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Fed readies debt-limit guidance for financial firms
July 28, 2011 / 6:51 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.

<p>Dozens of Tea Party supporters, including one dressed as Captain America (C) and a George Washington impersonator (R), rally near the U.S. Capitol against raising the debt limit in Washington, July 27, 2011. REUTERS/Jonathan Ernst</p>

“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 both the U.S. and global economy for years to come and would 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 “If the Fed starts to say we’re going to do things to mitigate the financial repercussions, you’re giving them some leeway you don’t want to give.”

Low said a Fed contact had been unable to provide details about what the central bank’s plans are.

U.S. officials said on Wednesday that the Treasury would lay out a plan in the next few days about how the government will operate if it appears Congress may miss the August 2 deadline.

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

“We haven’t heard much from the Fed,” said Ray Stone, an economist at Stone & McCarthy in Princeton, New Jersey. “A default has such severe consequences for the financial markets and the real economy that they have to do something.”

Fed officials have acknowledged preparations have been taking place behind the scenes on operational issues to be ready for any financial breakdown.

Philadelphia Federal Reserve Bank President Charles Plosser told Reuters last week the Fed has been locked in discussions with Treasury about cash management and other technical issues that would arise in the event of a default.

The Treasury needs to decide who would get paid if the government runs out of enough cash to meet all its obligations, and analysts expect it would seek 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.

However, the central bank would likely face some momentous decisions if a default sparks a crisis. For one, they may need to decide whether to continue to accept Treasury debt as collateral for emergency bank loans if the United States loses its vaunted AAA credit rating.

Richmond Fed President Jeffrey Lacker said on Thursday the Fed may need to reevaluate how it values government debt it accepts as collateral, possibly making banks take steeper “haircuts” on the debt.

Some analysts have speculated the Fed could step in to keep government checks flowing in the event the Treasury runs out of cash. However, Fed officials have sought to quash that notion.

The Fed is the fiscal agent and the depository for the Treasury. It receives bids for Treasury securities sold at auctions, issues the securities and clears government checks.

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

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