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.

To be sure, some observers said banks could turn to other areas for liquidity if necessary.

 “If we get to the point where” Democrats and Republicans “can’t talk and we default, it will be tougher for the banks to borrow money,” said Paul Miller, a managing partner with FBR Capital Markets. “But I think the Fed would step in and supply that liquidity.”

Miller said the warnings raised by bankers and industry representatives can help drive focus on the need to craft a debt deal. Top executives addressed the issue earlier this month at a press conference held at the White House, and a Senate Banking Committee hearing on the subject is planned for Thursday where witnesses include representatives from the American Bankers Association and SIFMA are scheduled to testify.

“Is not raising the debt limit bad if we default on the debt? Yes. Why do you need Jamie Dimon to say that?” Miller said. “It’s because he carries more weight and it gets on the front page.”

Main Street Impact

In addition to interfering with the architecture of the financial markets, several observers said the potential of a debt default to stun the U.S. economy will affect banking on Main Street as well.

“Increasingly, you’re going to see nervousness among consumers and businesses,” said James Chessen, the ABA’s chief economist. “For businesses, that nervousness freezes any decisions they have for expansion and taking out more loans. Uncertainty can be devastating in terms of moving the economy forward.”

Nichols said banks “essentially chase” the gross domestic product. “In an economy that is plummeting into recession, you’re generally going to see banks do less well,” he said.

Hunt said the effects of failing to raise the debt ceiling could be felt longer-term on Main Street.

“Wall Street will always come back. Main Street is always the lagging indicator. They’re the last to come back to the party,” he said.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.