Money markets interbank pipelines still frozen in euro zone

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* Interbank lending volumes steady in January, despite excess cash* Any improvement is expected to be slow, policy dependant* Greece, Portugal hurting confidence among banksBy Marius ZahariaLONDON, Jan 31 Euro zone interbank lending activity is yet to pick up after the first month of the year in a sign that policymakers must complement the ECB's massive cash injections with bold reforms to restore confidence. The European Central Bank threw almost half-a-trillion euros at the banking system in late December via an auction of unlimited three-year euro loans, and banks can take as much cash as they want in another such tender next month. The availability of "easy money" should erase any bank funding concerns for the next three years and normally encourage banks to lend to each other at least on a short-term basis. But the rift between the few top-rated banks in northern Europe and the rest of the euro banking sector that was opened up by the Lehman Brothers collapse in 2008 and widened during the three-year-long sovereign debt crisis is hard to repair. Analysts say an increase in interbank lending activity, seen as key to bringing the euro zone economy back on a growth path, will be a slow process and a lot more policy effort is needed.

A plan to strengthen fiscal unity within the euro zone, a lack of which many economists say is at the root of the current problems, is only in its inception phase, unemployment is high around the bloc and fiscal deficits are naggingly large. Also, risks that the currency union could break up persist, with a vital Greek debt swap deal yet to be reached and fears growing that Portugal will be the next to restructure its debt."We haven't seen much activity in the interbank market despite lower rates. If I'm long cash, why would I lend at lower rates? If I have some confidence in the whole political process I might, but at the moment this is still lacking," a trader said. The average daily volume in the overnight Eonia euro lending markets in January was 30.27 billion euros, little different to December or November and significantly down from 45.4 billion euros in January last year, according to Reuters data.

In September 2008, just before the situation started to unravel, daily Eonia volumes reached over 70 billion euros. One head of money markets at a bank in London who declined to be named saw no signs of pick-up in activity for longer maturities either."Some larger names are talking of an increase in activity perhaps ... (But) from what I see there has been no pick-up in interbank lending activity," he said. FROZEN PIPELINES

A large take-up at February's ECB three-year cash tender may still go a long way in gradually restoring confidence between banks and their counterparties. Expectations about the amount to be taken by banks are on the rise. A Reuters poll showed markets expected the ECB to allot 325 billion euros in three-year loans in February, compared with 263 billion in a previous survey. This is improving sentiment in other asset classes, with short-term debt rates across the euro zone having come down sharply in the past two months and equities rallying. Interbank lending, however, will probably be slower to react."If I have some internal lending restrictions for individual countries themselves or a particular group of banks within a country, I'm going to be cautious still until I have more information about the extent to which they participated (in the first tender)," FXPro chief strategist Michael Derks said. One worry is that, trying to secure ECB loans, some banks bought even more low-rated state debt to use as collateral, thus increasing their exposure to sovereign debt. Analysts say that as banks gather more information about the impact the first tender had on the balance sheets of their counterparties, they might be willing to unclog some of the credit lines."That may come to some degree in March perhaps. The issue is that Portugal is starting to implode ... That will freeze the pipelines again," Derks said.