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* Basel Committee to discuss liquidity on Sunday * Regulators set to relax timing on liquidity ratio-source * Threat of credit crunch prompts rethink * Banks would have had 1.8 trillion euro funding shortfall By Steve Slater and Huw Jones LONDON, Jan 4 (Reuters) - Europe's credit-starved economieslook set to be the main beneficiaries of plans to relax newrules and give lenders more time to build up their cash buffers. The Basel Committee of global regulators will on Sunday givebanks longer to comply with stricter new rules on the amount ofliquid assets they hold, a regulatory source said on Thursday.Further tweaks could also be seen. Banks have been fighting hard to delay implementation andalter parts of the liquidity coverage ratio (LCR) rules -governing the level of easily tradeable assets such asgovernment bonds they need to hold to ensure their stability ifmarkets freeze up. Some top regulators have also warned the original rules, dueto come into force by 2015, will cut lending just when they aretrying to encourage the flow of money to help kick-starteconomic recovery. "The banks have made quite marked progress in addressing theissue of liquidity since the crisis. Basel now seems to beworried about the danger of a knock-on impact on the widereconomy," said Chris Wheeler, analyst at Mediobanca in London. "Banks are still deleveraging ... so they (regulators) seemkeen to provide a little bit of leeway, on the basis thatprogress has been made, and they don't need to force it,"Wheeler added. A senior executive at a top European bank last year toldReuters the LCR needed to be eased significantly as it was tooprescriptive and could spark another huge wave of deleveraging,or banks cutting their loan books. The liquidity rules will run alongside tougher capital rules- covering the amount banks have to hold to absorb losses -which have already forced banks such as Royal Bank of Scotland, Lloyds, Citi, BNP Paribas andSociete Generale to aggressively shrink their balancesheets. SECOND WAVE That has been achieved largely by shedding capital-marketsassets, including derivatives on toxic sub-prime mortgages, oroverseas loans, but a second wave of deleveraging was likely toland closer to home and hit domestic lending, the top bankexecutive warned. The Basel Committee, made up of supervisors from nearly 30countries, will discuss the liquidity issue at a meeting onSunday. Regulators have for some time been expected to approveeasing some parts, although they remain keen to be seen to betaking a hard line on banks. The aim is to better protect taxpayers from having to bailout banks and avoid a repeat of the 2007-09 financial crisis. Aliquidity rule could have prevented the short-term fundingfreeze that brought down lenders like Britain's Northern Rock. Investors, too, are keen to see banks meet new rules early.That will help Basel relax the rules on timing, analysts said,as banks are aware they could be punished by investors if theylag behind rivals in meeting new standards. Most regulatory focus has been on strengthening capital andhigher capital rules being phased in from this month are due tobe fully implemented by 2019. Yet the LCR is another key plank of Basel III, aiming toensure banks have a stable funding structure and hold enougheasy-to-sell assets to survive a 30-day credit squeeze in timesof stress. The implications are huge. If the LCR had been in force at the end of 2011, the world'sbiggest banks would have needed 1.8 trillion euros moreliquidity, or about 3 percent of their assets, the BaselCommittee has estimated. AT RISK Most of the shortfall is in Europe, where banks would haveneeded about 1.2 trillion euros, or 3.7 percent of their assets,Europe's banking regulator estimated. Banks in France and Spainare among those most at risk of falling short, some analystssaid. In addition to wanting more time, banks say more assetsshould be eligible and deemed highly liquid, possibly includingmortgage-backed securities. "A phasing in of the LCR would enable banks to betterfinance growth as the economy recovers, rather than stashingassets away in government bonds," said Simon Hills, director atthe British Bankers' Association. "And including retail mortgage-backed securities in the LCRbuffer would stimulate the securitisation market, enabling banksto shift good-quality mortgages off their balance sheet (and)freeing up capacity for the new loans to SMEs (or small andmedium-sized firms) that they want to make," Hills added. Banks that have a shortfall need to scale back their lendingor business activities that are most vulnerable to a short-termliquidity shock, or lengthen the term of their funding beyond 30days, or opt to hold more liquid assets. Yet the measures themselves are not risk free. Industry sources say potential unintended consequences ofthe rules include an even greater emphasis on holding governmentbonds, which the euro zone crisis has shown carry their ownrisks; banks chasing a limited pool of retail deposits; and apossibility that more disclosure on liquid assets creates scopethat short-term changes will panic investors. Banks do not typically release LCR data. The BaselCommittee's last assessment said at the end of 2011 the averageratio across the 102 biggest global banks was 91 percent andacross the next 107 banks 98 percent - short of the required 100percent. Some 38 percent of the banks in the sample would have had aratio of below 75 percent, signaling they would need to takesignificant action.