FRANKFURT Feb 4 (Reuters) - Excess liquidity in euro zone money markets is set to fall back this week to levels that sparked volatility in bank-to-bank lending rates last month.
The European Central Bank absorbed the full amount of its first government bond programme on Tuesday, withdrawing 175.5 billion euros from the market - around 24 billion euros more than last week.
Banks also took around 20 billion euros less in the weekly refinancing operation.
This means the amount of money banks have beyond what they need for their day-to-day operations will fall to around 140 billion euros from the current 186 billion euros once the operations are settled on Wednesday - a level that saw EONIA overnight lending rates spike above the ECB's key rate last month.
That rate is currently at 0.25 percent while EONIA has dropped to 0.14 percent. The problem will be if the falling excess liquidity drives the latter rate up again.
The ECB will hold its February policy meeting on Thursday. It said last month an "unwarranted" rise in interbank lending rates could trigger further action.
ECB policymakers have discussed the possibility of stopping the weekly withdrawal to add more liquidity to the system. News agency Bloomberg said on Tuesday the ECB would need overt backing from Germany's Bundesbank to consider such a move.
The ECB bought government bonds from Italy, Spain, Greece, Ireland and Portugal during the European debt crisis under its now-terminated Securities Markets Programme (SMP) and still holds around 170 billion euros worth of bonds.
To counter the threat of inflation, the ECB has been withdrawing the total amount of the SMP holdings on a weekly basis, but the operations began to miss the total sum late last year, also due to an end-of-year tension in money markets.
At the same time, banks have started to wean off central bank funding, paying back large chunks of their 3-year crisis loans also to get into shape for a balance sheet check that will be based on a snapshot of their books at the end of last year.
All this drove excess liquidity down, which increased upward pressure on bank-to-bank lending rates. If these rise too quickly, it has potential to derail the euro zone recovery.
(Reporting by Eva Taylor Editing by Jeremy Gaunt)