* German banks' use of ECB funds drops to 49.5 bln end-Jan
* Banks from euro zone core pay back 3-yr loans early
* Italian, Spanish banks still rely on central bank
* Divergence gives headache to ECB (Adds details, background, national data)
By Sakari Suoninen
FRANKFURT, Feb 18 (Reuters) - German banks' use of European Central Bank crisis funding dropped by a third in January from the previous month, a further sign that banks in the heart of the euro zone are returning to money markets after last year's credit squeeze.
Banks in countries on the periphery of the 17-member bloc still rely on central bank lending, which, while at a record-low interest rate of 0.75 percent, is above market rates. The divergence complicates the ECB's interest rate-setting plans.
The Bundesbank data released on Monday showed that German banks owed the central bank 49.5 billion euros ($66.1 billion) at end-January, 23.6 billion less than a month earlier, suggesting they took advantage of the first opportunity to pay back the 3-year loans to the ECB, known as LTROs, on Jan. 30.
Most - 20.6 billion euros - of the fall came in German banks' use of longer-term facilities, which cover anything from one month to three years.
The ECB gave banks the ultra-long term loans in two instalments roughly a year ago, with euro zone lenders taking more than a trillion euros in cheap cash.
In the first of the twin loans, offered in December 2011, banks took 489 billion euros. In the first opportunity to pay back those loans early, banks returned 137.2 billion euros to the Eurosystem of euro zone central banks on Jan. 30.
Banks with market access can get overnight funds at 0.06 percent, while the interest rate for 3-month loans is 0.223 percent.
ECB President Mario Draghi said earlier this month that the financial market conditions had improved significantly and that the early repayments were "a sign of confidence".
"Many banks had accessed (3-year) LTRO for precautionary reasons because they were, a year ago, uncertain about the liquidity situation - about the funding prospects. And now they are less uncertain, than they were a year ago. So, that is also a positive sign," Draghi said in a post-rate decision news conference.
National central bank balance sheets showed, however, that a lion's share of funds paid back came from core countries of Germany, France and Belgium, and that peripheral countries' banks continue to rely to great extent on the central bank for funds.
This complicates the ECB's task of setting interest rates suitable for the whole block, as its policy decisions do not get transmitted in the same form to all countries.
The ECB has announced a yet-to-be-activated bond-buying programme, dubbed Outright Monetary Transactions (OMT), to address the issue.
While the plan has calmed worst fears in the market, ECB lending data shows that national divergence still looms large.
The use of ECB lending also went down considerably in France and Belgium, data from their national central banks showed.
French banks' use of ECB facilities was 152.7 billion euros on Feb. 12, down from 179 billion a month earlier. Virtually all of the reduction came from longer-term refinancing operations, which was cut by 25.6 billion.
Belgian banks chopped off a quarter of their borrowing from the ECB, which went down to 29.2 billion euros at end-January from 40 billion at the end of last year.
By contrast, Italian banks used the facilities more at the end of January, taking 273.9 billion, up from 271.8 billion. Italian banks' share of total ECB lending rose to 27 percent from just above 24 percent.
In Spain, which together with Italy has been drawn deeper into the centre of the debt crisis, banks used the central bank for funds almost as much in January as a month earlier.
They took 346 billion euros from the central bank, down from 357.3 billion, but they remained the heaviest users of the ECB, with their share amounting to 34.1 percent.
Banks in countries hit hardest by the debt crisis, especially in Greece and Ireland, rely on emergency liquidity assistance from their national central banks, as they lack suitable collateral to access regular ECB operations.
($1 = 0.7490 euros) (Reporting by Sakari Suoninen, editing by Paul Carrel and Philippa Fletcher)