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NEW YORK/LONDON (Reuters) - Renewed fears that the euro-zone debt crisis could infect the financial system put pressure on the short-term funding markets on Thursday, forcing some European banks to pay higher rates for U.S. dollar loans.
Banks rely on money markets for cash to fund their trades and loans. Fear about the safety of banks exposed to highly indebted countries reduces willingness to lend to them. In the extreme cases, such as the days immediately after the collapse of Lehman Brothers in September 2008, investors could stop funding banks completely, wreaking havoc on the entire economy.
The benchmark for unsecured dollar loans between banks, three-month Libor, rose to its highest level in 4-1/2 months, the latest in a series of such peaks.
Barclays and Royal Bank of Scotland were paying slightly above the 0.29778 percent LIBOR rate to borrow three-month money.
In another sign of abnormalities in financial markets, the Swiss National Bank tapped the Federal Reserve for extra dollars. It drew down on its special swap line for foreign central banks, the New York Fed said.
The $200 million transaction was the first time the SNB has used the swap lines since they were reopened in May 2010, and the first time since early March that the Fed has provided liquidity to any foreign central bank.
The latest wave of anxiety came on news that the New York Fed and the U.S. Treasury were scrutinizing both U.S. and foreign banks that have exposure to Europe. U.S. officials are urging banks to review all levels of risk -- not just immediate exposure from a counterparty, but also to look one or two levels deeper at whether that bank also borrows from or lends to risky institutions, which could cause them unexpected funding problems, a source familiar with the Fed and Treasury discussions told Reuters.
The Wall Street Journal first reported on Thursday that the Fed is taking a closer look at the U.S. units of Europe's biggest banks on worries that the region's debt crisis could spread to the U.S. banking system.
Responding to the report in The Wall Street Journal, William Dudley, the president of the Federal Reserve Bank of New York, said the Fed is "always scrutinizing" banks and that it treats U.S. and European banks "exactly the same."
The heightened scrutiny became public a day after an unidentified euro-zone bank borrowed $500 million in one-week dollars from the European Central Bank. It was the first time a euro-zone bank tapped the ECB for such funding since February.
Investors have not completely cut off funding to European banks, but most of them are reluctant to lend beyond a week, market participants said.
"Clearly, these euro-zone banks are having a tough time raising money, but it's not at a level that's alarming," said Joe D'Angelo, managing director of money markets at Prudential Fixed Income in Newark, New Jersey, who oversees $50 billion in assets.
French banks, for example, could borrow overnight cash in the repurchase market at about 0.05 percent on Thursday, the same level as U.S. banks. But their borrowing cost for three-month dollars could be 0.30 percentage point higher.
There is deepening gloom over the prospects of solving the euro-zone debt crisis after a French-German summit earlier in the week did little to soothe investor concerns that the problems could spread from weaker countries to the heart of the financial system.
Of the 11 European banks that contribute to the calculation of Libor, six are paying above the daily fixing, while the rest are paying below that level.
Foreign banks also reduced issuance of U.S. commercial paper in the latest week as investors became more anxious about the European debt crisis, Federal Reserve data released on Thursday suggested.
"A lot of flows have not returned to the interbank market. Most investors are not very comfortable right now," said Mike Lin, director of U.S. funding at TD Securities in New York.
London interbank offered rates for three-month dollars rose to 0.29778 percent from 0.29589 percent on Wednesday.
UK banks Barclays (BARC.L) and Royal Bank of Scotland (RBS.L) said they paid 0.3400 percent for three-month dollars on Thursday. It was the second-highest rate paid, just behind the 0.34500 percent Japan's Norinchukin said it paid.
In the meantime, top French banks have been under intense scrutiny due to their high exposure to peripheral debt.
But BNP Paribas (BNPP.PA) said its borrowing cost on three-month dollars was 0.29500 percent, slightly below Thursday's fixing.
The Libor data suggested not all European banks are being lumped into the same risk group, though that is cold comfort for a market where strains are running high.
With the rise in interbank rates and elevated cost to borrow dollars in the currency market, European banks are borrowing in money markets only if they need to do so. Some are said to have already secured longer-term dollars.
"The majority of the European banks have taken care of themselves in dollar funding for this year," said Paul Presinzano, head of short-term dollar interest-rates trading at BNP Paribas in New York.
The risk premium on two-year U.S. interest-rate swaps over two-year Treasuries recorded its biggest jump in 1-1/2 weeks to 27.00 basis points on Thursday. The two-year swap spread grows with counterparty fears.
Additional reporting by Rachelle Younglai in Washington and Karen Brettell in New York; Editing by Jan Paschal and Leslie Adler