Money markets banking system stress levels rise, but no panic yet

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* Risk of Cyprus-led deposit run fuels money market caution* Stress rising but still way below past crisis flashpoints* Tension may surface in repo, EUR/USD cross currency swapsBy William James and Ana Nicolaci da CostaLONDON, March 19 Money market stress gauges started to rise on Tuesday as the impact of plans to partially fund a bailout for Cyprus by taxing savers raised the risk of a more widespread crisis in the euro zone system. Although the tension was rising, the full-blown panic seen at previous crisis flashpoints remains some way off thanks to steps taken by the European Central Bank to shore up the region's banks and foster confidence in sovereign bond markets. Measures of interbank borrowing costs ticked higher, driven by lenders demanding a higher premium because of the increased risk that any drain on deposits in Cyprus could quickly spread. The cost of swapping euros into dollars also rose, indicating that U.S. lenders were starting to think twice about exposing themselves to euro zone banks, and increased demand for ultra-safe German collateral was evident in repo markets. Cyprus's plan to tax savers, which is yet to secure parliamentary approval, took markets by surprise and raised concerns that depositors could start withdrawing cash - a move that would hit an already weakened Cypriot banking sector and could spill over to banks in larger euro zone states.

"However unique the situation in Cyprus is, this challenges what we're told about bank deposits. If people don't feel their money is safe then Euribor rates might have to go higher and banks may have to pay a little more long-term," a trader said. This was reflected in a rise in Tuesday's daily Euribor fixing, a proxy for bank borrowing costs, and a selloff in Euribor futures which pointed to expectations that rates will rise further. The gap between the 'risk-free' overnight lending rate and the expected cost of interbank lending widened. The spread, which measure the premium lenders demand when making loans to other banks, has widened 4.5 basis points since Friday to 14.5 bps for contracts due to start in September - the widest level seen since January. The equivalent spread hit 77 bps in late 2011 when fears about the health of banks paralysed lending between institutions and pushed the ECB to flood the market with long term loans.

Despite some early repayments, much of that ECB cash is still in the banking system and the ability of the central bank to supply more was seen by some as a limit on the risk that an outflow of Cypriot deposits could spark another crisis."The ECB still acts as a backstop. Even to Cypriot banks they have the option of providing emergency liquidity assistance so I think once that becomes clear that could ease some of the initial fears," said Commerzbank strategist Benjamin Schroeder. REALISING RISKS

Even with the stress gauges at low underlying levels and the presence of the ECB's backstops, some market participants still saw the risk of further shocks later this week when Cyprus's banks re-open after an extended bank holiday. One area that would feel the force of a run on bank deposits would be the repo market, where money is lent out in exchange for government bond collateral."When uncertainty hits financial markets in a serious way, very little can happen without the very best possible collateral and demand shoots higher accordingly," said ICAP analyst Chris Clark. Demand for German debt would rise sharply and allow holders of such bonds to charge a large premium to swap them for cash - a reverse of the 'normal' situation where bondholders pay a premium to use their collateral to raise money. However, the impact on cross currency basis swaps, used to switch euros into dollars and seen as a measure of money market stress, would be muted compared to previous crisis points because euro zone banks can now borrow dollars from the ECB."There does appear to be less pressure on basis markets these days when bad news hits. We shouldn't see the sorts of massive price shifts we were used to back in 2011," Clark said. The three-month cross currency basis swap was last at -23 bps, down from around -19 bps on Friday, indicating a small rise in the cost of switching euros into dollars.