Europe's banks are paying insurers and pension funds to take their illiquid bonds in exchange for better quality ones, in a desperate bid to secure much-needed cash from the European Central Bank.

Banks are relying on the ECB as the main provider of short-term funding, with interbank lending mostly shut down because of the European debt crisis. But they are now running out of the right types of collateral to secure the money.

That's why they are increasingly swapping securities with institutional investors, which they can then use to secure more funding from the central bank.

The lenders of the securities benefit because they get paid a fee.

It is a way for them to keep those assets in their portfolio and benefit from some additional return, said Nicolas Christen, head of the alternative funding group in the fixed income division at French bank BNP Paribas.

They lend the bond to a bank for a fee which provides the yield enhancement, and they receive another bond as collateral which mitigates their credit risk to the bank.

The deals are known as liquidity swaps, and have a far longer maturity than the short-term repurchase operations (repos) the banks normally do with the ECB, which is another advantage, according to Christen.

The head of Italy's UniCredit, Federico Ghizzoni, and other European top banks met ECB officials in Frankfurt this week, to urge the central bank to increase access to its borrowing for Italian banks, Reuters reported on Wednesday.

Signs of bank funding stress grew on Thursday, with a Fitch Ratings report highlighting concerns over U.S. banks' exposure to euro zone debt as Italian bond yields held above 7 percent, a level deemed unsustainable in the long term.

MUTUAL BENEFIT

The emergence of the market for liquidity swaps -- a relatively new phenomenon -- this year has sparked some concern from the UK's Financial Services Authority (FSA), which in a July consultation paper pointed out several risks.

Sidika Ulker, a spokeswoman for the Association for Financial Markets in Europe (AFME), said the industry association was now discussing these risks, but that none of the points mentioned was insurmountable.

One crucial benefit was that the deals enabled a type of secured lending between banks and insurers, she said.

The deals were mutually beneficial for both parties, she said. Insurers with an excess of for instance UK government bonds, could swap those in return for a higher fee and free up liquidity in the bank market.

For much of the year, banks have been seeking help from cash-rich U.S. banks, which signed private agreements to lend their ailing European counterparts tens of billions of dollars, according to recent reports by IFR.

The ECB allows different types of assets to be used as collateral, and euro zone member central banks in addition can choose to use Emergency Liquidity Assistance (ELA) cash to aid cash-strapped banks.

The ELA collateral is typically of a lower average quality than is accepted by the ECB.

Both Ireland and Greece have used the ELA mechanism, which the ECB defines as support given by central banks in exceptional circumstances and on a case-by-case basis to temporarily illiquid institutions or markets.

On Thursday, traders said unsecured borrowing between banks was virtually non-existent, with many unable to access even overnight funds. Banks with excess funds were lending only to top-rated European banks, they said.

(Editing by David Cowell)