Bank borrowing costs hit highest level in a year

London interbank offered rates for three-month dollars increased to 0.31428 percent, the highest rate since last August and up from 0.31178 percent on Tuesday.

The rate has been steadily rising as investors have become increasingly reluctant to make dollar-based loans to European banks on longer than an overnight basis.

"Term funding markets have significantly less liquidity than they had, a lot of investors are getting very short. They don't want to take a lot of term risk," said Ira Jersey, interest rate strategist at Credit Suisse in New York.

US money funds, which have traditionally been among the largest lenders of short-term dollar loans to European banks, have been reducing exposures to the region on concern over bank exposure to the debt of peripheral European nations.

There has been a resulting dearth of dollar-based funds that the banks need to run their US operations and has sent the cost of exchanging euros to dollars in the foreign exchange market to post-crisis highs.

The three-month euro-dollar cross currency basis swap, which measures the premium banks have to pay to swap euros into dollars, traded at 84 basis points on Wednesday. It has widened from under minus 20 basis points in April.

US funds are also reducing loans, and increasing cash hoards, on fears that they could face large redemptions as low interest rates make it harder to generate returns for investors.

"There are a bunch of different dynamics going on and a lot of them have to do with rates being extremely low and that they are going to stay low for a long time," said Jersey.

Bank funding costs are also unlikely to see any relief soon, with futures markets pricing for a continual increase in Libor through year-end. Eurodollar contracts currently imply three-month Libor will increase to a peak of 57 basis points in December.

EUROPEAN BANKS LEAD WEAKNESS

The Libor panel continued to reflect tiering of banks, with European banks including Barclays, Credit Agricole, Credit Suisse, Royal Bank of Scotland, Societe Generale and UBS all reported having to pay slightly above the daily fixing.

US banks funding costs, including those of Bank of America, were stable.

BofA has seen volatility in its stocks, bonds and credit default swap costs in recent days as fears over mortgage litigation increased speculation the bank would need to raise new capital.

BofA on Wednesday said its three-month loan costs were unchanged at 0.29 percent.

BofA's credit default swaps rose on Wednesday but remained under a record high reached briefly on Tuesday.

Traders said that illiquidity in the corporate bond market has driven investors to buy protection in the CDS market in the place of selling the bonds.

The CDS last cost 378 basis points, or $378,000 per year to insure $10 million in bonds for five years. It was up from 377 basis points late on Tuesday, but down from a record 435 basis points reached earlier on Tuesday, according to data by Markit.

SIGNS OF STABILIZATION?

Some positive signs emerged on Wednesday, as the European Central Bank said no banks took advantage of its weekly offering of dollars.

Markets were roiled last week when the ECB announced a bank had borrowed $500 million in funds, the first time a bank had used the facility in six months.

Some indicators of bank credit risk also retreated, though remained at relatively elevated levels.

Two-year interest rate swap spreads, which are an indicator of bank credit risk, tightened to 29.25 basis points, after trading as wide as 33.50 basis points on Tuesday, the widest level in over a month.

The spread had hit a record wide near 100 basis points during the 2007-2009 credit crunch.

Copyright Reuters, 2011