REFILE-ECB FOCUS-Turbulence pockets may hit ECB smooth exit plan

* Removing crisis measures creates potential flashpoints

* End to unlimited liquidity, 1-yr refis, collateral key

* Difficult to avoid short-term rate jerk

* Tightening by stealth could hit recovery at key stage

(Refiles to fix slugline)

By Marc Jones

FRANKFURT, Nov 23 (Reuters) - The European Central Bank believes its crisis support measures can be unwound smoothly, but markets and economists spot pockets of turbulence that could give money markets and banks a bumpy ride.

ECB policymakers have given a clear signal that from next month they will start whittling down the stack of support measures put in place to get the euro zone through its turmoil.

In a further sign that the ECB is moving towards exit mode, the central bank said on Friday it would tighten from March its rating requirements for banks using asset-backed securities (ABS) as security in its lending operations.

Banks' profits are likely to suffer as the support is taken away. On the other hand, if there were strong demand at the ECB's likely final injection of 12-month loans to the banking system in mid-December, this could keep liquidity levels exceptionally high until mid-2010 -- an unwanted outcome.

"It may be deemed appropriate to reduce the frequency of some (liquidity) operations and perhaps change the terms of some others," ECB policymaker Athanasios Orphanides told Reuters last week, backing expectations it will stop providing private sector banks with one-year loans, and cut back 3- and 6-month funding.

The ECB's moves, due to be confirmed on Dec. 3, would signify that the worst of the crisis is over and the exit strategy is in motion, and they are expected to make few waves in money markets.

That's because the ECB has made it clear it will leave its most supportive measures firmly in place for some time. So financial markets are looking further into the future for the major dangers in the exit process.

"When the ECB stops full allotment (unlimited lending to banks) that is something that could trigger some jitters in the market," said Danske Bank economist Frank Oland Hansen.

"The risk is that short-term rates will rise and you'll see volatility return."

"The other main pressure point is collateral eligibility rules. When they start to change these back it will certainly raise some questions," he added.

An unlimited supply of ultra-cheap loans and accepting lower quality assets from banks as insurance for loans have been key planks of the ECB's emergency plan.

While opinions on timing vary, analysts generally expect the ECB to keep unlimited cash on offer until at least the middle of next year, while ECB President Jean-Claude Trichet told Reuters earlier this month he saw no reason not to keep looser collateral rules in place until the end of 2010 as planned.

RATE HIKE BY STEALTH

Other potential flashpoints are also on the horizon.

Banks have to deal with the possible problems of paying back each of the ECB's ultra-long term one-year loans. In July they have to return 442 billion euros, 75 billion in September and in December, whatever they take next month as well.

Traders are already getting in position for some volatility.

"There has been some paying (locking in) of short-dated Eonias around that period (July) so people are expecting a bit of a pressure point around then," said one London-based money market desk head who did not want to be named.

However, this should not create too many tensions for banks as they know they will be able to borrow again by switching into the ECB's traditional 1-week or 3-month tenders.

Analysts at Goldman Sachs say the main issue is that, as the cash taps are turned off and the excess in money markets drains away, short-term rates will automatically pull up towards the ECB's main interest rate -- a "tightening by stealth".

Were key overnight rates, currently around 0.35 percent, to rise to the 1 percent level of official ECB rates, it would equate to a rate hike of almost 0.75 percentage points, an increase which could throttle recovery just as it gets going.

"Tightening by stealth will surely lead to significant volatility in the money market," Goldman's economists warned.

"The issue therefore boils down to whether the ECB would worry much about money market volatility. We think the answer is no, unless the volatility transmits further out the curve."

PROFIT MACHINE

The ECB's ultra-cheap lending during the crisis has been a profit machine for banks, a process seen as key to the recovery story by many economists.

It has allowed cheaper refinancing for institutions and given them plenty of scope to bolster margins by lending to firms and consumers at rates well above the ECB's.

Trichet warned last week that banks were running the risk of becoming addicted to the ECB's liquidity support.

Germany's biggest lender, Deutsche Bank, reported a sharp rise in earnings in the third quarter but chief executive Josef Ackermann told a conference last week that the good figures reported by many banks were a special situation. "Markets and banks around the world are drawing benefits from monetary and fiscal support measures. How banks will cope after a normalisation, when these measures are withdrawn, remains to be seen," he said.

The ECB's next, and expected to be final, injection of 12-month loans to the banking system in mid-December could also complicate the situation.

Lacklustre demand could strengthen the ECB's belief that money markets are on the mend -- a Reuters poll last month showed money market traders expected 123 billion euros.

However, strong demand would keep liquidity levels exceptionally high until the middle of next year unless the ECB takes steps to manually remove it.

That would entail putting a never-before trialled tactic in place to siphon money out of the system over a longer period. But that could jolt markets expecting only a steady rise in market rates over the next six months. (Reporting by Marc Jones; editing by Stephen Nisbet) (marc.jones@thomsonreuters.com; +49 (0)69 7565 1219; reuters messaging: marc.jones.reuters.com@reuters.net))