Fears a euro zone bank could soon collapse eased on Friday as use by lenders of European Central Bank instant-access funding dropped sharply, but record sums parked with the ECB overnight showed money markets remained partly paralysed.

Banks tapped the emergency overnight window for less than 2 billion euros (1.65 billion pounds) for the first time since the end of November.

The ECB charges 1.75 percent interest for the overnight funds, which are borrowed anonymously, instead of the 1.0 percent on offer at its regular refinancing operations.

Barring a technical spike in mid-2010 as banks prepared for the ECB's first injection of one-year loans, use of the funding over the traditionally tense end-of-year period topped 17 billion euros for the first time since the collapse of Lehman Brothers.

That sparked concerns that one or more euro zone banks might be in trouble.

Banking sector tensions were also ratcheted up several notches on Wednesday when UniCredit was forced to deeply discount a 7.5 billion euro rights issue and its shares tumbled, raising worries the fundraising could flop and other banks may struggle to raise cash if they need it.

Elevated use of the overnight facility started in late September, shortly before France and Belgium bailed out Dexia SA and with the bank in the process of being broken up.

Questions started to surface however when the figure shot up to 17 billion euros from 4 billion on December 28. As the ECB does not reveal which banks or how many take such funding, markets were in the dark.

On Friday the figure dropped back to 1.86 billion euros, still relatively high in historical terms but the first time since Nov 28 it has been below 2 billion euros.

The drop also come after the latest injection of 1-week ECB funding, suggesting a simple miscalculation may have been the reason for the spike.

One thing I couldn't understand over the last week and a bit was that somebody was still borrowing over 15 (billion euros) from the ECB every night. But that has now come down... so we are moving in the right direction, said one London-based euro zone money market trader who requested anonymity.

RECORD HOARDING

Other data illustrated the ongoing paralysis blighting the money market as banks parked an all-time record 455 billion euros overnight at the ECB, a figure expected to keep rising over the next week.

The ECB flooded the financial system with an unprecedented 489 billion euros of ultra-cheap three-year loans late last month in a bid to underpin banks' finances, prevent them slamming the brakes on lending and hopefully repair fragile confidence in the sector.

Banks are still digesting the cash, which has pushed excess funding in the euro banking system to well over 400 billion euros.

With the debt crisis showing no sign of easing, banks continue to be wary of lending to each other. Many have also yet to find corporate or consumer customers to lend the surplus to or are keeping it to cover their own refinancings due this year.

The ECB pays 0.25 percent interest on overnight deposits, well below the 0.369 percent for which banks could get on open interbank markets, highlighting how many are currently opting for safety over profit.

Traders say the ECB's massive funding injection of has helped money markets around the world, though it has not overcome a fundamental reluctance to lend beyond the extreme short term.

The market is obviously extremely liquid now.. (but) it has done nothing to correct the fact that nobody will lend any money beyond one week, , said a European money market trader.

Longer-term lending would only return when the debt crisis subsided or if a central clearing house was created, he said - something only euro zone central banks had the ability to do.

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For a package of graphics on the ECB, click on: http://link.reuters.com/nyd85s

http://link.reuters.com/neg32s

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(Reporting by Marc Jones, additional reporting by Sakari Suoninen; Editing by John Stonestreet)