Fear over European banks' exposure to risky government debt stalked markets and harried bank executives on Friday, as unsecured lending between banks evaporated and the cost of secured loans rose.

Dwindling trust between the banks is forcing them to rely more and more heavily on the European Central Bank (ECB) to fund their activities, which in turn is spooking investors concerned about the health of the countries funding the ECB.

Various indicators of money market stress spiked in signs investors were increasingly concerned about preserving their cash. The head of Europe's seventh-largest bank, Deutsche Bank's Josef Ackermann, said long-term funding was increasingly hard to obtain.

Short-term financing is fine, but the big question is how we can ensure long-term funding, Ackermann told reporters at a conference in Frankfurt. The willingness of investors to make long-term investments in banks is not very pronounced.

The latest sign of worries about banks' health was the movement of German treasury bill yields, which were heading into negative territory as some investors withdrew money from banks and put it in German government short-term paper as a way to preserve cash.

German treasury bills of up to 9 months were bid at rates as much as 0.35 percent, but sellers were asking for prices that would imply negative yields of as low as minus 0.30 percent.

Negative yields means investors are willing to pay to keep their money in T-bills, rather than keep money in a bank deposit and receiving interest.

When there is panic you don't look at yields anymore, you don't trust parking your money in deposits in the banking system, you want something that protects you cash, even if you pay for it, said ING rate strategist Alessandro Giansanti.

Key euro-priced bank-to-bank lending rates also ticked up -- indicating how nervous banks are about lending to one another.

VICIOUS SPIRAL

That nervousness is pushing them into the arms of the ECB, which is already lending heavily to banks in the wake of the 2008 financial crisis, and can lend more.

After loosening the rules on the collateral it accepts from banks in return for lending them short-term cash, the ECB can potentially lend up to 14 trillion euros to banks.

But some are running out of the right types of collateral, and banks are increasingly swapping securities with institutional investors which they can then use to secure more ECB funding, Reuters reported on Thursday.

Banks are currently borrowing just short of 500 billion euros. UniCredit SpA Chief Executive Frederico Ghizzoni urged the ECB this week to increase access to ECB borrowing for Italian banks.

You don't expect anyone to fall over, but this creates a nasty feedback loop where everybody sees the Italian and French banks borrow large amounts from the ECB, which in turn makes people worry more about the sovereign. Then sovereign spreads keep widening, which completes the feedback loop, said Matt King, a credit analyst at Citi.

There is a very real problem here. Banks are under enormous pressure to reduce their balance sheets and that raises the likelihood of a credit crunch in Europe, he said.

It is looking increasingly likely more European banks will be forced to tap the European Central Bank's U.S. dollar facility, as stress in the cross currency basis swap market has once again become acute this week.

The cost for euro zone banks to swap euro rates into dollar rates rose to its highest since the height of the Lehman crisis in 2008 to 138.50 basis points.

New governments in Italy and Greece could buy time, but the risk of a funding crunch intensifying in 2012 remains on the horizon, and a failure to attract investors for the euro zone bailout fund, the EFSF, had knocked confidence, one banker said.

It's not clear where the external demand will come from, the banker said of the EFSF's plan to leverage the fund.

COSTS JUMP

The risk associated with European banks is reflected by a big rise in the cost of insurance against banks defaulting.

The Markit iTraxx index for credit default spreads for European senior financials has risen to 300 basis points, from 225 at the start of the month. The subordinated financials index has jumped to 540 bps, from 424 at the start of the month. Both indices have doubled since the end of June.

Banks are wary of disclosing details on how willing they are to lend, but big banks including BNP Paribas have sold substantial sovereign debt in recent months.

British banks have also cut lending to banks in trouble spots, according to data they released in recent results.

HSBC , Europe's biggest bank and a net liquidity provider due to its hefty level of retail deposits from Asia, cut its lending to banks in Italy, Spain, Greece, Ireland and Portugal by one-fifth in the third quarter to $8.2 billion at the end of September.

Barclays , Lloyds and RBS also reduced their lending to banks in peripheral Europe, and Standard Chartered cut its liquidity to the euro zone earlier in the year.

Despite the concerns, there are some positive signals. More than a dozen banks signed up to underwrite a 7.5 billion euro rights issue by UniCredit this week, showing they are confident of its health.

(Additional reporting by Edward Taylor in Frankfurt and Steve Slater and Douwe Miedema in London; Writing by Jodie Ginsberg; Editing by David Holmes and David Cowell)

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