April 24 (Bloomberg) -- Interest-rate derivatives are signaling that the rate banks charge for loans in dollars in London may rise further as financial institutions remain reluctant to lend.

The difference between the rate of three-month loans in London relative to the overnight index swap rate, known as the Libor-OIS spread, is 87 basis points. The gap reached 90 basis points on April 21, the widest since Dec. 12.

The London interbank offered rate, or Libor, for dollars had climbed to a seven-week high amid speculation the global credit crunch prompted lenders to manipulate the rate to prevent their borrowing costs from escalating. The British Bankers' Association said last week it will speed up a review of the process by which money-market rates are set daily and ban any member providing misleading quotes.

``The correction in Libor has not completely happened,'' said Bulent Baygun, head of interest-rate strategy in New York at BNP Paribas Securities Corp., a unit of France's largest bank. ``Given the dynamics that have persisted in the past few weeks, it looks like there could be a little bit more room for an increase.''

Three-month Libor for dollars has advanced 19 basis points to 2.91 percent since April 16. It dropped 1 basis point today, the first decline since April 14.

The three-month Libor-OIS spread was as narrow as 24 basis points on Jan. 24 and reached as high as 106 basis points on Dec. 4. A basis point is 0.01 of a percentage point. The OIS rate signals what traders' expect the overnight federal funds rate to average over the time period of the swap.

More TAF Needed

The dominance of European banks among the 16 members the BBA uses daily to set Libor may skew borrowing costs for U.S. lenders and prompt the need for alternative index based in the U.S., Scott Peng head of U.S. rates strategy in New York at Citigroup Global Markets Inc., wrote in a report last week.

The persistence of banks' need for cash and increase in Libor rates has triggered speculation that the Federal Reserve will increase, for the third time, the amount it loans through its Term Auction Facility, which is known as TAF. The Fed has auctioned a total of $360 billion in temporary funds through TAF since its debut in December. This month, both TAF auctions were for $50 billion each in 28-day loans.

The rate at this week's TAF was 2.87 percent, or 82 basis points above the minimum bid set by the Fed, the highest spread to date. An increase in the spread signals a rise in demand for funds in the banking system.

Open Interest Declines

The TAF auction rate was 3 basis points below one-month Libor for dollars at 2.90 percent, after the prior auction's rate was 10 basis points above one-month Libor, sparking heightened attention on Libor. The rates for a collateralized loan, as are TAF funds, are typically lower than those that are offered without it, as with Libor, given the maturity is the same.

Use of Eurodollar futures, which are based on predictions for Libor rates, as a bet on expected changes in Fed interest- rate policy has waned amid the questions regarding Libor rates, according to Credit Suisse Securities USA LLC, one of the 20 primary dealers that trade directly with the Fed.

Eurodollar futures open interest, or the total number of futures contracts that have not been closed, liquidated, or delivered, declined by 21 percent since the end of January, according to CME Group data. It fell 4.7 percent for the week ended April 18, after the BBA announced it was monitoring banks involved in the Libor process, from the end of the prior week.

``Libor uncertainty has led to a large-scale deleveraging in the Eurodollar complex,'' wrote Dominic Konstam, head of interest-rate strategy at Credit Suisse, in a note published on April 18. ``Over the past week, the decline in open interest has been dramatic as the problems with Libor have become more publicized.''

Eurodollar futures, which trade in price terms, settle to three-month dollar Libor at expiration. The settlement price is derived by subtracting the Libor rates from 100.

To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net

Last Updated: April 24, 2008 09:23 EDT