Funding strains prompt demand for ECB dollar tender

LONDON: Interbank dollar borrowing costs rose on Wednesday and the European Central Bank's weekly dollar tender attracted demand for the first time since February, with more banks likely to tap the ECB for the greenback as money market strains persist.

A Franco-German proposal to tax financial transactions could further erode confidence in the euro zone financial system, shaken in recent months by a festering debt crisis and worries about softer global growth, some strategists said.

The region's financial sector has been struggling to raise dollars to fund obligations as the sovereign debt crisis which threatened to engulf Italy and Spain made US banks wary of lending to European counterparts.

London interbank offered rates for three-month dollars continued their upward march on Wednesday to 0.29589 percent , staying at its highest in nearly four months.

The ECB saw demand for seven-day dollar loans for the first time in almost six months, with one bank taking up $500 million at a fixed interest rate of 1.1 percent, well above the rates that more trusted banks can get dollars for on open markets.

"As is always the case when there is a bit of a liquidity squeeze, if funds are available from another source, in this case the ECB, banks will make use of it," ICAP broker Kevin Pearce said.

"As we've seen in the past, price becomes very much secondary to being adequately funded, so I'm not surprised that one bank made use of the tender and think that if current conditions persist more will do so in the future."

Dollar funding costs for euro zone banks have trebled over the last month on market turbulence as a result of the 18-month long debt crisis, making the usually overpriced ECB's dollars more attractive.

ECB BACKSTOP

Less volatile markets this week have seen a tentative recovery in currency markets which euro zone banks have tapped heavily to swap euro-based cash flows for dollars. The three-month euro/dollar cross currency rate was last at -77 basis points, from its most expensive level since late 2008 hit last week at -95 bps.

While most analysts said further deterioration in dollar funding conditions could not be ruled out, the rate was unlikely to reach levels around -300 bps hit in the aftermath of Lehman Brothers' collapse in September 2008.

The ECB's swap line with the US Federal Reserve to provide euro zone banks with dollars should be enough to head off acute money market ructions, they said.

But the lack of concrete plans from the Franco-German summit on Tuesday to quickly fix the sovereign debt crisis were likely to keep money markets on guard after the region's two biggest countries stopped short of increasing the bloc's EFSF rescue fund and said common euro zone bonds would have to wait.

They proposed taxing financial transactions, a move which was mooted but quickly discarded last year.

"Psychologically, discussions of a Tobin (style) tax will reinforce concerns that the EU's management of this crisis is not aimed to backstop the fears of European bank creditors but to increase financial protectonism," Lena Komileva, head of G10 strategy at Brown Brothers Harriman, said.

"The need for a greater private sector involvement in sovereign losses will undermine confidence," she said.

Copyright Reuters, 2011