French and German banks see short-term lending squeeze

* Greek debt fears prompt cautious lending to banks

* U.S. investors switching to shorter-term maturities

* Exacerbated by French banks now on ratings watch

* Some can't lend to companies on ratings watch

By Aimee Donnellan

LONDON, June 22 (Reuters) - French and German banks may be forced to turn to the European Central Bank to plug a short-term funding gap if cautious U.S. investors continue to rein in lending on fears of potential losses from a Greek debt default.

Contagion fears, which have been exacerbated by recent negative ratings action by Moody's on France's top three banks -- BNP Paribas , Credit Agricole and Societe Generale -- has seen a sharp drop of S18 billion in short-term lending to European banks since May as money market accounts and dealer balance sheets are becoming more risk averse, according to Barclays research.

U.S. investors are already switching to shorter maturities, and some are prohibited altogether from lending to French banks and others on ratings watch, commercial paper traders said.

"Investors express their risk view through duration. Most of the trades done in the financial sector were less than 60 days in duration," said Giuseppe Marafino, an analyst at Barclays Capital.

Jittery investors are not demanding additional premium to lend, instead they have shortened the maturity of the short-term paper they are willing to buy by five days during the last two weeks, CP market traders said.

"There is currently a class of investor that can't buy from French banks, even if they roll over the maturities, because they're on rating watch. A lot of the investors are struggling to find banks they want to invest in. They can't lend to Ireland, Greece, Portugal, Spain and now France. They have run out of options," said a U.S.-based commercial paper trader.

Commercial paper markets are a cheap source of financing but while it may be cost-efficient, the downside is the very short-term average maturity, which is approximately 50-55 days in Europe, bankers said.

An inability to roll short-term debt has significant implications for commercial banks, and the closure of CP markets was behind central banks' dramatic expansion of liquidity facilities in the third quarter of 2008.

RUNNING OUT OF OPTIONS

U.S. money-market funds currently have $360 billion invested in European banks, of which $200 billion is invested in France. That $200 billion is about 12 percent of the top 10 funds' assets under management. According to a recent Fitch survey, that figure has not changed despite heightened volatility caused by the ongoing Greek debt problem.

Negative headlines on the continent's peripheral sovereign debt crisis have driven investors to hoard cash in a bid for safer lending options. Short-term lending is expected to be reduced even further, unless a solution to the Greek crisis is found.

One corporate paper (CP) trader said a significant portion of the recent drop-off had come from France and Germany, which he estimated at a combined decrease of $13 billion.

"U.S. investors are looking at reducing their European exposures. They are at the point where they don't care about yield. They want to play safe and make sure they are only exposed to the markets they see as safe," another CP trader said.

However, there are some European CP officials that believe the issues surrounding France's short-term debt options will be short lived, and there is always the ECB to turn to.

European banks recently took advantage of the ECB's limit-free offering of one-week funding and took 187 billion euros, more than 50 billion euros above what traders polled by Reuters expected. The figure was the highest amount taken since February of this year. The ECB offered funds at a flat rate of 1.25 percent, a significant rate advantage to the 1.31 percent offered by the public markets for the same duration.

"We haven't seen any sustained selling pressure from U.S. investors. A lot of U.S. fund managers have said they knew France had exposure to Greece, particularly because Moody's rating was higher than that of S&P. Prices haven't changed since the Moody's action, but we have seen a shortening of maturities," explained a European CP origination official. (Reporting by Aimee Donnellan; Editing by Alex Chambers, Alexander Smith and Will Waterman)