* Spanish and Italian bond yields rise
* Banks may face higher margins in repo market
* Investors wary after S&P downgrades Spain
By Emelia Sithole-Matarise
LONDON, April 27 Benchmark interbank lending rates set a new 22-month low on Friday, held down by the European Central Bank's flood of cheap cash, but Spanish and Italian banks could face higher funding costs in the private repo market if their bonds remain under pressure.
The ECB's 1 trillion euros of ultra-cheap, three-year funding to banks, started at the end of December, has driven interbank rates to half of what they were last August.
But investors remained defensive on Friday as the euro zone debt crisis flared up once again, subduing activity in the interbank market.
Standard & Poor's downgrade late on Thursday of Spain's credit rating by two notches to BBB-plus propelled the country's 10-year bond yields back above 6 percent, pulling Italian yields up in their wake.
S&P cited expectations that government finances would deteriorate as a result of a contracting economy and an ailing banking sector for the downgrade.
A major risk for bank funding is that a rise in sovereign bond yields may lead to higher margins in the repurchase (repo) market, where banks use the bonds as collateral to access cash, making it a less effective method of funding.
Clearing House LCH.Clearnet SA raised its margin rate on Spanish bonds late on Wednesday following the increase in the country's 10-year yields over the past month.
"If this volatility in the bond market continues we may start to see higher funding rates in Italy and Spain in the repo market," a trader said.
Italian one-year general collateral (GC) rates were around 55-60 basis points on Friday, according to quotes from two traders, little changed from Monday. But German GC fell to seven basis points from Monday's 11-12 basis points, reflecting the demand for low-risk assets seen in the bond market.
Traders said they were seeing little activity in lending beyond three months and few were willing to give quotes on Spanish GC.
"The downgrade of Spain was already priced into the market so I don't expect there will be a huge impact but it will have a negative effect on the functioning of the market," said Alessandro Giansanti, a rate strategist at ING.
"The private repo market will continue to stay highly illiquid as long as there will be the risk of a further deepening of the euro zone debt crisis."
In the unsecured market, euro-priced interbank rates continued their march lower under pressure from the excess of cheap cash in the system.
Three-month Euribor rates, traditionally the main gauge of unsecured interbank euro lending and representing a mix of interest rate expectations and banks' appetite for lending, fell on Friday to 0.715 percent from 0.720 percent - the lowest since June 2010.
Equivalent euro Libor rates also fell.
Six-month rates fell to 1.007 percent from 1.013 percent and 12-month rates dropped to 1.321 percent from 1.329 percent.