FACTBOX - Potential Fed exit strategy tools

(Reuters) - The U.S. Federal Reserve's tools for removing its unprecedented array of emergency lending programs are fraught with risks of their own, according to a high-level advisory group to the Treasury Department.

Minutes from the Treasury Borrowing Advisory Committee's November meeting, released on Wednesday, suggest market participants are not yet convinced that the move away from massive liquidity provisions will be a simple affair.

Below are some of the Fed's exit strategy options from its emergency policies along with some drawbacks discussed by analysts and the Treasury Borrowing Advisory Committee.

PAYING INTEREST ON EXCESS RESERVES:

This is because banks generally will not lend funds in the money market at a rate lower than they can earn risk-free at the Fed.

"Raising the interest rate paid on balances that banks hold at the Federal Reserve should provide a powerful upward influence on short-term market interest rates, including the federal funds rate, without the need to drain reserve balances," Fed Chairman Ben Bernanke wrote in his monetary policy report to Congress in July.

A number of central banks around the world have effectively used this tool.

Cons: 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 BofA Merrill Lynch Global Research.

LARGE-SCALE REVERSE REPURCHASE AGREEMENTS:

The Fed could arrange large-scale reverse repurchase agreements, or repos, with financial market participants, which would drain reserves from the banking system and reduce excess liquidity at other institutions.

Reverse repos involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

The Fed has said it could conduct reverse repos with a number of institutions, not just primary dealers, its usual counterparties.

Cons: Who the counterparties are will be key to the scope of the program and the ease with which it can be set up, according to a member of the Treasury Borrowing Advisory Committee cited in the group's November minutes.

"In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates," according to the committee member, who was not named in the minutes.

"Moreover, draining excess reserves may dampen the demand for Treasury securities by banks given that banks are investing in securities -- particularly Treasuries -- in the absence of loan demand," he said.

TREASURY SUPPLEMENTARY FINANCING PROGRAM:

The Fed could ask the Treasury to ramp up its Supplementary Financing Program again. Last fall, the Treasury raised almost $560 billion (337.9 billion pounds) by issuing SPF 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 scaled back the program to $15 billion, citing the debt ceiling as a concern.

TERM DEPOSIT FACILITY:

The Fed could create a new "term deposit facility" for banks, similar to certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the fed funds market.

"Such deposits would pay interest but would not have the liquidity and transactions features of reserve balances. Term deposits could not be counted towards reserve requirements, nor could they be used to avoid overnight overdraft penalties in reserve accounts," Bernanke wrote in his monetary policy report to Congress in July.

Cons: Taking in term deposits lacks a clear mechanism for rate setting and bank use, according to a member of the Treasury Borrowing Advisory Committee cited in the minutes.

ASSET SALES:

The Fed could sell a portion of its holdings of longer-term securities into the open market.

Cons: Large-scale selling of Treasury securities could disrupt markets and potentially hamper the Treasury's ability to issue new debt, analysts said.

The Fed is likely to be very cautious about selling its agency mortgage-related assets for fear of distorting those less-liquid markets.

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.

Cons: 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.

(Sources: Research by Goldman Sachs (NYSE: GS - news) , JPMorgan Chase, Wrightson ICAP, Bank of America (NYSE: IKJ - news) -Merrill Lynch (NYSE: MER - news) , Ben Bernanke's Monetary Policy Report to Congress and speeches, Minutes of the Treasury Borrowing Advisory Committee)

(Reporting by Reuters Fed team in New York and Washington; Editing by James Dalgleish)