* Borrowing declines at three-month ECB lending operation
* Excess liquidity drops 40 bln euros in September
* Liquidity drop positive but market funding still tricky
By William James
LONDON, Sept 26 (Reuters) - Euro zone banks have cut their borrowing from the European Central Bank as confidence slowly creeps back into the embattled financial sector and reduces the desire to hold large liquidity buffers.
Bank borrowing fell by 7.6 billion euros at the ECB's offer of three-month cash on Wednesday, contributing to a 40 billion decline in excess liquidity in September, according to Reuters data.
Banks still have loans outstanding from the ECB of a huge 739 billion euros above their estimated needs but that amount is edging lower as the latest plans to defuse the euro zone debt crisis improve the outlook for financial institutions.
The ECB said earlier this month it would buy bonds issued by struggling euro zone sovereigns if they submitted to a bailout programme, a landmark step that has pushed sovereign yields lower and opened up capital markets for banks.
"Some banks were using this (ECB) refinancing as a cushion to avoid a liquidity crisis but now there is an opening in the bond market, some banks have less concern," said Alessandro Giansanti, strategist at ING in Amsterdam.
Banks from the weak euro zone periphery have been rushing to borrow in the bond market since the ECB unveiled its plans on Sept. 6, including institutions that were unable to sell debt for most of the year.
However, market participants said that while the decline in dependence on ECB loans was a positive sign, it should not be over-interpreted,
"This all seems to be pulling in the right direction, but in the grand scheme of things there's still a lot of liquidity out there," said Orlando Green, strategist at Credit Agricole in London.
Financial markets remain on edge over whether Spain, at the leading edge of the sovereign debt crisis, will activate the ECB's bond-buying support and optimism is unlikely to grow much further without Madrid applying for a bailout.
One interbank loan broker said there had been an increase in lending activity related to the upcoming quarter end, but no sign of unsecured credit lines opening up to new banks.
Despite some encouraging signs of increased volume in the overnight lending, only the most highly regarded institutions can borrow for longer periods without providing collateral to their counterparty.