A grand bargain to stop the euro zone debt crisis from spreading would cheer global markets but may not ease the dollar squeeze faced by Europe's banks.

Even as European Union leaders hinted at a ground-breaking deal ahead of a Wednesday summit, investors demanded that banks pay higher interest rates for short-term dollar loans, a trend that has persisted since late July.

Investors say that isn't likely to change overnight. Money market funds, a traditional source of the short-term funds banks need to finance trades and loans, will want to be sure that the spread of a crisis that has brought Greece to the brink of default has been turned back, not just slowed down.

I don't think there's a magic bullet that makes this all go away, said Thomas Simons, money market economist at Jefferies & Co in New York.

And since access to funding tends to dry up at the end of the year as investors lock in profits, banks may be facing several more months of stress.

That could be an additional pressure on the market right now, said Perry Piazza, who helps manage $3.4 billion (2.1 billion pounds) as director of investment strategy at Contango Capital Advisors in San Francisco.

SAFETY FIRST

The $2.6 trillion U.S. money market industry grew wary of lending to European banks over the summer. Despite the promise of high returns, many bailed out for fear of banks' exposure to bonds issued by Greece and other troubled euro zone countries.

Last week, Fitch Ratings reported that prime U.S. money market funds had cut exposure to short-term debt issued by French banks by 42 percent in the month through the end of September. They now hold just 6.7 percent of their assets in short-term French debt.

Euro zone banks have been forced to pay more to access cash in the interbank market or by tapping emergency funds and dollar swaps set up by the European and U.S. central banks.

On Tuesday, the day before the EU summit, the benchmark for unsecured three-month dollar loans between banks rose to 0.4222 percent, its highest since August 2010.

Investors don't look to the cash portion of their book to generate out-sized yield, they just want it to be safe, said Piazza. We've got a bit of European short-term fixed income but not anywhere near what we used to have.

Emerging market banks also saw access to short-term funding in international markets narrow in the third quarter, according to an Institute of International Finance survey, for fear of spillover effects from Europe's debt crisis.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, which manages about $55 billion, says he has kept his cash for clients in Treasuries-only money market funds even though they are earning nothing.

Most investors see the risk-reward as still skewed, said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia. The upside is 2 percent, while downside is 20 percent.

BABY STEPS

Jens Nordvig, head of G10 currency strategy at Nomura, said investors worry that the compromises needed to get a deal done will water down any solution.

European banks, he said, probably need to be recapitalized to the tune of 300 billion euros, while officials are talking about 110 billion.

They're still taking baby steps, he said.

Meanwhile, talk of forcing private creditors to agree to take losses of up to 60 percent on their Greek debt holdings could cause even more trouble for European banks.

If they impose a big haircut on the Greek debt, banks are going to have to realise those losses, Simons said. That certainly won't relieve funding pressure.

The accidental beneficiary of all this may be U.S. banks, investors say, who have greater access to cash that investors are loathe to invest abroad.

U.S. banks also are far more flush with cash than their overseas counterparts, as indicated by $1 trillion in excess reserves held with the Federal Reserve.

U.S. banks have so much more cash than they used to, Simons said. So the challenge for their funding desks today is what you do with the cash rather than where you get it.