European money markets healing

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.

One measure of money market stress, the spread of three-month dollar Libor rates over overnight indexed swap rates, has tightened to around 55 basis points, a long way below the roughly 365 bps seen during a panic last October, but still far from the near-zero spread that prevailed before the crisis.

Forward three-month Libor/OIS spreads show the anticipated difference between future dollar interbank rates and OIS is 46.5 bps for December, according to BNP Paribas, indicating markets expect only modest further improvement this year.

This implies that while the banking sector has stabilised, the markets do not feel systemic risks have disappeared.

"The causes of the money market stress remain unresolved and the correction of bank balance sheets has much further to run before this crisis is over and money market activity returns to normal," said Lena Komileva, director of market strategy for G7 nations at broker inter-dealer broker Tullett Prebon (TLPR.L).

The definition of "normal" is a matter of debate, since tighter banking regulation and capital standards in the wake of the crisis may mean money markets never quite return to their previous vigour.

But analysts at BNP Paribas suggest forward Libor/OIS spreads will converge through 2011 towards levels around 30 bps for dollars and 25 bps for euros.

COUNTERPARTY RISK

In order to restore confidence, banks need to finish cleansing their balance sheets of bad debt and "toxic" assets, complex derivatives for which valuations are not clear.

International Monetary Fund Managing Director Dominique Strauss-Kahn said last week that clean balance sheets were a precondition for economic recovery. But the markets clearly do not feel the banking sector is close to reaching that point.

Tentori at BNP Paribas uses the so-called 3s6s basis swap curve in U.S. dollars as a measure of the markets' perception of counterparty risk in longer-term lending.

This is the difference between an interest rate swap curve based on a three-month reference rate and a curve using a six-month rate; it shows the perceived difference in risk between lending over the two periods.

This spread was typically almost zero before the credit crisis started in 2007, and it then rose steadily until last month. For one-year swaps, it now stands around 36 bps versus about 45 bps in April.

The ECB last week acknowledged in a report that attempts by governments and central banks to alleviate the funding gap left by the closure of wholesale money markets had not yet managed to unlock longer-term liquidity.

In fact, around 20 billion euros of the newly injected money is still deposited back with the central bank on a daily basis, as institutions prefer that risk-free approach to earning a return by lending in money markets.

The ECB said banks remained relatively pessimistic about the recovery of money market funding, feeling it would "probably take years" for it to become normal.

(1 euro = $1.36)

(Editing by Swaha Pattanaik and Andrew Torchia)