By Richard Leong
NEW YORK (Reuters) - Cyprus' plan to seize individuals' savings to avoid bankruptcy nudged bank borrowing costs up on Monday as investors fretted whether it would establish an unwelcome blueprint for euro zone leaders in dealing with other troubled members of the shaky currency union.
The rise in interest rates in money markets, where banks raise money for loans and investments, was most pronounced early in the day. The squeeze eased a bit by the afternoon as Cypriot officials worked to revise the plan, though it still knocked Wall Street stocks 0.5 percent lower.
Initially they had proposed a 10 percent tax on all of the island nation's bank deposits.
The worry for investors is that such a move could spur bank runs in Cyprus and beyond, leading to a massive withdrawal of money from the euro zone to perceived safe havens such as the United States.
"With the latest Cypriot bailout package, European leaders have opened a can of worms in that future bailouts may now affect bank depositors," said David Keeble, global head of interest rates strategy at Credit Agricole Corporate & Investment Bank in New York.
In the early days of the 2008 financial crisis, money markets effectively seized up and choked off a key source of funding for banks and businesses. It took a massive rescue effort by central banks to restore confidence in the market.
The posted rate for overnight wholesale dollar deposits shot up 11 basis points from Friday to a mid-price of 0.26 percent, the highest level since July.
Also, interest rates on one-month commercial paper issued by French and German banks to raise dollars edged up 1 basis point to about 0.20 percent, while rates on their six-month commercial paper rose 3 basis points to about 0.25 percent.
Finally, the costs for banks to pledge euro-denominated assets in order to obtain dollars rose. The three-month interest rate on this type of loan widened to negative 0.20 percentage point from negative 0.15 percentage point late Friday, the biggest one-day move since late September. A negative rate indicates that banks lending dollars sought more compensation for their risk.
Still, the overall levels of interest rates for euro zone banks remain near historic lows given the unprecedented support from the European Central Banks, analysts said.
By late Monday, some key markets signalled that worries about Cyprus sparking a contagion were overblown.
The spread between the two-year dollar interest rate swap and two-year U.S. Treasury notes, which widens when investors grow anxious about the global banking system, initially grew to the widest level in five weeks at 15.75 basis points in overnight trading from Sunday night into Monday morning. By Monday afternoon, the gap narrowed to within three-quarters of a basis point from late Friday's level.
The implications of a bank tax for risk assets such as stocks was unclear.
"It's a very small blip right now," said Joe D'Angelo, head of money markets in Prudential Fixed Income in Newark, New Jersey.
D'Angelo and others said the contagion risk to euro zone banks from the financial woes in Cyprus is small because of its tiny economy and miniscule exposure of French and German banks to the country.
Cyprus' economy is equivalent to $22 billion, or 0.2 percent of the euro zone's. It is a tenth of the economy of its northern neighbour Greece, which has received two rounds of bailouts.
Still, if investors perceive European leaders might widen the use of a bank tax as a means to help a country stay solvent, this could cause a bank run across the euro zone and snowball into another global financial crisis, analysts said.
"If that's the play-book, people will have to rethink their risk tolerance for this type of capital structure," said Lance Pan, director of investment research and strategy at Capital Advisors Group in Newton, Massachusetts.
(Reporting by Richard Leong; Editing by Dan Grebler)