MONEY MARKETS-Italian debt concerns hit interbank lending

* Interbank rates rise, banks likely to turn to ECB funding

* Bond market stress to hit dwindling unsecured lending markets

* Banking stress tests add to tension, focus on Italy

By William James

LONDON, July 11 - Intensifying bond market anxiety centred on Italy and impending bank stress test results look set to drive interbank funding rates higher and boost demand for European Central Bank loans.

Bank-to bank lending rates rose on Monday on signs the euro zone debt crisis is escalating to a new level as investors turn their fire on Italy, the euro zone's most heavily indebted state.

The benchmark London interbank offered rate (Libor) for three-month funds rose by the largest amount since early May to 1.54563 percent, its highest level since March 2009. Equivalent euribor rates also rose.

Libor rates have been on an upward path over recent months due to the ECB's rate hiking cycle, and analysts said souring market sentiment was giving rates a further push higher by making banks less willing to lend to each other on an unsecured basis.

The deteriorating appetite for interbank lending was likely to push more banks to take funding from the ECB rather than sourcing credit from the market.

Demand for ECB cash was likely to increase at one-week and one-month funding operations later this week, when around 190 billion euros ($275 billion) of loans will expire.

"I would not be surprised if we see an increased takedown. We've seen before in severe stress scenarios that this is what's most likely going to happen," Peter Schaffrik, head of European rates strategy at RBC Capital Markets.

Analysts said an injection of liquidity into interbank markets would keep overnight rates subdued near current levels of 59 basis points despite last week's interest rate rise.

ITALY FOCUS

Bond market concerns over the sustainability of Italy's sovereign debt added to concerns about the capital strength of its banks -- large holders of these bonds -- before stress test results due later this week.

Such concerns have added to volatility in Italian banking shares and prompted regulators to seek disclosure of certain short positions.

"The question really revolves around whether they (Italian banks) have raised enough over the last few years while other banks have been more actively engaged in the market to grab capital," said Hank Calenti, head of bank credit research at Societe Generale.

Although banking sources told Reuters on Friday the country's banks would pass the stress tests, Calenti said that should any capital raising be deemed necessary, conditions looked 'tenuous at best' in the current market.

Despite the growing tension, market participants said it was difficult to identify immediate discrimination against Italian institutions in interbank funding markets as low levels of overall activity and ECB liquidity muddied the water.

There continued to be a growing reliance on collateralised lending through repo markets to meet day-to-day funding needs across all euro zone countries, ICAP said.

"There's been a notable offered tone in term Italian repo, but no signs that Italian banks are taking any particular hit in the funding markets," said ICAP analyst Chris Clark.

"There's no sense of great urgency or, god forbid, panic, but the offered tone has been seen continuing in repo this morning and reflects the same concerns that have been reflected in the bond market." ($1 = 0.689 Euros) (Editing by Ruth Pitchford)