July 28, 2011 / 6:48 PM / 6 years ago

Fed readies debt-limit guidance for financial firms

WASHINGTON (Reuters) - The Federal Reserve plans to provide guidance to banks soon on how to handle the potentially turbulent financial waters if the United States exhausts its borrowing authority.

“We have been engaged in operational planning with the Treasury,” Fed spokeswoman Barbara Hagenbaugh said on Thursday. “We expect to be able to give additional guidance to financial institutions when there is greater clarity from the Congress and when Treasury outlines its specific operational plans.”

The Treasury has said it will not be able to borrow more funds after Tuesday if Congress does not raise the nation’s $14.3 trillion debt ceiling by then, raising the prospect of a government default. Lawmakers on Thursday were still deadlocked over how to move forward.

Officials say a debt default would damage the U.S. economy for years to come and likely provoke a severe financial crisis, but they have been hesitant to discuss contingency planning.

“No one in Washington wants to do anything to relieve the pressure on lawmakers to get this done by the deadline,” said Chris Low, chief economist for FTN Financial in New York.

U.S. officials say the Treasury will soon lay out a plan for how the government will operate if it appears Congress may miss the August 2 deadline. An announcement could come as soon as Friday evening.

This would pave the way for the Fed, which acts as the government’s bank, to make its plans clear.

“A default has such severe consequences for the financial markets and the real economy that they have to do something,” said Ray Stone, an economist at Stone & McCarthy in Princeton, New Jersey.

Fed officials said on Thursday that the U.S. central bank might need to reevaluate the way it discounts the Treasury securities that banks use as collateral for emergency loans.

“We might need to reevaluate discount window haircuts on Treasury securities if it was warranted,” Richmond Federal Reserve Bank President Jeffrey Lacker told reporters.


Among issues of concern to banks is whether the government would back up money market mutual funds if Treasury debt receives a ratings downgrade. The president of the San Francisco Fed, John Williams, played down the risks to money funds.

The Fed would make clear to banks that it would keep the financial system liquid, Williams said.

Another topic the Fed may need to address is how capital requirements for banks might change if there were large inflows or outflows of funds in response to a debt downgrade.

Fed officials have acknowledged preparations have been taking place behind the scenes on operational issues.

Philadelphia Federal Reserve Bank President Charles Plosser told Reuters last week the Fed has been locked in discussions with Treasury about how the government’s cash would be managed if the debt limit is not raised.

The Treasury needs to decide who would get paid if the government runs out of enough cash to meet all its obligations. It is widely expected to ensure holders of U.S. government debt are first in line.

While the Fed would likely step in to provide liquidity if financial markets appeared at risk of seizing up, the guidance for banks is likely to be more mundane.

The Office of the Comptroller of the Currency said it plans to advise the national banks it regulates that when assessing customer overdrafts, they should consider whether a customer failed to receive a government check due to the debt ceiling impasse. The Fed could be expected to follow suit.

Fed Chairman Ben Bernanke told a hearing on July 13 the Fed would do what it could to keep the financial system functioning. However, he said it would not be a financial backstop to help the government pay bills if it cannot borrow.

“We would do what we could to preserve the operationality of the system,” Bernanke said. “But I want to eliminate any expectation that the Fed through any mechanism could offset the impact of a default on the government debt.”

Additional reporting by Emily Flitter in New York; Editing by James Dalgleish and Leslie Adler

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