* Mounting sovereign crisis weighs on banking sector
* Funding stress indicators worsen
* ECB providing liquidity, but is there collateral problem?
By Kirsten Donovan
LONDON, Nov 17 Signs of bank funding stress grew on Thursday as the euro zone sovereign debt crisis seeped deeper into countries such as France and markets looked to the European Central Bank to take more dramatic action.
Italian bonds yields held above 7 percent despite more ECB bond buying while the premium investors demand to hold French 10-year government bonds rather than German Bunds topped 2 percentage points.
With a Fitch Ratings report highlighting concerns over U.S. banks' exposure to euro zone debt, banks showed little willingness to lend to one another.
"It's not a liquidity crisis as during the Lehman time anymore, it is increasingly becoming a credit problem and there's little the ECB can do about that," said Commerzbank rate strategist Benjamin Schroeder.
"They can buy time and provide liquidity but the issues have to be sorted by the politicians. The ECB can't take on risk for these banks."
ECB officials have repeatedly said they will not engage in unlimited, unsterilised bond buying, which would effectively be the quantitative easing already undertaken by the Federal Reserve and Bank of England, despite many in the market viewing it as a necessary step to contain the growing crisis.
It is, however, supplying a large section of the banking sector with liquidity as other sources of funding dry up.
Gross liquidity in the euro zone banking system is at its highest since July 2010 at almost 690 billion euros, according to Morgan Stanley, nearly 300 billion more than requirements.
Weekly borrowing jumped by more than 35 billion euros this week alone, linked to the rise in the cost of borrowing using Italian government bonds as collateral in the secured lending market last week.
Meanwhile, traders said unsecured borrowing was virtually non-existent with many unable to access even overnight funds.
Banks with excess funds who cannot use the ECB's overnight deposit facility were lending only to top-rated European banks, otherwise preferring to look outside the euro zone.
Benchmark three-month Libor and Euribor rates ticked higher with the spread of three-month Libor rates over equivalent overnight indexed swap rates -- a measure of market stress -- around its highest since early 2009.
The premium for swapping euros into dollars rose further with the three-month cross-currency basis swap around 6 basis points wider at -136 basis points, the most since the 2008 financial crisis.
Commerzbank's Schroeder said that although it looked cheaper to get dollar funding via the ECB's dollar-swap lines, banks were not doing this yet.
"Demand for dollars from the ECB has still been fairly muted in recent weeks, there is still a lot of stigma attached to the ECB operations," he said.
"The pain threshold has not been reached yet... so we could still some more widening in money market spreads, especially in the dollar space, in FRA/OIS for example."
In a sign that ECB funding may soon not be enough, the head of Italy's UniCredit bank has called on the ECB to increase access to funding for Italian banks, a source close to the bank said on Wednesday.
News reports said the request was for a widening in the type of collateral the central bank would take in return for the cash, adding to concerns that some banks were running out of assets to borrow against.
Borrowing from the ECB's overnight lending facility -- which at 2 percent is costly versus the 1.25 percent charged at liquidity providing operations -- has been above 2 billion euros since early October, suggesting funding may not be available through regular tenders.
Longer-term funding was also close to non-existent, with just 10 billion euros of senior unsecured debt issued since July, according to Societe Generale.
Spain's largest bank Santander will modestly boost its capital by getting investors to exchange 6.8 billion euros of subordinated debt into new senior notes but analysts said the exchange terms were not attractive.
"For a national champion like Santander to offer such punitive exchange terms highlights more than ever the stresses in the financial system," said Suki Mann, credit strategist at Societe Generale.
"(The UniCredit report) is worse for the market than (Santander's) liability management exercise, it highlights the huge funding problems the banks have in senior unsecured."