July 9 (Bloomberg) -- The size of the Federal Reserve’s balance sheet shrank for a third straight week, falling below $2 trillion for the first time since March, as lending to banks in the U.S. and abroad declined.

Assets fell $12.8 billion, or 0.6 percent, to $1.99 trillion in the week ended yesterday, the Fed said today in Washington. The Fed’s Term Auction Facility lending to commercial banks declined $9.1 billion to $273.7 billion. Currency swaps, in which other central banks lend dollars in their countries, fell $5.44 billion to $109.1 billion.

The central bank will let one of its emergency programs expire and trim two others in a sign that improving financial markets allow a first step toward ending its interventions. Fed policy makers decided at their meeting June 24 to maintain plans to buy as much as $1.75 trillion of Treasuries and housing debt to lower interest rates.

A monthly balance-sheet report begun by the Fed on June 10 said the recent shrinking of Fed liquidity programs has accompanied “improvements in financial market conditions over recent weeks.”

Biweekly TAF auctions will be reduced to $125 billion from $150 billion, effective July 13, the Fed said June 25, and if market conditions continue to improve, “TAF funding will be reduced gradually further.”

Discount-window lending to commercial banks fell to $34.5 billion from $35.7 billion. Commercial paper held by the Fed under an emergency program begun in October declined to $109.2 billion as of yesterday from $111.1 billion.

Programs Extended

The currency swaps and other facilities were extended by three months to Feb. 1.

Holdings of mortgage debt were little changed at $462.5 billion, while Treasuries on the balance sheet gained $10 billion to $673.5 billion. Federal agency securities held by the central bank were unchanged at $97.8 billion.

The Fed has commitments to purchase a net $156.7 billion of MBS as of yesterday.

Wall Street bond-dealer borrowings stood at zero for the ninth straight week. On May 13 the amount fell to zero for the first time since Sept. 10, just before the bankruptcy of Lehman Brothers Holdings Inc.

Fed Chairman Ben S. Bernanke has increased total assets on the balance sheet by $1.1 trillion in the past year to unfreeze credit markets and support banks’ demand for cash.

Fed officials lowered the benchmark interest rate to a target range of zero to 0.25 percent in December and have switched to using credit programs and outright purchases of Treasuries, mortgage-backed securities and housing agency debt as the main tools of monetary policy.

Balance Sheet Peaked

The balance sheet’s size peaked at $2.31 trillion in December. Yesterday’s total is the smallest since $1.90 trillion on March 11.

The Fed’s loans to a program providing liquidity to the asset-backed commercial paper market and money-market funds fell to $9.56 billion as of yesterday from $14.8 billion.

Credit extended by the Fed in connection with the rescue of insurer American International Group Inc. declined to $81.5 billion from $83.4 billion last week. Last month AIG announced that it agreed to hand over stakes in two overseas units to the New York Fed to reduce its central bank debt by $25 billion.

The Fed said the M2 money supply fell by $36.2 billion in the week ended June 29. That left M2 growing at an annual rate of 8.7 percent for the past 52 weeks, above the target of 5 percent the Fed once set for maximum growth. The Fed no longer has a formal target.

The Fed reports two measures of the money supply each week. M1 includes all currency held by consumers and companies for spending, money held in checking accounts and travelers checks. M2, the more widely followed, adds savings and private holdings in money market mutual funds.

For the latest reporting week, M1 fell by $16.2 billion, and over the past 52 weeks, M1 rose 16.3 percent. The Fed no longer publishes figures for M3.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: July 9, 2009 16:30 EDT