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"All of the consequences of an actual default are just severe and unfathomable," Nichols said.
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How A Debt Ceiling Default Would Damage Banks

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WASHINGTON – Bankers are growing increasingly fearful that the U.S. could breach the debt ceiling as the prospects for a deal ahead of a looming Oct. 17 deadline appear uncertain.

Their concern primarily centers on a key fact: Treasury bonds do more than fund the government; they buttress the financial system. Bankers warn that a default on certain Treasuries could put market collateral at risk, harm overnight lending and drain key sources of liquidity from the market.

“All of the consequences of an actual default are just severe and unfathomable and unthinkable,” said Rob Nichols, the president and chief executive officer of the Financial Services Forum. “If we were to default on our debt, that would probably spook investors, which would dry up overnight lending. You would imagine that accompanying that sort of event, we would be downgraded, which probably would lead to a sharp spike in rates, which would have its own drag on the economy.”

Absent a political deal, the government is expected to exceed the current $16.7 trillion debt limit in a little over a week, although the Treasury Department is said to have certain funding measures in place to continue paying obligations for a short time thereafter.

A default would come on top of the federal government shutdown, which began last week after House Republicans tied efforts to defund President Obama’s healthcare law to a budget resolution. Bankers are already feeling the sting  from that closure, as Federal Housing Administration loan approvals have slowed while Small Business Administration loans have ceased altogether.

But a debt breach would be even worse. In addition to affecting Wall Street’s use of Treasuries, industry representatives said a breach of the debt ceiling, and default on the nation’s debt, may also hurt Main Street banking if a debt crisis spooks consumers and small businesses.

“When a consumer is not confident about the economy, they’re less likely to borrow money to create jobs. Without jobs, there is no economy. … If the consumer does not have confidence in the economy, they’re not going to hire people, they’re not going to borrow money,” said Richard Hunt, president and chief executive officer of the Consumer Bankers Association.

“It’s ironic. This may be the moment in the history of the banking system when we have the most money to lend. But there’s no demand. In 2011, when we had the first debt ceiling crisis, we saw consumer confidence going off a cliff. It just returned a couple of months ago.”

Following are key consequences to the banking system in the event of a default:

The Financial Market’s ‘Pipes’ Burst

As banking policy analyst Karen Shaw Petrou describes it, Treasury obligations are the “water” in the financial system’s plumbing.

“They’re the global reserve currency and they are perceived to be the most secure thing you can own,” said Petrou, managing partner of Federal Financial Analytics. “That is why it is pledged as collateral. … The very biggest banks fear that a debt ceiling breach breaks the pipes.”

The challenges the government would face issuing new Treasuries and paying off existing ones without an increase in the debt ceiling could potentially wreak havoc on the market for repurchase agreements – known as repos – which serve as a key funding instrument for financial institutions. A report released Sunday by Keefe, Bruyette & Woods said Treasuries “provide more than $600 billion in liquidity” in the repo market.

“Even the perception of a default, if it were to have an impact on the value of Treasury securities, could be very detrimental to banking sector,” said Paul Merski, vice president of congressional relations and chief economist for the Independent Community Bankers of America. “Treasury securities are used both as safe investments for financial institutions and also the collateral for backing up trades between banks – what’s known as repos.”

The yield on one-month Treasuries began surging Oct. 1 and they are now trading well above three-month Treasuries, suggesting that demand for the short-term paper has fallen ahead of the looming debt ceiling deadline.

Rob Toomey, managing director and associate general counsel at the Securities Industry and Financial Markets Association, said institutions are concerned about whether Treasury bonds that default are no longer transferable between market participants.

“Essentially, whatever the size is of the obligation that Treasury is unable to pay, that kind of liquidity would just disappear from the market for whatever time the payment is not made,” Toomey said.

Investors could also begin to lose confidence in money-market mutual funds, which rely heavily on U.S. Treasuries. If investors begin a run on such funds, as they did during the 2008 financial crisis, it would have a significant impact on short-term lending, Nichols said.

 “Banks would be dealing with a host of mechanical issues that they’ve never had to deal with before, coupled with the broader macroeconomic impacts,” Nichols said. “There would also just be real fear on the part of investors to continue investing in the United States while we’ve made a judgment to stop paying” some obligations.

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Comments (2)
Fear mongering does not help the economy either. "'Essentially, whatever the size is of the obligation that Treasury is unable to pay, that kind of liquidity would just disappear from the market for whatever time the payment is not made,' Toomey said."..But as is noted later, the Fed is not going to stand idly by. What is to stop it from buying up any defaulting security?
Posted by Edward Kane | Tuesday, October 08 2013 at 6:11PM ET
Hopefully, this conversation of increasing the "debt" ceiling to pay our "debt" will gravitate towards the next logical conversation of... "We can't pay our debts with income". We have a saying around the bank that "you can't borrow your way out of debt", and that holds true for consumers and governments. People in Greece were shocked when temporary government shut downs turned into permanent shut downs through Austerity Measures. Democrats don't seem to think that the US can suffer the same consequences of insolvency, but I would encourage them to study the chart of historical US debt compared to Greece. When you can't pay your debts with income, you're insolvent. The strongest US economy we have ever had could not pay the interest on our current debt. Balancing the budget, cutting programs/spending and increasing taxes is the only chance this country has to keep its identity, and avoid socialism.
Posted by Small Bank President | Wednesday, October 09 2013 at 3:36PM ET
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