FACTBOX-Potential Fed exit strategy tools

WASHINGTON, Sept 16 (Reuters) - The U.S. Treasury Department on Wednesday said it would begin shrinking a program aimed at helping the Federal Reserve manage its balance sheet, which it expanded in a bid to cushion the economy from the financial crisis.

The balance sheet of the Fed -- the U.S. central bank -- ballooned to nearly $2 trillion during the crisis through temporary liquidity programs and longer-term asset purchases.

Fed Chairman Ben Bernanke has said the Fed has a comprehensive plan to reverse its unorthodox policies while keeping inflation under control. He has sought to reassure markets nervous that the Fed's aggressive policies could fuel inflation if not withdrawn in a timely manner while reassuring investors that stimulus will not be withdrawn too soon to allow the recovery to gain momentum.

Below are some of the Fed's exit strategy options, with a discussion of some of the drawbacks: WAYS TO DRAIN RESERVES:

REVERSE REPURCHASE AGREEMENTS

The Fed's longer-term assets could be lent as collateral to dealers in return for cash, which would drain reserves from the banking system. However, reverse repurchase agreements, or repos, could inflate dealer balance sheets as dealers re-lend the collateral from the Fed to money market funds.

"As anyone who lived through the last few quarter-ends knows, the dealer community does not have $1 trillion of spare balance sheet room, sharply limiting the capacity of this tool to drain reserves," Bank of America-Merrill Lynch wrote in a note to clients.

TREASURY SUPPLEMENTARY FINANCING PROGRAM

The Fed had said it could take in more cash from the Treasury through the Supplementary Financing Program. Last fall, the Treasury raised almost $560 billion by issuing SFP bills and held the funds on deposit at the New York Fed to offset part of the ramp up in the Fed's balance sheet at the time. The Treasury has kept an extra $200 billion on deposit with the Fed.

The Treasury said on Wednesday it would shrink the account to to $15 billion in coming weeks as bills mature, citing the nearing $12.1 trillion debt ceiling as a concern.

A Fed spokeswoman responded to the Treasury move by saying the Fed had the ability to steer monetary policy when it needed to.

FED BILLS

Other central banks such as the European Central Bank have the authority to issue their own debt as a way to drain reserves.

A problem with this is that the Fed would need congressional authorization and lawmakers, already uneasy about huge bank bailouts, are unlikely to be keen on granting the Fed more powers. Fed borrowing would also compete with Treasury borrowing during a wave of government debt issuance.

ASSET SALES

The Fed could sell assets that were in its account before the crisis began, which Goldman Sachs has estimated amount to $476 billion. It could also let maturing securities expire and sell some of the securities acquired during the crisis.

Selling the pre-crisis assets are unlikely to cause capital losses, while letting maturities expire would not affect the Fed's earnings.

A downside to this approach would be that if the Fed sells an asset for less than its book value, it books a capital loss. Large-scale selling of Treasury securities could disrupt markets and potentially hamper the Treasury's ability to issue new debt. The Fed is likely to be very cautious about selling its agency mortgage-related assets for fear of distorting those less-liquid markets. WAYS TO MANAGE POLICY WITH EXCESS RESERVES IN SYSTEM:

PAYING INTEREST ON EXCESS RESERVES

By setting the interest rate on excess reserves the Fed essentially creates a magnet for banks to place those reserves with the Fed rather than lend those reserves out into the financial system. This would enable the Fed to conduct monetary policy even with excess cash in the system.

However, there could be a political backlash if the Fed was paying banks a significant amount of taxpayer money to push up interest rates.

"That payment is perfectly logical from a monetary policy perspective, but it is a disaster from a public relations perspective," according to Bank of America-Merrill Lynch research.

TERM DEPOSIT FACILITY

The Fed could create a new "term deposit facility" for depository institutions, which could possibly involve an auction to determine an interest rate that would encourage depository institutions to park excess reserves at the Fed. The facility would be for terms greater than overnight.

"This would have almost exactly the same effect as doing term reverses, except that the instrument being offered by the Fed would be structured as a deposit rather than a secured loan. That would eliminate a lot of operational headaches, as the Fed would not have to allocate collateral to each of its individual counterparties," Wrightson ICAP economist Lou Crandall said in a note to clients.

RAISE RESERVE REQUIREMENTS

The Fed cut reserve requirements in the early 1990s to make banks more competitive with the shadow banking system and could raise them again. By boosting reserve requirements dramatically, the Fed could fuel enough demand to create a working federal funds market even at high levels of reserves.

The argument against this is that it would be an effective tax on the banking system and could make banks less competitive versus non-banks.

"This would be a last-ditch option, as reserve requirements have long been viewed as too blunt a policy tool," Goldman Sachs economist Ed McKelvey said. (Sources: Research by Goldman Sachs, JPMorgan, Wrightson ICAP, Bank of America-Merrill Lynch) (Reporting by Mark Felsenthal in Washington and Kristina Cooke in New York; Editing by James Dalgleish)