FRANKFURT (MNI) - Banks unexpectedly tightened credit standards in the second quarter, as the sovereign debt crisis affected their ability to obtain funding even while the economic recovery sparked a pick-up demand for loans, the European Central Bank said in its July Bank Lending Survey (BLS), released Wednesday.

Looking ahead, banks expect continued constraints on wholesale funding access.

"In the second quarter of 2010, negative spillover effects from the sovereign debt crisis appear to have worsened banks' ability to obtain funding. Hence, banks reported that access to wholesale funding became more difficult compared with the first quarter," the ECB said.

In the third quarter, "banks expect that the current difficulties in accessing wholesale funding will remain, although not to the same extent as observed in the second quarter of 2010," the central bank added.

News of tighter credit standards is a disappointment, especially since banks had previously projected unchanged credit standards in the second quarter for both businesses and households, and more recent developments had pointed to easing tensions on money markets.

Demand for loans, on the other hand, picked-up for both enterprises and households as the Eurozone's recovery continued.

"While credit supply conditions deteriorated, the July 2010 BLS results pointed to a gradual improvement in the net demand for loans in the second quarter of 2010, being only slightly negative for loans to enterprises and turning positive for loans to households," the report said.

Nevertheless, results also disappointed on business loan demand. In the previous bank lending survey, banks had forecasted positive net loan demand for enterprises in the second quarter.

The survey was conducted from June 14 through July 2 2010 on a sample group of 120 euro area banks. The response rate was 100%, the ECB said.

The release of the survey follows the publication Tuesday by the ECB of June's M3 lending data, which appeared to send more encouraging signals. The M3 data showed June mortgage lending rising at the fastest pace in almost two years, raising hopes that bank lending in the Eurozone may be on the path to recovery.

European bank stress test results published last Friday also signaled that the Eurozone's banking system is in relatively sound shape, authorities have said, suggesting that the economic recovery should not be constrained by a credit crunch.

Critics of the tests, however, argue that the criteria used were too soft to detect problems.

Today's ECB data show that while the banking system may be on a recovery path, it is certainly not healthy enough to resume regular lending activity, suggesting that credit conditions might yet dampen the recovery.

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