May 19 (Bloomberg) -- The cost of borrowing in dollars between banks had its biggest two-day drop in more than four months amid confidence record low interest rates and a recovery among financial institutions is unlocking credit.

The London interbank offered rate, or Libor, for three- month dollar loans declined three basis points today to 0.75 percent, the British Bankers’ Association said, bringing its drop in the past two days to seven basis points, the most since Jan. 13. The rate has decreased in each of the past 35 days.

“The tension has disappeared and we are gradually normalizing,” said Patrick Jacq, a senior fixed-income strategist in Paris at BNP Paribas SA, the biggest French lender. “There’s less stress in the market and banks know they will get liquidity.”

Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley applied to refund a combined $45 billion of U.S. government money, people familiar with the matter said. That would mark the biggest reimbursement to taxpayers since the $700 billion Troubled Asset Relief Program, or TARP, began. Mitsubishi UFJ Financial Group Inc., Japan’s biggest bank, forecast a return to profit, adding to evidence the worst of the financial crisis may have passed.

The availability of credit has improved as the Federal Reserve committed $12.8 trillion to stem the longest recession since the 1930s and central banks around the world cut interest rates to near zero. Congress established the TARP program to stave off turmoil after Lehman Brothers Holdings Inc. collapsed in September.

TED Spread

Libor, used to set borrowing costs on about $360 trillion of financial products globally, according to the BBA, rose to 4.82 percent in October, after Lehman’s failure.

The TED spread, the difference between what banks and the U.S. Treasury pay to borrow for three months, narrowed six basis points to 57 basis points, the lowest level since August 2007, when the credit crisis began. The Libor-OIS spread, another gauge of banks’ reluctance to lend, narrowed three basis points to 55 basis points, the least since Feb. 26, 2008.

The Libor-OIS spread may reach the 25 basis points in the “next few weeks,” according Ivan Comerma, head of treasury and capital markets in Andorra at Banc Internacional d’Andorra, which manages about $1.6 billion in fixed-income assets. Former Fed Chairman Alan Greenspan said in June last year he wouldn’t consider money markets back to “normal” until the spread was at 25 basis points. The average in the five years preceding the credit squeeze was 11 basis points.

Bank Contributions

“Liquidity is in the banks’ balance sheets already and there’s no reason for the spread to stay at current, abnormal levels,” said Andorra-based Comerma.

Libor is derived from a survey of banks conducted by the BBA each day in London. Institutions are asked how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. The BBA then calculates averages, throwing out the four highest and lowest quotes, before publishing them before noon.

Royal Bank of Canada quoted the highest rate today for three-month dollar loans, at 0.88 percent, while Deutsche Bank AG, HSBC Plc and JPMorgan contributed the lowest, at 0.70 percent, a difference of 18 basis points, down from 20 basis points yesterday.

-With assistance from Anna Rascouet in London, Christine Harper and Elizabeth Hester in New York and Finbarr Flynn in Tokyo. Editors: Justin Carrigan, Daniel Tilles

To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net

Last Updated: May 19, 2009 08:46 EDT