May 29 (Bloomberg) -- Banks routinely misstated borrowing costs to the British Bankers' Association to avoid the perception they faced difficulty raising funds as credit markets seized up, said Tim Bond, a strategist at Barclays Capital.

``The rates the banks were posting to the BBA became a little bit divorced from reality,'' Bond, head of asset- allocation research in London, said in a Bloomberg Television interview. ``We had one week in September where our treasurer, who takes his responsibilities pretty seriously, said: `right, I've had enough of this, I'm going to quote the right rates.' All we got for our pains was a series of media articles saying that we were having difficulty financing.''

Discrepancies in the rates that banks quote are creating a crisis of confidence in the London interbank offered rate, the benchmark for 6 million U.S. mortgages and more than $350 trillion of derivatives and corporate bonds. In the first four months of 2007, the difference between the highest and lowest rates for three-month Libor didn't exceed 0.02 percentage point, according to JPMorgan Chase & Co. In the same period this year, it was as wide as 0.17 percentage point.

BBA Announcement

The criticism has prompted the BBA to accelerate a review of the 24-year-old system of setting rates. The findings, due tomorrow, may determine how fast the banking industry recovers from the credit crisis.

The rate surged in August as banks suddenly became wary of lending to each other because of mounting losses on assets tied to U.S. subprime mortgages. Writedowns have reached $382 billion, according to data compiled by Bloomberg. The gap between Libor and the three-month U.S. Treasury bill, known as the TED spread, widened to 2.40 percentage points on Aug. 20 and has since narrowed to 0.77 percentage point.

Barclays Plc, the U.K.'s third-biggest bank and parent of Barclays Capital, quoted three-month dollar rates to the BBA that averaged 7 basis points more than those of their peers in the first week of September. Barclays dropped 9.1 percent on the London Stock Exchange that week, compared with the 5.5 percent decline in the 59-member Bloomberg Europe Banks and Financial Services Index.

`Above the Parapet'

``Other banks tried to push their head above the parapet on occasions as well, but with every attempt you were met with a lot of rumor and innuendo,'' Bond said in the interview. ``It wasn't a very easy environment.''

Simon Eaton, a spokesman for Barclays Capital in London, declined to comment.

As well as varying from member to member, rates show little correlation to banks' costs of insuring debt from default. UBS AG, whose default-insurance costs rose 919 percent between July 2 and April 15 as it racked up $38 billion of writedowns and losses, quoted dollar-borrowing costs that were lower than its rivals on 85 percent of the days during that period, Bloomberg data shows.

By contrast, the U.K.'s Lloyds TSB Group Plc, which wrote down $1.4 billion, quoted rates that averaged less than 1 basis point above Libor. A basis point is 0.01 percentage point.

The BBA, an unregulated trade group, asks 16 member banks each day how much it would cost them to borrow from each other for 15 different periods ranging from overnight to one year, in currencies from dollars to euros and yen. It then calculates averages, throwing out the four highest and lowest quotes, and publishes them at about 11:30 a.m. in London. Three-month dollar Libor was set at 2.68 percent today.

`Every Confidence'

The BBA said on April 16 that any member deliberately understating rates would be banned. The cost of borrowing in dollars for three months rose 0.18 percentage point to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze in August.

The BBA ``is not prepared to be drawn into speculation'' over whether it will investigate banks that have misstated their funding costs, Brian Mairs, a spokesman for the BBA in London, said today. ``We have every confidence in the integrity of the BBA Libor-setting process and the accuracy of the figures it produces.'' The BBA's policy to ban banks that deliberately misquote rates hasn't changed, Mairs added.

``The issue is critical for the BBA and involves the City of London's credibility,'' said Peter Hahn, a fellow at the London-based Cass Business School and a former managing director at Citigroup Inc. ``If you can't believe Libor then what else that comes out of London needs second guessing.''

Trading Alternatives

Traders are resorting to alternative measures for borrowing costs as the BBA struggles to maintain Libor's status.

One option growing in popularity is overnight indexed swaps, a gauge of expectations for central bank rates.

``OIS rates have the advantage that they are set off the fed funds effective rate, which is an overnight rate based on a volume-weighted average of trades that occur each trading day through the major brokers,'' Eric Liverance, head of derivatives strategy at UBS Securities LLC in Stamford, Connecticut, wrote in report dated May 27. ``There is no guesswork involved.''

Trading in fed fund futures has also surged 55 percent in April from the prior month to an average of about 98,000 contracts a day, while transactions in Eurodollars, which are priced off Libor, slid 7.5 percent to an average 2.6 million contracts, according to CME Group data. Futures are agreements to buy or sell assets at a set date and price.

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.net; Elliott Gotkine in London at egotkine@bloomberg.net

Last Updated: May 29, 2008 12:16 EDT