Banks scramble for cash as Fed's Kohn notes risks

LONDON (Reuters) - Banks scrambled for cash on Wednesday to cover their funding needs as a year-end credit squeeze intensified and the European Central Bank stepped in to lend three-month funds at its highest rate in 6-1/2 years.

The ECB lent banks 50 billion euros ($73.7 billion) -- less than half the amount they bid for -- to tide them over the New Year period. The banks paid an average 4.70 percent, way over the ECB's policy rate of 4.0 percent and the highest since April 2001, when its policy rate was 4.75 percent.

It still wasn't enough. "We didn't see any effect on markets after the (auction result) announcement. The amount they're needing is a lot more than the ECB is allotting," said a euro zone money market trader.

The lending rates banks charge each other have surged far above official benchmark rates as banks hoard cash for fear of exposure to the high-risk debt that proliferated during a long-running credit boom. That has intensified the usual worries about tight liquidity over the New Year period.

A U.S. central banker said the global crunch that halted the boom in August might hit households and businesses harder than previously thought as banks make it harder and more expensive for them to borrow.

Federal Reserve Vice Chairman Donald Kohn told the Council on Foreign Relations in New York on Wednesday that markets had partly reversed the recovery they had begun in late September and October.

"Should the elevated turbulence persist it would increase the possibility of further tightening in financial conditions for households and businesses," Kohn said.

SIGNS OF STEADYING?

Even so, world stock prices and measures of credit market sentiment steadied on Wednesday, suggesting markets are gradually coming to terms with the squeeze that began when defaults on U.S. mortgages brought home how much high-risk debt had been sold on around the world during the boom years.

Shares in Switzerland-based bank UBS AG (UBSN.VX) jumped on hopes that profitability would improve after its third-quarter loss, and that fresh money from Asian, Gulf and Russia could target banks hurt by the crisis after Abu Dhabi gave Citigroup Inc (C.N) a $7.5 billion capital injection on Tuesday.

The Fed as well as the ECB promised this week to put extra funds into the markets to tide them over into 2008.

However, London interbank offered rates (Libor) -- the benchmark lending rates between banks -- showed cash getting less available and more expensive.

The Libor rate for two-month euros rose to 4.73875 percent at the daily fixing, the highest since May 2001. In early August rates were below 4.2 percent.

Libor rates for two-month dollars rose to a one-month high of 5.08563 percent, while sterling rates for the same period rose to a two-month high of 6.63875 percent.

"The level of confidence remains quite low. Banks are still reluctant to lend because of counterparty risk and balance sheet constraints on their own side," said Nathalie Fillet, senior fixed income strategist at BNP Paribas.

Meanwhile Norwegian bank Terra Gruppen shut its brokerage arm and sacked its chief executive on Wednesday due to a furore over structured investments put together by Citigroup that Terra sold to four Norwegian municipalities before the summer credit crunch.

The investments were based on debt issued by U.S. cities and states with high credit ratings. However, the municipalities leveraged their investments with short-term loans, which became costly when financial market liquidity dried up in August.

(Reporting by David Milliken in Frankfurt, Natsuko Waki in London, Andrew Hurst in Zurich and Aasa Christine Stolz in Oslo)