* ECB liquidity provision welcome, but not enough
* Libor/OIS spreads narrow as rate cut expectations ease
* Covered bond programme supports narrower spreads
By Kirsten Donovan
LONDON, Oct 7 Steps by the European Central Bank to provide longer-term liquidity to the banking sector are welcome but do little to address underlying solvency concerns in the face of the euro zone debt crisis.
The ECB said on Thursday it would offer struggling banks two new injections of 1-year funding -- a 12-month operation in late October and a 13-month one in December -- and resume its covered bond buying programme for a total of 40 billion euros.
Some signs of market stress eased with the spread of three-month Libor rates over overnight indexed swap rates falling around 10 basis points to 65 bps, led by a rise in overnight rates as expectations of aggressive ECB rate cuts faded.
Markets are now pricing in one 25 bps rate cut in December, according to forward overnight Eonia rates, analysts said.
But fears over the effect of a sovereign debt default on the banking sector are growing, prompting policymakers to make recapitalisation plans.
"It's not just a liquidity problem but that is where the ECB can help," said Norbert Aul, rate strategist at RBC Capital Markets.
"The ECB buys the time for a recapitalisation of banks but that would have to be done by local governments or the EFSF (European Financial Stability Facility)."
Some analysts said the banks were unlikely to repeat their 442 billion euro cash-grab of 2009 at the 12-month tender, as part of the demand then was due to rates being such that it was attractive to borrow the money to buy higher-yielding assets.
Also, banks may be reluctant to take funding for a year when political developments may mean they can re-access markets at some point over the next 12 months.
BNP Paribas saw demand of around 250 billion euros, skewed to the December tender as it covers funding needs at the end of 2012, while Morgan Stanley thought banks could take over 440 billion euros by rolling shorter-dated funding into the new facilities.
"If the issue for banks is now more one of the credibility of their assets ... then merely extending the tenor of their liquidity provision rather misses the mark," Morgan Stanley strategists said.
Underlining the desperate funding situation for some banks, data released on Friday showed Italian banks sharply increased their reliance on funding from the ECB in September to more than 100 billion euros from 85 billion euros in August.
"With 1-year Euribor currently at 2.10 percent, the 60 basis point spread to the refi-rate is likely to attract a considerable uptake (at the 12-month operation) in addition to the increasing periphery demand," said RBS rate strategist Simon Peck.
The 40 billion euros of covered bonds the ECB has pledged to buy from next month to October next year is less than the 60 billion euros in the previous programme beginning in May 2009. However, there have already been signs it will support the market, allowing banks to raise longer-term funding.
In the days leading up to the announcement, Portuguese Obrigacoes Hipotecarias showed the strongest reaction, tightening by 145 bps compared to a widening of more than 480 bps between June to September 26, according to IFR data and Spanish Cedulas tightened in 16 bps-20 bps.
During the first programme which ran from June 2009 to June 2010, the ECB bought 27 percent of the total 60 billion euros in the primary market and 73 percent in the secondary market.
"It would be a disappointment if the likes of the Bundesbank or the Banque de France were mainly to buy their home markets," Societe Generale strategists said in a note.
"They need instead to focus on the higher-yielding segments, where the problems are, even if this means increasing their risk exposure."
The bank noted that the announcement of the original programme in May 2009 led to an immediate reopening of the primary market, despite purchases only starting in July.
"At a stroke, the ECB has secured access of the banking sector to long-term capital funding through covered bonds, and unlimited funding until January 2013 through the LTROs," SG said.