* Analysts expect strong demand at first-ever 12-month refi
* Too-strong demand could upset the aim of flattening curve
* Banks could also hoard cash to bolster capital buffers
By Marc Jones
FRANKFURT, June 19 (Reuters) - There is expected to be plenty of interest from banks eager to get their hands on cheap funding next week when the European Central Bank holds its first ever one-year refinancing operation.
The ECB announced last month it would double the length of time it lends out money to a year from the previous maximum of 6 months. It is the latest attempt to restore order in the euro zone's money markets, get banks lending again and reduce the cost of borrowing for banks, firms and consumers.
It will allot its first year-long loans on Wednesday. The ECB is not the first major central bank to go as far as 12-month lending: the Bank of Japan tried the tactic earlier in the decade as its economy struggled with anaemic growth.
The chance to secure unlimited funding for a year at a flat rate of 1.0 percent is likely to create intense demand, analysts and traders say, although exactly how much is a hot topic.
"The range of estimates rumoured in the street for the demand at next week's 12-month ECB tender is truly amazing. The talk is 250 billion to 1 trillion euros," said BNP Paribas analyst Alessandro Tentori.
"It is difficult to believe the ECB is expecting such a demand as it would constitute a significant amount of 2009's system liquidity needs, at some point even in excess of the needs."
The ECB hopes pumping this money into the system will give banks the prod they need to start lending freely to firms and consumers again and put to rest any lingering worries about banks' own funding situations.
The impact of the move will depend on how much money banks take at the tender, and what they do with it. The ECB imposes no conditions on how banks use the funds, but expects that the money will be lent on to banks' customers.
The ECB's aim is for the extra funds to push down euro money market rates around the six to 12-month sweet-spot, flattening the money market rate curve and reducing spreads.
Under this scenario, the impact would feed through to the euro zone's homeowners and help support growth. Mortgage rates in countries such as Spain are linked to 12-month Euribor rates, and have not fallen as far as official rates. [ID:nLA588271]
But there is a danger of the impact becoming distorted if banks take much more money than they need, steepening the curve at the short end.
Excess cash sloshing around the system would force banks to
lend cheaply in money markets or park the cash back at the ECB
every night at an interest rate of just 0.25 percent -- pushing
down overnight rates.
While that may please those in the ECB angling for cheaper borrowing costs in the euro zone, it could be a potential loss-maker for the banks who are borrowing at 1 percent.
Another hitch could be if banks looking for a quick fix for flagging capital buffers keep the cash to boost their holdings of top-quality tier one capital under international banking rules, rather than lending it on.
That might help euro-zone banks through stress tests planned for later this year, but analysts did not see this as a major driver.
"Having the cash will always be better. It is especially attractive to go for it now and use assets that are probably on the borderline of being downgraded," said Nomura economist Laurent Bilke.
"Potentially it could help with Tier 1 ratio issues, but I'm sure the main use will be for investment. 1 percent for 1 year is pretty cheap," he added.
Depending on demand, the ECB may have to further modify the rest of its liquidity framework. Dresdner Kleinwort analysts said massive demand could create headaches that could force the ECB to tweak its fine-tuning operations in coming months to prevent the amount of money in the system getting out of hand.
One option would be to start holding longer-lasting fine-tuning operations to help siphon off the extra cash.
"It seems justified to ask whether overwhelming demand would not tie the ECB's operational hands," they said in a note.
"The ECB could resort to the collection of fixed-term deposits for more than one day as fine-tuning operations or even the issuance of debt certificates as structural operations in order to absorb some of the cash dished out."
BNP Paribas believes it may then decide to add a premium for future operations to feather demand.
However, this could send the wrong message about an early exit. It's a move many believe will be the first step the ECB takes when it starts to reel in all the measures it has cast out during the past couple of years of financial turmoil.
Alternatively, the ECB could rewiden the gap between the rates banks pay to borrow and receive when they deposit at the ECB -- now at 150 basis points, from the usual 200 basis points.
The ECB has modified its rate corridor three times since the financial crisis intensified but reducing its deposit rate past the current 0.25 percent would be unacceptable to many ECBers.
Whatever happens, the introduction of 12-month funding is expected to slash demand for the three and six-month funds the ECB offers.
Money market watchers say banks have already been clearing the decks for next week, looking at the results of recent longer-term one, three and six-month tenders.
Banks took just 14.5 billion euros at the last three-month tender settling on June 11, compared to 30 billion taken at the operation in March which it replaced.
Dresdner Kleinwort calculates that rolling over the last four longer-term operations with a settlement date past that of the 12-month operation brought a net drain of 110 billion euros. (Reporting by Marc Jones; Editing by Toby Chopra)