can get a bit of interest rate and it's a very mature and liquid government bond market so you can move in and out of your positions easily," he said. The RepoFunds rate on Italian bonds was at 0.010 percent at Friday's fixing, compared with -0.026 percent for German bonds and -0.013 percent for France.
The cost of borrowing using French and German government bonds has been driven back below zero since data last week showed the euro zone economy slipped deeper than expected into recession in the fourth quarter, reviving speculation the ECB would cut its deposit rate. Money markets had all but priced out a cut in the rate the ECB charges banks to deposit cash at its overnight facility to negative territory but its vice-president, Vitor Constancio, said on Thursday such a move was "a possibility" though no decision had been taken. The hunt for yield has also seen activity in the Spanish repo market pick up, according to traders, though figures on volumes were not readily available. Reduced fears of a euro zone break-up has also seen Spanish bond yields tumble from unsustainable levels, enabling the country to keep funding itself."We're not seeing trading in long-term but in short-term where foreign counterparties are interested again and are opening lines to trade Spanish and Italian repo. It's easier to sell Spanish paper in the repo market than before," one money repo trader said.
May 29 Spanish efforts to recapitalise Bankia, its fourth biggest lender, have eased pressure on the cost of insuring Spanish bank debt against default - but not for long because the move is seen as further undermining the country's precarious finances. The fate of Spain and its banking system is increasingly intertwined as markets worry that any bank rescue will further drive up national borrowing costs in a vicious cycle. The cost of insuring debt issued by Santander and BBVA fell on Tuesday, having risen in the beginning of May when risk sentiment was also hurt by an anti-austerity vote in the Greek elections. But analysts expect the fall in the cost of insuring Spanish bank debt against default to be short-lived and that spreads will realign with those on sovereign bonds on concerns that Bankia could be just the start of a rolling rescue of an over leveraged banking system. Bankia's parent company BFA has asked for 19 billion euros in government help, in addition to 4.5 billion the state has already pumped in to cover possible losses on repossessed property, loans and investments.
Analysts worry that Spain could eventually be forced to seek an international bailout with unforeseeable consequences for the euro zone and financial markets. A government source told Reuters on Tuesday Spain will recapitalise the nationalised lender by issuing new debt, not by injecting bonds, and will likely adopt on Friday a new mechanism to back its regions' debt."I guess a couple of weeks ago we didn't have news about this bailout. I am surprised that people have taken it that optimistically. I guess having something injected is better than nothing," Michael Hampden-Turner, credit strategist at Citigroup said.
"We are likely to see quite a lot of volatility in the bank CDS premium as the summer goes on. We see some volatility but I think it's probably a temporary thing. I think it's likely to realign (with sovereign CDS prices)."The cost of insuring debt issued by Santander against default fell 11 basis points on the day to 401 bps, while the BBVA equivalent shed 10 bps to 441 bps, according to Markit data. Five-year Spanish sovereign CDS meanwhile flirted with a record high of 560 bps, trading at 556 bps - little changed on the day and up from 508 bps in late April. Ten-year Spanish government bond yields also remained above 6 percent danger levels and not far from 7 percent - a level where Portugal and Ireland had to start considering bailouts.
"It seems like (increasingly) the credit risk is being transferred over to the sovereign fundamentally, that's why we have seen Spain hovering near its record wide," Markit analyst Gavan Nolan said. On bank CDS prices, he said: "They had widened out a lot in the previous few weeks. Mainly I think it's a bit of a pull-back from that."The trouble for Spanish banks could worsen if clearing house LCH. Clearnet SA further increases the cost of using Spanish bonds to raise funds via its repo service. Earlier this month the clearer raised the initial margin on two- to 30-year Spanish debt, with the largest move in the 10- to 15- year maturity sector."Imposition of higher initial margin charges from LCH on Spanish government repo is almost an inevitability now. This may further depress liquidity in both the underlying government bond market and term repo market for Spain," Don Smith, economist at ICAP said.