European money markets healing

By Kirsten Donovan

LONDON (Reuters) - Europe's money markets are recovering from the damage inflicted on them by the financial crisis. But the pace of improvement is likely to slow as financial firms struggle to repair tattered balance sheets.

Benchmark interest rates which banks quote in lending to each other have slid to record lows over the past several months, raising hopes that healthier money markets will support an economic recovery.

But many banks remain unwilling to lend for periods longer than a few months, and some are still being charged a lot more than others to borrow. That is limiting the availability of credit to consumers and may weigh on any economic recovery.

"It's not wrong to say money markets have improved...but there are still significant liquidity and counterparty risk premia," said BNP Paribas rate strategist Alessandro Tentori.

Central banks' huge liquidity injections into the markets, and governments' success in preventing major bank failures, have improved the environment dramatically since the dark days of late 2008, when the money markets essentially froze up.

For example, the three-month U.S. dollar London Interbank Offered Rate has dropped as low as 0.71 percent, after jumping about 2 percentage points in the space of a few weeks after Lehman Brothers collapsed last September.

But some gauges of risk remain well above levels seen before the financial crisis began in 2007. And over a third of euro zone money market traders in a poll published by Reuters this week said there could be more liquidity problems to come.

Only about half said the European Central Bank should resume the variable rate tenders which it used before the crisis; and half of those thought this would take over a year.

One problem is that benchmark Libor fixing rates do not tell the whole story, because plenty of banks have to pay very different rates to obtain money.

RATES VARY WIDELY

For example, a breakdown of the rates on which Tuesday's Libor fixing was based showed Barclays (BARC.L) and Rabobank believed they could borrow three-month euros at 1.19 percent, below the fix of 1.23 percent. But Deutsche Bank (DBKGn.DE) estimated it would have to pay 1.31 percent.

One market broker in London said traded prices ranged even wider, from as low as 1.0 percent to almost 1.40 percent.

"It highlights the still very sensitive nature of lending in the wholesale money markets, indicating nervousness and risk aversion is still high," said ICAP economist Don Smith.

"It's improving, but modestly, and the pattern of flows does not yet reflect a widespread, significant improvement in confidence across the market."

Other prices also suggest money markets will not return to pre-crisis conditions any time soon.