Interbank rates rise to confirm EU summit this weekend

LONDON: Euro zone interbank lending rates hit their highest in more than two months on Thursday as investors hoarded cash on uncertainties surrounding a European Union summit this weekend.

Money markets will be looking to the summit for details on how European banks' capital will be boosted and how the euro zone rescue fund will be leveraged as officials try to restore confidence in the region's struggling banking sector.

EU member countries have agreed that between 90 billion and 100 billion euros is needed to recapitalise the region's banks, EU and banking sources said on Thursday.

Alessandro Giansanti, strategist at ING, said anything short of $100 billion euros would be considered negative by money markets and could keep euro zone interbank lending rates at elevated levels.

"I would expect an impact (on Libor) if the number that politicians decide to pledge for bank recapitalisation is below the market's expectation," Giansanti said.

Benchmark three-month euro Libor rates fixed at 1.51438 percent the highest since early August according to Reuters data up from 1.51250 on Wednesday.

The US equivalent was around its highest in more than a year at 0.41556 percent, compared to 0.41167 percent on Wednesday.

Chris Huddleston, head of money markets at Investec, also expected three-month Libor rates to rise when details of the bank re-capitalisation plans emerge.

Banks will be required to come up with the capital from shareholders first, and if that fails than national governments would provide the support. Only as a last resort will the European Financial Stability Facility, the region's bailout fund, be used to recapitalise institutions.

"You might see a more aggressive uptick once the plans are announced but I think the banks are pre-empting the fact that they will need to recapitalise and the fact that they do need to raise cash," Huddleston said.

Any impact on money markets from plans to tackle the crisis would be offset by expectations for more liquidity coming into the financial system.

The European Central Bank will hold its first one-year tender in almost two years on Wednesday, in which European banks are seen taking up 60 billion euros, according to a Reuters poll published this week.

The forecasts for the poll were wide-ranging, underscoring the extreme uncertainty over European banks' funding needs.

Analysts said the extra liquidity coming into the system could ease pressure on key measures of financial stress.

The spread between three-month euro Libor rates and overnight indexed swap rates stood at 66 basis points, unchanged from the previous session but up from around 11 bps in June.

Another measure of counterparty risk, the three-month Euribor-OIS spread was around 76 bps up from around 19 bps in June.

"Because the one-year tender should attract strong demand, this can increase the absolute level of liquidity and maybe the most important impact would be that the duration of liquidity provided by the ECB would extend very significantly," Patrick Jacq, interest rate strategist at BNP Paribas, said.

"There could be less stress on Euribors-OIS spread, it could even decline somewhat."

Copyright Reuters, 2011