Europe Dollar Funding Costs Jump to Highest Level Since Lehman

The cost to European banks of swapping euros for dollars rose on Wednesday to its most expensive level since the collapse of Lehman Brothers as euro zone debt selloffs this week increased worries over banks' exposure to sovereign debt.

Ten-year French government bond yields hit their highest level since April as market concerns about government finances spread to the euro zone's second-largest economy, while Italian bond yields rose back above 7 percent..

Worries about how much European banks hold in bonds issued by euro zone governments have made banks reluctant to lend to each other, with many seeking support from the European Central Bank instead.

Adding to funding worries, UniCredit will ask the ECB to increase access to ECB borrowing for Italian banks at a meeting on Wednesday, a source close to the bank said. .

"(In the same) way that you were seeing dysfunctional markets in the last quarter of 2008 you are just seeing them again now," Simon Smith, chief economist at FxPro said.

Three-month euro/dollar cross-currency basis swaps show the rate charged when swapping euro interest payments on an underlying asset into dollars was at its most expensive level since 2008 at -129, still off levels of -300 bps seen in the fourth quarter of that year.

The spread between three-month euro Libor rates and overnight indexed swap rates -- an indicator of financial stress - was at 83 basis points in intra-day trading. It hit an intra-day high of 90 basis points -- its highest since early 2009.

BANKING FEARS

Earlier in the day the yield premium on 10-year French government bonds compared with the German benchmark hit its highest since the euro was launched as markets sold off even triple-A rated debt after a new government in Italy failed to reassure bond markets.

"The huge increase in spreads for French government bond has impacted the borrowing profile of French banks," Alessandro Giansanti, strategist at ING said. "French banks have been struggling in the interbank market."

French banks are the most exposed to Italian sovereign debt, according to the BIS, and Italian yields have again surged above 7 percent -- a level above which funding costs are perceived to be unsustainable.

The rise in the Italian yield was accentuated last week by a decision by clearing house LCH. Clearnet SA to increase the margin on debt from the euro zone's third largest economy, making it more costly for banks to use Italian bonds to raise funds..

Italian banks have ramped up their reliance on the ECB for cheaper funding in recent months, and the UniCredit story was only reinforcing funding worries, one trader said.

"Banking fears are still pretty much the major concern in money markets at the moment," the trader said.

Instead of lending to each other in the interbank market, banks are increasingly borrowing from the ECB, as well as parking their cash at the central bank overnight.

Banks took 230 billion euros ($310 billion) in the central bank's regularly weekly cash handout on Tuesday, well above the 190 billion traders polled by Reuters had expected.