* Eonia volumes drop year-on-year in January
* Partly caused by dropouts from rate-setting panel
* Banks also allocating more funds for longer-term lending
By Marius Zaharia
LONDON, Feb 4 Euro zone overnight bank-to-bank loan volumes shrank sharply year-on-year in January, partly reflecting signs of healing in the financial system as banks become more confident about lending longer-term.
Improved longer-term access to funds in money markets is a crucial pre-condition for banks to lend more money to businesses and help the region's economy recover.
Reuters data on settlements of the euro overnight Eonia rate showed the daily average volume of trades dropped to 17.37 billion euros in January 2013 from 30.47 billion in the same month of last year.
Withdrawals from the rate-setting panel, including heavyweights Citi and Rabobank, in the wake of a scandal over setting interbank interest rates, contributed significantly to the drop in volumes, but are unlikely to have accounted for the entire sum, traders said.
Better economic data in the euro zone and the United States and expectations the European Central Bank would step into government bond markets if the three-year-old debt crisis escalated are encouraging banks to take more risk.
That is shifting some of the money from low-risk overnight trades to longer-term maturities.
"The situation is improving from a curve extension point of view and the quality of names being lent to is also decreasing," one money market trader said.
"I've (even) seen one-year trades going through, but (most of the activity) is in the three-month and six-month sectors and volumes are picking up."
Another sign of improved confidence in money markets could be that banks repaid a higher than expected amount in three-year loans (LTROs) taken from the ECB late in 2011, when the central bank offered unlimited cash to prevent a credit crunch.
Paying back long-term loans to the ECB means banks become more reliant on the market for funds, and this may have also contributed to the extension of maturities in interbank loans.
"We have two effects. One, of course: the panel from which the rates are calculated is shrinking and some of the banks which you would expect to add more volumes to the calculation of the index have left the panel," Commerzbank rate strategist Benjamin Schroeder said.
"And two: at the moment we have the ... repayments of the LTROs so you have lower overnight volumes because banks extend the duration of their interbank trades to bridge the ... LTRO repayment dates."
Eonia rates are calculated on a trade-weighted basis using data from the same 39 contributors that make up the panel setting Euribor, an important gauge of how much banks pay to borrow from their peers.
Euribor and its London-based counterpart Libor are going through a credibility crisis as some banks have been accused of manipulating Libor rates. Several lenders have pulled out of the Euribor panel in recent months.
The overnight rate last settled at 0.081 percent, comfortably within an extremely narrow range seen in the past six months. Longer-term rates rose sharply in January -- one-year Eonia rates have risen five-fold to 0.2 percent -- due to expectations ECB loan repayments could massively reduce the excess liquidity in the euro zone.
The pick-up in volumes and in rates at the longer end of the money market curve can only be sustained if economic data continues to improve, traders said, and many in the market have expressed doubts that would be the case.
"It's only so far we can move away from fundamentals," ICAP strategist Philip Tyson said.