MONEY MARKETS-Interbank rates inch lower, spreads still strained

* Sterling, euro three-month Libor rates ease, spreads widen

* Three-month dollar rates inch higher

* BOJ holds rates, tweaks market operations

* Fed facility for money markets could bring down spreads

(Updates with Libor fixings, adds new quote)

By Kirsten Donovan

LONDON, Nov 21 (Reuters) - Three-month interbank lending rates in sterling and euros extended a steady fall on Friday but spreads between interbank and policy rates showed persisting reluctance among banks to expose themselves to credit risks.

Three-month dollar rates inched higher with signs of distress in the global economy continuing to mount. Worries grew over the outlook for U.S. bank Citigroup, while the future of U.S. automakers hung in the balance.

Such worries resulted in a sizeable rally for government bonds and interest rate futures on Thursday, some of which fed through into Friday's fixing of London interbank offered rates.

Three-month euro Libor rates fell 5 basis points to 4.004 percent, the lowest since April 2007, while equivalent sterling rates fell 3 basis points to 4.038 percent.

The fall in three-month dollar rates stalled again however, with rates up nearly half a basis point at 2.158 percent.

"The whole market is on tenterhooks at the moment, the risk trade has come back into fashion very rapidly and banks have been suffering on equity markets," said Calyon's Keeble.

"The issue of the economy, particularly in the U.S., is snowballing and its inevitable that will have an effect on the basis, especially as we're entering the end of year period."

The spread between 3-month euro and sterling Libor and market expectations of official interest rates, measured by overnight index swaps, widened on Friday.

The U.S. spread, although slightly tighter on Friday, has widened over the week to around 170 basis points after hitting a 7-week low close to 160 basis points.

"What's important to note is that this time stock markets, CDS markets and credit markets are effecting sentiment on financial markets, rather than the other way round," said Morgan Stanley rate strategist Laurence Mutkin.

"So far, compared to the mess in the risk markets, financial markets have in the last couple of days been fairly unfazed."

In Asia, the Bank of Japan held back from a rate cut on Friday and tweaked its market operations to ease funding pressures towards the end of the year.

But domestic liquidity remained an issue in Asia, keeping interbank rates in countries such as South Korea, India and Indonesia far above the yields of the safer government bonds.

European banks also preferred to rely on their central banks rather than each other. Overnight deposits at the European Central Bank were still over the 200 billion euro mark, as commercial banks continued to hoard money rather than lend it on money markets.

ECB Executive Board member Jose Manuel Gonzalez-Paramo stressed that the bank will continue to provide liquidity as needed to ease money market tensions.

IS IT ENOUGH?

U.S. Treasury Secretary Henry Paulson, speaking late on Thursday defended his handling of the financial crisis, but refused to say whether any further help would be offered to struggling Citigroup.

Comments from Paulson last week, appearing to change the use of the United States' $700 billion bailout fund, rattled markets and led to the first rise in term dollar Libor rates in a month.

There was however some expectation that spreads, at least on dollar funding, could narrow next week when the New York Federal Reserve's cash facility for money market funds kicks in.

The New York Fed is expected to start lending to money market funds under its Money Market Investor Funding Facility, or MMIFF, from Monday. The bank hopes the move will increase the availability of credit and help the funds which have been reeling from redemptions after Lehman's bankruptcy in September.

"Next week's launch of MMIFF could, and hopefully will, redirect a portion of money market portfolios away from T-bills and back into more risky assets including bank paper," Glenn Maguire, Societe Generale's Asian chief economist said in a note.

"This is an important link missing right now and preventing further normalisation in bank funding."

However, strategists raised concerns over other measures about to come into force in the U.S.

The Federal Deposit Insurance Corp plans to finalise a rule on Friday that provides a guarantee to banks' new senior unsecured debt, but analysts say the cost could be prohibitive.

"There's some conjecture over whether the charges for these guarantees could be prohibitive and cause participants to opt out," said Nomura rate strategist Sean Maloney.

"In a nutshell, the safety valve that has been put under the system may not be as great as initially thought." (Reporting by Kirsten Donovan and Vidya Ranganathan; Editing by Ruth Pitchford)