By Kirsten Donovan
LONDON, Sept 25 (Reuters) - Banks are unlikely to start lending freely to companies and consumers until their balance sheets are much healthier, even though the first link in the borrowing chain - the money market - appears to have been fixed.
The extraordinary measures taken by global central banks to prop up the banking sector since the collapse of Lehman Brothers in September 2008 have left the financial sector awash with liquidity, effectively bypassing the need for a functioning interbank lending market.
As a result, benchmark London Interbank Offered Rates (Libor) are at record lows below 1 percent for dollars, euros and sterling and on paper at least, "normality" has been restored.
"The link from the central banks to the banks, and the banks to each other, that's fixed, banks have money, so the next part of the transmission mechanism that needs looking at is between the banks and the non-financial sector," said Laurence Mutkin, Morgan Stanley rate strategist.
Without that circulation of funds to consumers and businesses, a sustained economic recovery is unlikely to take hold, analysts say.
One measure of financial market stress, the spread of three-month Libor rates over Overnight Indexed Swap Rates -- which Barclays Capital called the "poster child of the financial crisis" -- for dollars peaked at around 360 basis points last October. It has gradually declined to levels last seen in 2007 before the financial crisis hit at 11 basis points.
Equivalent sterling and euro spreads are also approaching their pre-crisis levels, and are seen bottoming out at around 20 basis points, in December, according to Reuters data.
Other spreads tell a similar story: for example, the U.S. 90-day commercial paper rate had soared to 4.73 percent at the height of the credit crunch, virtually closing the market to companies needing short-term working capital funds.
Since then, it has run in a 0.25 percent to 0.30 percent range and its spread versus risk-free three-month Treasury bills has returned to pre-crisis levels.
All good signs. But money market traders still report little term-lending flows between institutions due in part to a lack of demand and in part because counterparty credit lines were scaled back during the financial crisis.
And although traded volume in the European repurchase or repo market -- where borrowers are required to offer collateral as security against a cash loan -- edged up in the first half of the year as banks favoured secured lending, they remained sharply lower than levels seen a year earlier.
"Markets are much healthier, risk aversion is lower but money markets are less active because there is so much central bank liquidity, so we're waiting for the increase in cash and reserves to start to feed through to the broader economy," said ICAP economist Don Smith.
So far there is little sign of that happening. U.S. loan demand fell in the second quarter for every major category bar prime residential mortgages as banks tightened credit standards and borrowers remained cautious and in the UK, there was a record fall in lending to businesses in July.
Euro zone lending surveys have also made for gloomy reading with loan growth to households and businesses slowing almost to a halt and a third of small or mid-sized firms finding it harder to get bank loans.
"The process of deleveraging still has a long way to go and when banks need to do that and repair balance sheets, clearly the lending process is curbed, but policymakers are very well aware of that," said Matteo Regesta, BNP Paribas rate strategist.
Certainly market pricing does not reflect that anyone is expecting any stress in money markets over the critical year-end funding period with so much money sloshing around the system. Euro overnight rates seen are seen around 0.44 percent at year-end, from around 0.35 percent currently.
BALANCE SHEET STRENGTH
It may be central banks have done all they feel they can do.
The Federal Reserve, European Central Bank and Bank of England on Thursday said they planned to scale back massive injections of U.S. dollars into their banking systems and the ECB is only committed to providing more 1-year euro funds until the end of the year.
While there is speculation the Bank of England will cut remuneration on excess reserves, the Federal Reserve has already starting scaling back some of the measures it put in place to prop up the banking system and the economy.
"If a bank lends, balance sheet will be used and you need a greater Tier I capital ratio in order to accommodate that," said Calyon rate strategist David Keeble.
"As that capital comes into the banks, and it is gradually occurring, we should find them more willing to lend it on than stuff money into the reserve facilities," he added.
European banks will have lifted their Tier 1 capital ratio to an average of 10.1 percent by the end of this year, up from 7.5 percent at the end of 2007, according to analysts at Keefe, Bruyette & Woods, while British banks' should rise to 12 percent by the end of the year, from 7.1 percent at end-2007. (Additional reporting by Steve Slater in London and Richard Leong in New York; Editing by Ruth Pitchford and Toby Chopra)