May 14 (Bloomberg) -- The cost of borrowing in dollars between banks fell the most in eight weeks as government and central bank efforts to unlock credit markets showed signs of bearing fruit and deposits at financial institutions grew.

The London interbank offered rate, or Libor, for such loans fell almost three basis points to 0.85 percent today, according to the British Bankers’ Association. The so-called TED spread, the difference between what the U.S. Treasury and banks pay to borrow for three months, dropped to its lowest since the day before BNP Paribas SA halted withdrawals from three of its funds on Aug. 9, 2007, because of subprime-mortgage related losses.

Bank borrowing costs have tumbled as the U.S. government and the Federal Reserve pledged $12.8 trillion to drag the economy out of its longest recession since the 1930s and policy makers around the world cut interest rates to near zero. Libor is used to determine borrowing costs on about $360 trillion of financial products globally, according to the BBA.

“External liquidity is clearly going to get banking rates to realign with policy rates,” said Orlando Green, a fixed- income strategist in London at Calyon, the investment-banking unit of Credit Agricole SA. “Banks are trying to attract money, they want that solvency, so Libor is coming in strongly.”

Libor hasn’t fallen so much since March 19, the day after the Fed said it would buy as much as $300 billion of U.S. government bonds and step up purchases of mortgage and agency bonds to revive growth.

Recovery Concern

The rate of decline accelerated even as stocks dropped on concern the recovery from the global recession will falter. The MSCI World Index fell 3.2 percent this week.

The global economy may face near-stagnation for 10 years, similar to Japan’s “lost decade” in the 1990s, Nobel Prize- winning economist Paul Krugman said at a forum in Taipei today. The comment echoed those of fellow Nobel-laureate Joseph Stiglitz and former World Bank President James Wolfensohn.

The drop in Libor coincided with a surge in customer deposits, according to Jim Vogel, an analyst at FTN Financial. Deposits at U.S. banks jumped almost $400 billion in the past six months, reducing demand for loans in the interbank market, Vogel said.

The Libor-OIS spread, a measure of the unwillingness of banks to offer each other cash, narrowed three basis points to 64 basis points today, its lowest level since June 16. The TED spread dropped three basis points to 69 basis points.

Rate Calculation

“There may be more to the decline than meets the eye,” Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York, said in a note. “It is widely acknowledged and documented that American savings are rising. There seems to be some other complications whereby the decline in Libor, which is driving the narrowing of the Libor- OIS spread, is a function of the crisis itself, perhaps even signs of a liquidity trap.”

Libor is set each day by the London-based BBA following a survey of banks. Financial 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, and publishes them at about noon in London. Sixteen banks contribute to the dollar fixing, three of them U.S.-based.

Highest, Lowest

Royal Bank of Scotland Group Plc quoted the highest rate today for three-month dollar loans, at 0.96 percent. Deutsche Bank AG contributed the lowest, at 0.70 percent. It’s the first time every bank gave a rate below 1 percent, according to BBA data. The difference between the highest and the lowest rates was 26 basis points, down from 30 basis points yesterday.

“I wouldn’t say that nothing can stop Libor’s fall, but there isn’t enough out there to cause any big panic,” said Padhraic Garvey, head of investment-grade debt strategy at ING Groep NV in Amsterdam. “So far, so good.”

Libor, which determines rates on everything from mortgages to student loans, surged as high as 4.82 percent in October following the collapse of Lehman Brothers Holdings Inc. a month earlier. The Libor-OIS spread ballooned to 364 basis points.

To contact the reporter on this story: Anna Rascouet in London at arascouet@bloomberg.net

Last Updated: May 14, 2009 13:08 EDT