May 15 (Bloomberg) -- The cost of borrowing in dollars between banks fell, capping its biggest weekly decline in four months, as government cash injections and interest-rate cuts led by the Federal Reserve began to thaw credit markets.

“Interbank rates are heading lower, at an accelerating rate,” Rob Carnell, chief international economist at ING Groep NV in London, wrote in a report today. “If these trends continue, the Fed is likely to conclude that it is winning the battle to save the economy and financial markets.”

The London interbank offered rate, or Libor, for three- month loans in dollars decreased almost two basis points to 0.83 percent today, the British Bankers’ Association said. The TED spread, the difference between what banks and the U.S. Treasury pay to borrow for three months, narrowed to the lowest level since August 2007, when the credit crisis began.

Bank borrowing costs slid as the U.S. government and 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. Libor, used to set borrowing costs on about $360 trillion of financial products globally, according to the BBA, jumped to 4.82 percent in October, following the collapse of Lehman Brothers Holdings Inc.

The TED spread, the difference between Libor and the three- month Treasury bill yield, dropped three basis points to 67 basis points today, the least since Aug. 8, 2007, the day before France’s BNP Paribas SA halted withdrawals from three of its funds because of losses related to subprime mortgages.

Still Wary

Today’s drop in three-month Libor was the 33rd consecutive day of declines, the longest sequence since Jan. 24 last year. The rate declined every day since May 5, when it fell to an all- time low of 0.99 percent.

Some measures show financial institutions are still wary of lending on concern their counterparts won’t be able to honor their commitments. Banks racked up more than $1.4 trillion of writedowns and losses since the start of 2007.

The difference between the Fed’s target rate for overnight bank loans between banks and three-month Libor was at 58 basis points today, compared with an average of 22 basis points in the five years before credit markets froze. It widened to 332 basis points on Oct. 10, from 82 basis points just before Lehman filed for bankruptcy.

“We can link Libor’s fall to a reduction in risk aversion, better economic data and the sentiment that we are headed towards stabilization,” said Nordine Naam, an interest-rate strategist at Natixis in Paris. “Money markets are relaxing, even if the path to recovery will be bumpy.”

‘Less Fear’

The Libor-OIS spread, a measure of the unwillingness of banks to offer each other cash, narrowed three basis points to 63 basis points, its lowest level since March 24, 2008. 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.

Contracts in the forward market show traders are betting the spread will fall to 52 basis points by December, according to data compiled by Tullett Prebon Plc, the second-biggest broker of interbank transactions after ICAP Plc.

“Money-market safe-haven spreads continue to narrow significantly, suggesting less fear in the banking system and more liquidity creating a less restrictive lending environment,” Greg Gibbs, a currency strategist in Sydney at Royal Bank of Scotland Group Plc, wrote in a note today. “The excessive fear phase of the credit crisis is coming to a close.”

Deposits Jump

The drop in Libor coincided with a surge in customer deposits. Cash placed in U.S. banks jumped almost $400 billion in the past six months, reducing demand for the interbank market, according to FTN Financial.

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.

Royal Bank of Canada quoted the highest rate today for three-month dollar loans, at 0.91 percent, while Deutsche Bank AG contributed the lowest, at 0.70 percent, a difference of 21 basis points. That compares with a dispersion of 26 basis points yesterday.

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

Last Updated: May 15, 2009 11:55 EDT