Interbank lending revival won't take root till 2010

LONDON (Reuters) - Bank-to-bank lending will take well into next year to recover from two years of crisis, with record low interest rates and unprecedented injections of central bank cash set to continue for months to come.

Banks' stress about lending to each other -- the heart of the credit crunch -- have eased, and the rates they charge have fallen from peaks reached after Lehman Brothers' implosion last year froze lending.

But while some stability has returned, markets are still barely functional due to banks' nerves over their balance sheets, blocking much of the day-to-day lending needed to see off the worst recession in decades.

"The longer that the excess liquidity is there the more it becomes less attractive to park the money in the short end of the curve," said Sean Maloney, an interest rate strategist with Nomura in London.

"Natural processes will be such that we will eventually see it spill into lending but it seems like it will be a very slow process."

Banks are reluctant to up lending to troubled consumers and businesses as lenders try to rebuild capital, while rising unemployment means the demand for credit is also drying up.

London interbank offered rates for euros have fallen below the European Central Bank's main rate of 1 percent since the ECB injected almost half a trillion euros ($616.2 billion) of one-year funds late last month.

But while headline interbank rates are low, the reality is that smaller banks have to pay a much higher risk premium which makes it hard for them to fund daily operations via the market.

"Right now rates are just being artificially depressed by liquidity support from central banks. If they take it away, rates will go up again," said Christoph Rieger, short-end rates strategist at Dresdner Kleinwort in Frankfurt.

"We think this situation will last long into next year."

HOARDING CASH

A Reuters survey last week showed three-month money trading steady around current levels for much of the year ahead across the euro zone, Britain and the United States.

The ECB is due to make two more offers of one-year funds this year and money market participants expect those to be offered at the refi rate plus a small spread.

But the heart of the debate is when all that cash will be put into play to jump start growth, since banks are instead parking a significant portion of the funds back with the ECB rather than lending the money on to customers.

Overnight deposits with the central bank soared to a record 316 billion euros after the first one-year tender. Before that they had fallen as low as 7.4 billion euros.

ECB President Jean-Claude Trichet conceded on Monday it might take time for banks to digest the massive liquidity boost and pass it on in extra lending, urging commercial banks to lend to firms and households.

"Although the provision of the liquidity technically encourages supply of credit, it only does so if the banking sector is in good shape, with healthy balance sheets," said Charles Diebel, an analyst with Nomura in London.

"If not, then the risk is that liquidity is hoarded and recycled into the bond market," he said.

PERSISTENT CONCERNS

Last week, ECB Executive Board member Lorenzo Bini Smaghi said there was still uncertainty about the impact of recession on banks' bad loans and that the banking system was still unable to finance itself over the medium and long term.

While closely-watched risk premium measures against Libor are down to pre-Lehman levels as confidence gradually recovers, the cost of borrowing is still higher than before the onset of the credit crunch.

Spread of three-month Libor over Overnight Index Swaps are 50 basis points for euros and 33 basis points for dollars compared to 10-20 basis points before the crisis.

"We don't think the market can return to their paper-thin levels of credit risk pricing pre-August 2007," said Everett Brown, a bond strategist at IDEAglobal.

"We would view these spreads as having limited room for further narrowing and generally stabilizing in the 25-50 basis points range."

Bank borrowings from the ECB's overnight window have also risen above 100 billion euros. Banks currently receive 0.25 percent interest on overnight deposits and pay 1.75 percent to borrow overnight, higher than in the interbank market.

That means some banks are effectively paying to hold cash with the ECB rather than risk lending it out, and analysts say it reflects the limited access that some banks have to the interbank market.

They warn that sooner or later the ECB will be forced to take further measures to coerce banks to start lending.

"If the ECB gradually becomes concerned by the lack of use of liquidity, it could cut the rate of the deposit facility, to zero, or even could set a negative rate as an incentive to lend liquidity to markets," BNP Paribas said in a note.

"In such a context, and given the slope of the Eonia curve, interbank lending would lead 3-month to 9-month maturity to be received. As a result, such a decision would cause a flattening of the money market curve."

(editing by Patrick Graham)