Banks borrowed less than expected from the European Central Bank in a key funding operation on Wednesday, easing fears about how they would cope with repaying close to half a trillion euros in emergency loans on Thursday.

The relatively low take-up helps to ease concerns about bank finances which have rocked stock and debt markets this week, but also raises the risk of market interest rates ticking higher as liquidity supplies may recede.

The ECB said 171 banks borrowed 131.9 billion euros ($161.4 billion) over three months, below expectations in a Reuters poll for demand of 210 billion euros.

The amount is still the highest ever borrowed in a three-month operation but pales beside the 442 billion euros of one-year money which 1,121 banks must repay to the ECB on Thursday as the ECB's first-ever one-year loans expire.

European shares gained on the news while the euro rose across the board and yield spreads for Spanish and Italian government bonds eased.

All in all it is a positive signal for the European banking system, said UniCredit fixed income strategist Kornelius Purps.

This is, in my view, why we see the reaction in the market ... some of the fear is being priced out of the fixed income universe.

Investors are watching the euro zone money market closely for signs of the sort of problems in bank to bank lending which broadened the financial crisis in 2008. It is also vital that the market functions well to generate affordable loans for consumers and businesses, needed to spur economic growth.

Deutsche Bank economist Gilles Moec said the low take-up blunted concerns about an unhealthy dependency on ECB funds, which have focused on Spanish, Greek and Portuguese banks.

It's definitely a good sign and means there is still some interbank lending occurring within the European money market, and that's it's not just a vertical relationship between banks and the ECB, he said.

LIQUIDITY SQUEEZE?

The roll-over accounts for less than a third of the 12-month money which the ECB has flushed through the financial system since the height of the financial crisis, pushing interbank rates to record lows. Banks, though, will still have the chance to borrow unlimited six-day funds at another operation on Thursday.

Market participants said the results of this operation would also be fundamental to gauging the extent of bank funding stress and the likely impact on interest rates.

We still have the six-days to be filled, it's about the total, one euro zone money market trader said, predicting demand of about 180 billion euros.

In my opinion there will be enough over-liquidity to keep rates around current levels ... but we will see tomorrow.

Benchmark Euribor rates have risen to 9-1/2 month highs as the repayment date approached but still remain below the ECB's 1 percent benchmark for maturities out to five months, and overnight rates around 0.3 percent.

Commerzbank analyst Christoph Rieder said without including the results of the six-day operation, there would be a net outflow of 269 billion euros from euro-zone money markets on Thursday and this could push rates higher.

This is a level where upside pressure on overnight rates could be building, he said.

Funding conditions look set to become more restrictive during this summer with the volume and maturity of outstanding ECB operations declining.

Calculations based on ECB data show there is about 327 billion euros in excess liquidity in the system on Wednesday, suggesting banks will need to borrow around 60 billion euros over six days to keep current buffers in place.

The next crunch day for liquidity supply is September 30, when banks must repay a total of 225 billion euros in 12-, six- and three-month funds -- including the latest operation -- and can take advantage of the ECB's last scheduled three-month operation with unlimited allotment to meet liquidity needs for the remainder of 2010.

(Reporting by Krista Hughes, editing by Mike Peacock and Patrick Graham)

European central bank Quantitative easing