UPDATE 1-Modest demand at ECB loan offer calms markets

* Banks borrow relatively modest 111 bln euros for 6-days

* Signals net drain of 199 bln when 12-month money repaid

* Analysts say liquidity supplies still adequate

(Adds details, reaction, by-line)

By Krista Hughes

FRANKFURT, July 1 (Reuters) - A European Central Bank tender eased fears over euro zone banks and financing on Thursday, padding banks' repayment of almost half a trillion in emergency loans, another step in the battle to return bank-to-bank lending to normal.

Banks borrowed 111.2 billion euros ($136.1 billion) in six-day funds, which analysts said was modest and effectively cut 199 billion euros from the euro zone's liquidity surplus -- meaning institutions are better able to borrow from other banks instead.

The euro did inch lower after the result while benchmark government bond yields rose. But the currency was still trading generally higher and players said worries that the interbank market was heading for another crunch of the type that underpinned 2008's financial crisis were fading.

Overnight money market rates, which had jumped as high as 0.7 percent before the operation, fell back to 0.4 percent on relief the drain was not larger.

"It doesn't look as though demand was as great as people were envisaging after yesterday. There's a bit of relief in the market that some of the worries about funding concerns in Europe may be overdone," said Nick Stamenkovic, strategist at Ria Capital Markets.

"Obviously if banks aren't borrowing from the ECB then they're borrowing from the markets -- the consequence of that is that money market rates tend to move higher."

Overall liquidity had reached a record high of 910 billion ahead of the deadline for repayment of 442 billion euros to the ECB, as banks took extra cash in preparation. ECBOMO=ECBF <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For a graph of ECB lending to banks, please see: here For graph of liquidity overhang, please see: here ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

NEARER TO NORMAL

The operations take the ECB another step along its path to the exit from generous emergency loans introduced at the height of the financial crisis, despite having to re-introduce some measures last month amid sovereign debt woes.

Analysts said the lower liquidity levels would push up market interest rates, but not dramatically.

The ECB said 78 banks borrowed funds in the latest operation, fewer than the 171 institutions which borrowed a lower-than-expected 131.9 billion euros at a separate three-month money operation on Wednesday.

Taken together, the two operations amount to 243 billion euros and fall 199 billion euros short of the repayment of 12-month funds.

Calculations based on ECB data put the excess liquidity in the system at about 150 billion euros on Thursday, from about 350 billion previously.

One euro zone money market trader said there was still enough liquidity to keep overnight rates below 0.4 percent.

"Less over-liquidity you could see as a good sign, it might mean that a big part of the one-year refi was used for arbitrage and the market needs less than before, it means banks are on track," he said.

Market interest rates are already at their highest levels in more than nine months and analysts had said low take-up of shorter-term funds would bring more upward pressure. EURIBOR=

Investors are watching the euro zone money market closely for signs of the sort of problems in bank to bank lending which were at the root of the financial crisis. It is also vital the market functions well to generate affordable loans for consumers and businesses, needed to spur economic growth. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For a graph of ECB lending to banks, please see: here For graph of liquidity overhang, please see: here ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^> (Reporting by Krista Hughes, editing by Patrick Graham)