* Euro zone banks to repay more ECB loans than expected * German business confidence data fuels demand for euro * Yen weakness continues; Japan defends yen policy By Gertrude Chavez-Dreyfuss NEW YORK, Jan 25 (Reuters) - The euro climbed to an 11-month peak against the dollar and a 21-month high versus the yen on Friday after the European Central Bank said banks will repay 137 billion euros in loans, reinforcing the view that the region's banking system is on the mend. A report showing improvement in business confidence in Germany also underpinned the euro. The ECB said 278 banks decided to repay the three-year crisis funds at the earliest opportunity next week, and the total amount was more than the 100 billion euros forecast by traders. This should bolter confidence in the euro zone and help the euro break through $1.35. "Many view this as the turn in the crisis, which has helped support the euro," said Camilla Sutton, chief currency strategist at Scotiabank in Toronto. Europe's shared currency rose 0.6 percent on the day to $1.3449, after hitting $1.3469, its highest since late February 2012. The next near-term target for the euro is the 2012 high of $1.3486. Sutton also said the euro is rapidly approaching three major resistance levels. Aside from this year's high of $1.3486, she also cited $1.3492, the 50 percent retracement of the May 2011 to July 2012 collapse, and the psychologically-important $1.3500-figure, all of which are within reach. But she said "we would not position too early for the downside and would instead trade with the trend until it breaks." The ECB is the first major central bank to start moving away from unconventional monetary policy measures, unlike the U.S. Federal Reserve and Bank of Japan, which are buying bonds to stimulate growth. Asset purchases by a central bank that effectively expands its balance sheet tend to hurt a currency as it increases its supply. Data showing German business morale improved for the third month in a row in January, adding to signs that growth in Europe's largest economy is picking up, also fanned demand for the euro.. It followed a positive private sector activity report in the euro zone's largest economy. The single currency rose 1.4 percent against the yen to 122.45 yen. Earlier, the euro touched 122.77, its highest since mid-April 2011. The German data "has been supportive of the euro and investors want to go long," said Geoffrey Yu, currency strategist at UBS. "It's all about momentum now, and data like this only helps." The euro has gained nearly 1 percent against the dollar and 1.8 percent against the yen this week as investors bet on more gains, encouraged by falling euro zone peripheral bond yields. In the options market, traders reported demand for euro calls, which are bets on more gains. One-month risk reversals traded at 0.05 vols in favour of euro calls, having flipped from euro puts. BMO Capital Markets said it was the first time the one-month had traded in this direction since October 2009. YEN WEAKENS The yen came under renewed pressure after reports on Thursday quoted Japan's deputy economy minister as saying the yen's decline was not over and a dollar/yen level of 100 would not be a concern. The dollar rose to a 2-1/2 year high of 91.19 yen, rising past reported options barrier at 90.75 and 91 yen. The U.S. currency has gained more than 14 percent since mid-November. The yen's steep drop since late last year and government efforts to ease fiscal and monetary policy have raised eyebrows abroad, with German Chancellor Angela Merkel singling out Japan on Thursday as a source of worry. Japanese Finance Minister Taro Aso, shrugging off Merkel's concerns, said on Friday monetary easing was aimed at pulling the country out of deflation, not manipulating currencies. BNP Paribas in a research note said the yen's downside momentum remained strong. However, it added that the back-and-forth statements about yen weakness between foreign politicians and Japanese officials should continue heading into the meeting of the Group of 20 developed and emerging market economies. That should potentially add to yen volatility, the bank said. One-month volatility in dollar/yen edged up on Friday to 11.45 percent after Merkel expressed concern about a weak yen.