Some European banks face short-term funding stress

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.