MONEY MARKETS-Bank funding costs extend fall; so does US CP

* Interbank funding costs extend decline

* 3-month dollar, euro, Libor at fresh lows

* U.S. CP market extends long contraction

By Burton Frierson and Ian Chua

NEW YORK/LONDON, July 30 (Reuters) - Benchmark bank-to-bank lending rates for U.S. dollars, euros and sterling fell to fresh all-time lows on Thursday but more signs emerged that the easy money might not be finding its way directly to the economy.

U.S. investors continued to sock away savings in super-safe U.S. T-bills, judging by the falling rates from one-month to one-year maturities <0#USBMK=>.

The U.S. commercial paper market contracted for a third straight week, eroded by the global credit crisis and protracted economic downturn, Federal Reserve data showed on Thursday. [ID:nN30347261]

"The low T-Bill yields signal, for one, somewhat of a flight to safety, a flight to quality," said Lou Brien, market strategist with DRW Trading Group in Chicago.

"But I think that part of it is that we've got a kind of a flight to quantity. A lot of the money that had previously gone into say commercial paper or other short-term corporate debt is now going into T-bills either because of concern over that stuff or just the lack of it."

The market is the smallest since at least early 2001, when the Federal Reserve began compiling data in its current form.

On the plus side, banks and companies are getting so used to seeking alternative sources of short-term funding, that commercial paper may not immediately mirror the economy's fortunes, some analysts say.

However, the money finding its way into T-Bills may well be short-term investments that formerly went to the private-sector.

PARKING A LOT

In Europe, commercial banks parked almost 200 billion euros at the European Central Bank's overnight vault on July 29, up from 193 billion euros deposited previously, indicating plenty of liquidity in the system.

Since it flooded the market with nearly half a trillion euros of cheap one-year funds last month, overnight deposits at the central bank have gone up, suggesting banks are keeping much of the funds rather than lending them out.

Indeed, an ECB survey this week showed banks tightened credit standards again in the second quarter and expect to continue doing so in coming months, although at a slower pace.

"Ample bank reserves created through central bank money creation have not substituted for the broken credit multipliers in the real economy and the demise of securitisation continues to undermine market, economy and policy efficiency," said Lena Komileva, head of G7 market economics at Tullett Prebon.

With so much liquidity sloshing around, interbank lending rates continued their decline.

The three-month euro London interbank offered rate (Libor) was set at 0.87063 percent EUR3MFSR=, while the equivalent dollar and sterling rates were fixed at 0.48313 percent USD3MFSR= and 0.89 percent GBP3MFSR= respectively.

See [ID:nLU393591] for the latest Libor rates.

Until banks mend their tattered balance sheets and the economy starts to show signs of picking up, analysts said banks will likely remain reluctant to lend.

Still, the global banking sector appeared to be slowly healing. Sumitomo Mitsui Financial Group (8316.T) and two other Japanese banks returned to quarterly profit. [ID:nT321705]

The Irish government will move one step closer to dealing with its banking problem and will unveil draft legislation later on Thursday, giving its "bad bank" project wide powers to deal with the financial crisis. [ID:nLU578783].

In Britain, the Bank of England will launch its Secured Commercial Paper Facility on Monday in an effort to improve the functioning of corporate credit markets. [ID:nLU538320] (Additional Reporting by John Parry)