MONEY MARKETS-Bank funding costs rise, BofA rally peters out

* Dollar funding costs continue to rise, highest in a year * LIBOR futures reduce expectations for further increases * Credit Agricole says has less access to money funding * Bank credit rallies on BofA investment, then peters out * Banks sell more commercial paper in latest week (Adds details, comments, rewrites throughout)

By Karen Brettell

NEW YORK Aug 25 (Reuters) - The cost for banks to borrow short-term dollar funds from other banks kept grinding higher on Thursday, while a rally in bank bonds after Bank of America got a capital boost quickly petered out.

London interbank offered rates for three-month dollars LIBOR increased to 0.31900 percent, the highest rate since last August, and up from 0.31428 percent on Wednesday.

The rate continued to reflect tiering, with many European banks paying slightly above the fixing, while U.S. banks pay less.

News that Warren Buffett's conglomerate Berkshire Hathaway (BRKa.N) would invest $5 billion in Bank of America also gave only a temporary boost to credit markets and traders said investors took advantage of price strength to quickly sell out of the bank's bonds.

Traders remain spooked that banks will be further pressured by a weakening economy and contagion from Europe.

The cost to buy debt insurance on Bank of America in the credit default swap markets tumbled though they remain at elevated levels and almost double where they traded at the beginning of August, according to data provider Markit.

The investment "did little to boost sentiment," Markit analyst Gavan Nolan said in a note.

The bank's credit curve is also inverted, meaning it is more expensive annually to buy short-term insurance than long- term insurance, a sign that investors fear near-term deterioration in the company's credit profile.

Bank of America's five-year credit default swap costs last traded at 315 basis points, or $315,000 per year to insure $10 million in debt for five years. They traded initially traded as low as 285 basis points on the news.

Eurodollar futures contracts that are used to speculate on the direction of LIBOR also showed that traders are expecting bank funding costs will keep rising through year-end.

A rally in the contracts on Wednesday and Thursday has, however, slightly reduced expectations of how high LIBOR may increase.

"Front-end Eurodollar futures are rallying on the day," said Michael Chang, interest-rate strategist at Credit Suisse in New York. "The sentiment is at least not worsening."

LIBOR futures are now implying that the three-month interbank lending rate for dollar loans will increase to around 52 basis points by December, down from expectations early Wednesday that they would increase to 57 basis points.

EUROPE FEARS REMAIN

European banks continued to have to pay a slightly higher short-term dollar funding rate on Thursday as concern over exposures to peripheral European debt remained elevated.

Barclays (BARC.L), Credit Agricole, Credit Suisse (CSGN.VX), Royal Bank of Scotland (RBS.L), Societe Generale (SOGN.PA) and UBS (UBSN.VX) all reported having to pay slightly above the daily LIBOR fixing on Thursday.

France's Credit Agricole (CAGR.PA) said on Thursday that its access to U.S. money-market funding had been roughly halved as a result of market jitters, to around 25 billion euros. Presenting its second-quarter results, the bank said it was however "well-positioned" in terms of liquidity and had alternative sources of dollar funding available.

U.S. money funds have been reducing their exposures to European banks and also shortening loans they do make, leading the banks straining for dollar funding they need to run their U.S. operations.

Instead, many banks have been exchanging euros to dollars in the foreign-exchange swap markets, which has kept the swap rate at elevated levels and near post-crisis highs.

The three-month euro-dollar cross currency basis swap EURCBS3M=ICAP, which measures the premium banks have to pay to swap euros into dollars, was at minus 83.25 basis points from 84 bps on Wednesday.

BANKS SELL MORE COMMERCIAL PAPER

The size of the U.S. commercial paper market rose on a non-seasonally adjusted basis in the week ended Aug. 2 due to increased issuance from financial companies, Federal Reserve data showed on Thursday.

After adjusting for seasonal factors, however, the market declined by $29.5 billion to $1.117 trillion in the week. Some analysts said the Fed's seasonally adjusted figures on the commercial paper market have been skewed after the 2007-2009 global financial crisis.

Banks and other financial companies issued $7.9 billion in this short-term debt in the latest week, bringing their non-seasonally adjusted commercial paper outstanding to $518.5 billion.

Foreign banks' dollar-denominated commercial paper outstanding grew $5.0 billion for the week to $121.2 billion, while the U.S. units of overseas banks' commercial paper outstanding grew by $1 billion to $153.9 billion, Fed data showed. (Additional reporting by Richard Leong in New York and Emelia Sithole-Matarise in London; Editing by Jan Paschal)