llen Freilich

The soothing balm of cash from the European Central Bank led bank-to-bank lending rates to hit a fresh 17-month low on Friday while inspiring enough confidence to cause U.S. prime money funds to increase their holdings of euro-zone bank securities.

Interbank lending rates in Europe reached that low as the ECB's injection of more than one trillion euros into the banking system applied further downward pressure, a day after the bank kept interest rates unchanged.

Reassured by the ECB's three-year loans, the first of which occurred in December, U.S. prime money funds increased their holdings of euro-zone bank securities in February.

That decision, as well as a like-minded one in January, suggested fund managers now take a more sanguine view of the euro-zone debt crisis, thanks to the ECB's three-year loans that have added cash to the euro zone banking system.

In the context of the ECB loans, bank-to-bank lending rates have dropped by more than a third over the last few months.

In a report released on Friday, J.P. Morgan analysts said prime money funds raised their euro-zone bank holdings in February, adding $30 billion (19 billion pounds) in euro-zone bank debt paper to bring their euro zone debt holdings to $211 billion. They boosted their euro-zone bank paper holdings by $27 billion in January, the first time they added such debt since April 2011.

The funds also bought more unsecured euro-zone securities than repurchase agreements and asset-backed commercial paper in February. The latter two asset classes are considered safer because they are backed by collateral such as U.S. Treasuries. That funds were willing to push into unsecured euro-zone instruments suggested worries about whether banks would have enough cash to service short-term obligations had abated.

What washed away some of those worries is the liquidity the ECB provided in two long-term refinancing operations - the first in December and the second last week. The cash is meant to give the region's banking system time to raise private capital and to deal with bad peripheral investments.

Greece's successful bond exchange with private creditors, averting the immediate risk of an uncontrolled default, has also boosted confidence, benefiting sovereign debt markets such as Italy and Spain.

The recently revived appetite for euro-zone paper has been most apparent in French bank debt. Money funds' holdings in French bank securities rose by $13 billion to $68 billion in February. This was still $156 billion below the peak seen in May 2011. France has a bigger exposure to Greece than any other euro zone nation. French banks had about $56 billion worth of Greek debt at the end of June 2011, according to data from the Bank for International Settlements.

February data indicate that investors felt more comfortable with French bank credit, J.P. Morgan analysts wrote in their report.

They cautioned, however, that purchases were concentrated in a few large money market funds.

Moreover, most of the purchases was in overnight time deposits, suggesting investors remain cautious about French banks, they said.

Money market funds also bought $11 billion in debt from German banks, boosting their holdings to $66 billion.

Besides euro-zone paper, prime money funds resumed their purchases of non-European bank debt with holdings growing by $18 billion to $572 billion in February.

U.S. prime money funds had combined assets of $1.069 trillion at the end of February, accounting for roughly 41 percent of the money fund industry.

Overseas, three-month Euribor rates, traditionally the main gauge of unsecured interbank euro lending and a mix of interest rate expectations and banks' appetite for lending, fell to 0.894 percent from 0.902 percent, the lowest level since September 2010.

The ECB's two three-year cash injections in December and February have pushed excess liquidity in the money market to record levels of about 790 billion euros, according to Reuters calculations.

The three-month euro Libor rate fixed at 0.80329 percent from 0.81429 percent. The rate has dropped by almost half a percentage point this year.

The enormous amount of excess cash in the money market is keeping short-term market rates well below the ECB's main 1 percent policy rate. Instead, the bank's 0.25 percent overnight deposit rate is acting as a floor for market rates.

(Additional reporting by Richard Leong in New York and Eva Kuehnan in Frankfurt; Editing by Padraic Cassidy)