Euro zone banks' demand for central funding surged to a two-year high on Tuesday, and U.S. funds cut their lending to the bloc's banks, tightening a squeeze that looks unlikely to ease this year.
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Fast-spreading sovereign debt worries have left lending markets virtually frozen and the European Central Bank as the only available funding option for many banks.
The ECB's weekly, limit-free handout of funding underscored the widespread problems, with 178 banks requesting 247 billion euros, the highest amount since mid-2009.
Just as fears about the financial health of Italy and Spain have stopped banks lending to some their peers, U.S. funds have also continued to retreat from the region, and Italian and Spanish banks have seen corporate deposits flow out to safer havens.
U.S. money market funds, which are key providers of liquidity to banks and have been pulling back from the euro zone since May, cut their exposure to European banks by a further 9 percent in October, according to ratings agency Fitch.
Bankers said there appeared little chance of wholesale funding markets reopening for euro zone banks this year, and the best that can be hoped is for a return to more normal conditions early in 2012.
"The reality is it's hard to see investors get any confidence (before the end of the year), as the sovereign crisis is out of control. Confidence has disappeared from the banks as they are a conduit for the sovereigns," a senior debt market banker said.
There are several warning signs flashing for euro zone banks' liquidity, limiting options and raising borrowing costs, leaving the European Central Bank as the only option for many of them.
"There won't be a crisis of liquidity because the ECB floodgates are open. But that's not long-term funding that banks need for sustainable planning," the banker said.
Financial markets have grown increasingly worried about banks' liquidity as the failure to get to grips with Greece's debt crisis has seen worries spread to Italy, Spain and France, raising their borrowing costs and threatening to saddle banks with losses on their sovereign debt.
"It all comes down to whether the politicians can find a fix for the euro zone. I don't think markets are going to unfreeze until we see some movement on that," said Simon Adamson, analyst at CreditSights in London, adding he doubted markets would reopen this year.
The ECB has reinstated some of its most potent crisis-fighting tools in a bid to try and calm tensions, but the moves have done little to revive wholesale funding.
European leaders will meet next week to discuss how to unblock funding, including potentially restarting state guarantee schemes to allow banks to access longer-term funding.
Key euro-priced bank-to-bank lending rates were steady on Tuesday, but the increase in Italian borrowing costs has lifted funding costs for banks there near to "junk" bond levels.
U.S. money market funds have cut their European exposure to the lowest in percentage terms since Fitch started compiling its data in 2006, the ratings firm said.
"Recent trends indicate that money funds are pursuing a range of strategies to mitigate euro zone risks, including reducing exposure levels, shortening maturities, and increasing the share of collateralized transactions in the form of repos," said Robert Grossman, managing director of Fitch Ratings.
Fitch said its sample of the top 10 U.S. money market funds had a $224 billion exposure to Europe's banks at the end of October, down 42 percent from the end of May.
Funds cut their exposure to French banks by 19 percent in October and by 69 percent since May. They have also shortened maturities, and more than half the exposure to them was for seven days or less at the end of October, Fitch estimated.
The funds also cut their exposure to German banks by 16 percent and to Nordic banks by 14 percent during October.
And reduced wholesale bank funding "could be now morphing into corporate deposit outflows in certain markets", according to Kinner Lakhani, analyst at Citi.
"We are starting to witness signs that corporates are withdrawing deposits from the banks in Spain, Italy, France and Belgium. This is a worrying development and potentially signifies another leg-up in banks' dependence on the ECB," he said.
The money headed to banks in Germany, the Netherlands and Sweden, Lakhani said.