Euro zone banks close to asking ECB for dollars

(Reuters) - Dollar funding costs for euro zone banks have trebled in three weeks and are expected to rise further, possibly forcing lenders to ask for greenbacks from the European Central Bank for the first time in a year.

A massive sell-off in stocks, led by banks, have prompted investors and banks to hoard funds and made them increasingly reluctant to lend dollars to euro zone lenders.

The increasing tension in money markets has led some in the markets to draw parallels with the freeze that followed the 2008 collapse of investment bank Lehman Brothers.

"I'm not sure we will see the same apocalyptic scenario as in 2008 ... Now (the lack of trust) is getting to the point where it will be cheaper to tap ECB dollar funding," said FxPro chief economist Simon Smith.

The ECB has a swap line with the U.S. Federal Reserve that allows the ECB to provide banks with unlimited dollars but it has been dormant for the past 12 months as banks have so far been able to borrow greenbacks more cheaply in the market.

This is about to change. The three-month euro/dollar cross currency basis swap, which shows the rate charged when swapping euro interest payments on an underlying asset into dollars, has reached minus 95 basis points, levels not seen since November 2008.

Banks seeking ECB dollars would pay a little over 100 bps at the auctions held every Wednesday.

While analysts say there would now be a stigma attached to banks seeking dollars, once bidding in the ECB tenders became cheaper than seeking funds in the market, FX basis swaps should stabilise at just over what the ECB charges. During the Lehman freeze basis swaps hit levels below minus 300 bps.

"It (the swap) could go up to 10 bps (over what the ECB charges) given that the ECB's tender is one-week and the basis swap we are looking at is three-months so it could be a term premium there," said Morgan Stanley strategist Elaine Lin.

The dollar swap line, together with the already widely used unlimited euro loans of up to six months, are among the key advantages the euro system has compared with how things stood at the time of the Lehman crisis. Analysts expect the ECB to make even more liquidity available if needed.

"If things go on like this even more measures may be introduced. The ECB should be capable of avoiding a Lehman-type scenario," said Commerzbank strategist Benjamin Schroeder.

INSUFFICIENT

European Central Bank cash can keep the euro zone interbank system afloat in the near term, but analysts say current provisions would be insufficient if Italy were forced out of bond markets, as Greece, Portugal and Ireland have been.

European banks may be able to deal on their own with writedowns on their holdings of Greek government debt, but analysts say some have too much Italian debt on their books to cope without asking for more capital.

"If Italy will have problems issuing bonds we will have a complete blow-out of the (euro) banking system," said ING strategist Alessandro Giansanti.

The key indicator to watch is Italian 10-year bond yield levels, which had risen sharply as investors feared the euro zone crisis could engulf the country.

Yields have retreated from over 6 percent to about 5 percent helped by ECB bond purchases, but as happened with the three countries already swamped by the crisis, this may only be a temporary reprieve.

The 7 percent level is widely seen as the line beyond which investors shy away from financing a euro sovereign, throwing it into the arms of Germany, France and others for help.

"If yields get to 7 percent ... It's a major systemic global risk, you could see a global meltdown," says RBS rate strategist Harvinder Sian.

"Bank debt, basis spreads everywhere would widen out very aggressively, bank stocks would crumble, you would see a 1 percent handle, maybe lower, on the U.S. 10-year."
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