MONEY MARKETS-Money markets brave Cyprus, risk of stress remains
* Messy Cypriot bailout has limited impact on money markets
* Capital outflows show liquidity tight -CrossBorder Capital
* Risk of further stress remains -analysts
LONDON, April 2 (Reuters) - Money markets largely braved Cyprus's bailout saga last week but an apparent tightening in liquidity conditions may make them less resilient to future flare-ups in the euro zone debt crisis.
The gap between the "risk-free" overnight lending rate and the expected cost of interbank lending rose to its widest since August last week as investors worried the messy bailout could spread contagion by raising fears that a precedent had been set in penalising bank depositors.
That gap, a measure of counterparty risk, has since retraced some of its rise, but some analysts say the risk of renewed stress in money markets remains.
"People fear that the contagion effect is not a direct one, as you would have seen in earlier crises, but more indirect through capital outflows or wholesale funding shortfalls for banks and other peripheral countries," Benjamin Schroeder, strategist at Commerzbank, said.
The fact that banks had reduced their dependence on the European Central Bank for funding since it injected 1 trillion euros into the financial system in late 2011 and early 2012 was a sign banks were not lacking cash, he said.
But they remained reluctant to lend to each other and another liquidity squeeze for weaker peripheral banks could not be ruled out, he said.
The FRA/OIS spread, which measure the premium lenders demand when making loans to other banks, rose as far as 19.9 basis points last week for contracts due to start in September. It has since fallen back to 14 bps but that is up from 10 bps in the beginning of March.
Data from CrossBorder Capital, an independent financial firm that specialises in analysing global liquidity flows, shows liquidity conditions are already getting tighter.
The euro zone saw its biggest capital outflow in March since late 2011 - around the time of the ECB liquidity injection.
Financial institutions and governments took a net $175 billion worth of bonds and stocks, on an annualised basis, out of the euro zone in March - the biggest outflow since $201.4 billion in December 2011, according to the data.
Capital has been flowing out of the bloc since July 2011, the data showed.
"Liquidity conditions are deteriorating fast and that's backed up by the fact that if you look at net financial flows into the euro zone they are basically trending lower. The Cyprus situation clearly hasn't helped," Michael J Howell, CrossBorder Capital's managing director, said.
He said the trend, along with a reduction in the size of the ECB's balance sheet as banks repaid ECB crisis loans, was reducing the amount of liquidity in the financial system.
That could lead to a funding problem in the region if and when the next flare-up in the crisis comes, he said.
"What you've got is a series of negatives which are weighing on the funding situation in the euro zone, which means if there is any slight wobble in the market over the next two or three months, you are going to see an upward spike in (interbank lending) rates," Howell added.
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