* Cross-border interbank loans slide
* Banks in Greece, Portugal, Germany hit
* Cyprus losses, new EU rules rattle banks
* Banks rely increasingly on domestic funds
By John O'Donnell and Sakari Suoninen
BRUSSELS/FRANKFURT, June 21 Euro zone banks are refusing to lend to peers in other countries in the common currency bloc, signalling a worrying fall in confidence that appears to have worsened since the Cyprus bailout earlier this year, data analysed by Reuters showed.
In a trend that could reignite fears about the euro and its banks, European Central Bank data shows the share of interbank funding that crosses borders within the euro zone dropped by a third, to just 22.5 percent in April from 34.5 percent at the beginning of 2008.
Banks are now lending to other banks across euro zone borders at only about the same rate as when the single currency was first launched, 15 years ago.
The silent retreat to within national borders is most pronounced in the troubled economies of southern Europe but is seen even in Germany.
Cross-border interbank funding of German banks was down by 11.2 percent year on year in March, equivalent to banks elsewhere in Europe withdrawing 29.5 billion euros from its biggest economy.
"We have seen the banks very much reverting to their domestic markets and not wanting to extend credit abroad," said Tony Stringer, a government debt analyst with ratings agency Fitch.
"Interbank deposits have been reduced. Confidence in banks across the euro zone has been reduced. If banks continue to struggle, then they can't extend credit to the real economy."
Euro zone banks' stock of lending to their Greek peers was a startling 68 percent lower in April than in the same month a year earlier - equivalent to 18 billion euros withdrawn. In Portugal, the decrease was roughly one quarter.
The figures, obtained from the ECB, include lending both between separate banks in different euro zone countries and within a single banking group to its cross-border units.
Faltering confidence may be responsible for the reduction in cross border lending, due in part to a bailout of Cyprus that closed one of its two main banks and imposed losses on creditors, making banks in the euro zone appear more risky.
While the withdrawal of cross-border funds seems to have taken place throughout the year, the figures spiked in several countries - including Germany and Greece - in March, the month of the Cyprus bailout.
Lobbyists for the banking industry also say a soon-to-be-finalised EU law making it possible to impose losses, or "haircuts", on bank creditors could hurt confidence.
"At any point in time, this thing can blow up," said Karl Whelan, an economist at University College Dublin, warning of a potential spillover onto regular savers.
"We are relying on an absence of panic among depositors while we sit around and work out who to haircut. There is a risk of large scale deposit withdrawals in Spanish banks, in particular. They are the obvious tinder box."
ECB DENIES PROBLEM
The European Central Bank denies that the fall in cross-border lending is a sign of confidence problems.
A spokesman for the European Central Bank countered that the trend was due to a general shift towards secured lending and funding via retail deposits. Banks were deleveraging, which increases the importance of stable retail deposits.
"Overall these facts suggest rather a stronger, more resilient banking system," the spokesman said.
The ECB itself has provided banks with an alternative source of funding, creating more than 1 trillion euros of liquidity in the past year by offering 3-year-loans.
But Lena Komileva of consultancy G+ Economics said ECB funding was no substitute for a healthy supply of loans from other banks across the bloc.
"Some banks suffer from chronic illiquidity in the capital markets," she said. "Central bank liquidity is no remedy for dysfunctional markets and undercapitalised banks."
The trend has put Europe's supervisors on alert and stands in contrast with statements by ECB President Mario Draghi that banks in "stressed" countries are finding it easier to get such loans and that the ECB had got "better control of monetary conditions in the euro area".
The cross-border freeze also blunts ECB efforts to bolster the economy by cutting interest rates because it prevents cheaper and easier loans for consumers and business, especially in southern Europe, where loan costs are double that of north.
Were the system working at its best, southern European banks should be able to borrow from northern ones and pass on the cheap rates to their customers.
Joerg Asmussen, the German member of the ECB's executive board, conceded that some banks continue to struggle: "Banks from the countries most severely hit still have only limited access to the money market," he said on Monday.
Such concerns set the backdrop for a gathering of European Union finance ministers in Luxembourg on Friday, which will shape a new EU law allowing the imposition of losses on bondholders and large depositors of a failing bank.
Some countries, partly due to nervousness that such rules will erode confidence or prompt big savers to withdraw cash, want national leeway in deciding whether to "bail in" creditors.
"It's at the back of our minds that investors are more exposed," said Sharon Bowles, a lawmaker in the European Parliament who will play a part in shaping the rules. "But that's a deliberate policy choice.
"The fact of the matter is it has to be done. We shouldn't be afraid to put a bank into resolution. You should be able to wind it down," she said.
The Institute of International Finance, a global bank lobby group, underlined its concerns.
"Cyprus and the broader debate in Europe about bailing in uninsured deposits and other unsecured debt has made depositors worried, including other banks," Hung Tran, its executive managing director told Reuters.
"The worse the economy would be doing, the worse this concern and risk aversion could become. It could lead to deposit flight and banks being unable to lend."
But for others, losses for bank creditors are long overdue.
"The policy has been to try to reassure people who lend money to banks that there will be haircuts but only in the future. That policy has always been an extremely stupid one," said Whelan, the Dublin economist. "The banks have bad debt problems now. It's time to get on with it."
Komileva from G+ said trust would not return before banks' balance sheets are cleaned up, and the longer this takes, the harder it gets for cross-border banking to re-emerge.
"The confidence wall to climb now in terms of investors returning is going to be that much higher," she said. (Editing by Peter Graff)