Costs for European banks to fund themselves in dollars in the foreign exchange market rose on Monday as investors continued to reduce loans to the region, leading banks to seek other ways to fund their U.S. branches.

European banks have been squeezed for dollar funding as U.S. investors, including money funds, reduce maturities of commercial paper loans to banks that are exposed to peripheral euro zone debt, or let them roll off.

This has reduced the amount of dollar funding banks have to run their U.S. operations, sending them scrambling to the foreign exchange market to swap euros into dollars.

It's getting more and more expensive for them to raise those dollars, said Jens Nordvig, head of fixed income research at Nomura in New York. Markets are getting very cautious.

The largest 10 U.S. money market funds reduced exposures to European banks by an additional 9 percent in July, and further reduced the duration of loans, Fitch Ratings said on Monday.

European banks now represent 47 percent of the $658 billion in exposures of these funds, with French banks representing 14.1 percent, Fitch said.

The three-month euro-dollar cross currency basis swap, which falls when dollar funding costs for euro zone banks rise, dropped as low as minus 92.5 basis points on Monday from minus 88 bps on Friday.

The rate remained off the 2-1/2-year lows of minus 96 bps seen a week ago, and many analysts expect it to be capped way off record lows of below minus 300 bps, hit at the time of Lehman Brothers' collapse, supported by weekly dollar loans provided by the European Central Bank.

FUNDS INCREASE REPO, BANKS STEP OUT

Fears of contagion in the euro zone from debt problems have also led many money funds to lend more in the repurchase agreement market, instead of through commercial paper. Repo is less risky as the loans are backed by high grade assets like Treasuries.

Barclays Capital estimates that demand for repo from these funds has risen by almost $100 billion since the end of June.

This increase in demand, however, has not reduced the cost of repo as banks have at the same time become significantly less active in the market.

As dealers rush to fund themselves they have also become less willing to act as intermediaries - that is, buying collateral in the intra-dealer market to sell to customers, Barclays analyst Joseph Abate said in a report sent on Monday.

Intra-dealer activity in the repo market has fallen by around 63 percent since the end of June, which has put upward pressure on repo rates, he said.

Rates nonetheless remain relatively low, with overnight repo trading at around 4 basis points for most of Monday.

London interbank offered rates for three-month dollars also maintained an upward grind, rising to 0.30844 percent, their highest in five months. Forwards imply the rate will continue to rise to the 41-basis-point area by mid-September.

Two-year interest rate swap spreads, which are seen as a measure of bank credit risk, also widened to 31.75 basis points, the widest level in over a month.

Some U.S. bank stocks also fell on Monday and the cost of insuring their debt in the credit default swap market jumped as investors fretted over further mortgage liabilities.

Bank of America (BAC.N), which has the largest mortgage exposures, was the worst performer with its CDS costs jumping over 20 basis points to 359 basis points, or $359,000 per $10 million insured for five years, according to Markit.

FOREIGN RESERVES AT FED RISE

In one potentially positive sign the amount of reserves held by foreign banks at the U.S. Federal Reserve rose in the latest week, stemming a decline that has seen about $131 billion withdrawn in the previous two weeks.

Foreign banks have built up a buffer of dollar reserves at the Fed, which in addition to liquidity offered by swap facilities instituted by central banks, has reduced some concerns that banks face the same risk of collapse as in 2008.

Investors will now closely watch the next Fed release, due on Friday, for further signs of whether deposits have stabilized, or are continuing to fall.

I think we're close to getting the verdict here on whether a 2008-type dynamic is a real risk or whether the funding markets globally are just in a much more resilient state than they were in 2008, said Nomura's Nordvig.

Fed data from the week ended August 10 showed that deposits rose to $813 billion from $758 billion the previous week.

It is hard to draw conclusions from the number, however, due to the range of events driving investor behavior that week.

Those events included the first downgrade of the U.S. credit rating by Standard & Poor's and the introduction of a new fee on deposits by Bank of New York Mellon Corp (BK.N) as banks struggled to cope with the influx of deposits from investors flooding perceived safe havens.

We had so much going on in the week the data covered, it's hard to say what was the dominant force, said Nordvig. The next datapoint is going to be more interesting because that was more a clear-cut European-driven problem.

(Additional reporting by Emelia Sithole-Matarise in London; editing by Jeffrey Benkoe amd Andrew Hay)