ECB cash glut may not free up euro zone lending

* Interbank lending limited to select group of banks

* ECB cash injections may not dramatically widen pool

* Banks still struggling to deleverage

By Marius Zaharia

LONDON, Feb 22 (Reuters) - A flood of European Central Bank cash may not be sufficient to unblock market funding channels for most euro zone banks struggling to reduce exposure to risky assets while a flare up in the sovereign debt crisis remains a threat.

The ECB's first offering of almost half a trillion euros in cheap, three-year funds at the end of last year and the prospect of a similar take-up at a second tender on Feb. 29 have been hailed as removing the risk of a major credit crunch and a chain of bank failures across the euro zone.

But the extra ECB cash has so far not persuaded lenders to introduce new credit lines or significantly extend the length of their existing funding agreements. Weak banks remain frozen out of money markets while the strong fear exposure to risky peers.

A marked pick-up in banks' ability to borrow money in the market - whether from other banks or money market funds - would encourage them to fund businesses and households, helping heavily indebted economies such as Italy and Spain grow.

Access to market cash is mostly restricted to a select group of highly-rated banks in the heart of Europe, such as Germany's Deutsche, Rabobank of the Netherlands and national champions in southern states, such as Spain's Banco Santander, traders say.

Weaker banks, often exposed to riskier euro zone debt or other toxic assets such as bad mortgage loans, depend on the ECB for funds. Analysts say this is unlikely to change as the threat remains that Greece may not be the last euro zone state to restructure its debts.

"Within one year a lot can happen. We all know the risks that are hanging over Europe ... is (a debt restructuring) necessary for Portugal as well?," said Gerard Moerman, head of rates and money markets at Aegon, which oversees investments worth 424 billion euros.

"I want to make sure that the portfolio can withstand any type of weather. In our money market fund we stick to the very high quality banks."

The average daily volume in the overnight Eonia euro lending markets in January was 30.27 billion euros, little different to December or November and significantly down from 45.4 billion euros in January last year, according to Reuters calculations.

Since December's ECB tender, there has been no major increase in longer-term lending and little cash changing hands for more than three months, trader said.

"Even if bank A is aware that bank B could be fully funded for the rest of the year, bank A may still be reluctant to lend simply because they don't want their exposure to appear on their books," said Max Leung, a rates strategist at BofA Merrill Lynch Global Research.

"The impression is that this could continue for at least another two or three quarters ... They would rather deposit the cash at the ECB than to take on the reputational risk."

Overnight deposits with the ECB, seen as the safest place to park cash but offering almost no return, were almost 450 billion euros on Wednesday, triple what they were six months before.

ON THE RIGHT PATH

Still, cheap ECB funding helps banks to repair their balance sheet and to pay down debt, which is key to regaining access to market funding in the future.

Deborah Cunningham, chief investment officer of Pittsburgh-based Federated Investors, one of the top six money market funds in the U.S., said she was not expecting to extend exposure to peripheral banks in the near-term.

"I would think we will begin to consider it if everything continues to plod along in 2012, whether we actually do it ... I'm not sure, but at least we're going to start discussing that," said Cunningham, who manages $285 billion in money markets, 80 percent of the group's total assets.

Plodding along means banks continuing to write down their exposure to public debt and bad mortgage loans, increasing their capital ratios and profits, while sovereigns undertake structural reforms and reduce the risk of a debt sell-off.

A potential positive example is the French banking sector, which in July suffered from a flight of U.S. money market funds due to worries over its exposure to Greece and Italy, but lately, it has written down most of its Greek debt holdings and cut is dependence on dollar assets.

Societe Generale said last week it cut its dependence on dollar liquidity by $55 billion during the second half of last year, while BNP Paribas said it had cut dollar funding needs by $57 billion.

Cunningham said Federated was only lending on an overnight basis to French banks but was considering lengthening the duration of their exposure.

"Those banks seem to be a lot less dependant on overnight funding or have a lot more avenues in that market," she said.