The Biden administration has until June 1st, so that the US does not end up in default, which in turn will bring a series of “chain” reactions that will cause a global economic shock. And the reason is very simple: American banks are “loaded” with government bonds and may collapse if the debt ceiling is not resolved and the possibility of bankruptcy in the USA is not avoided.
Especially since there has been a large outflow of deposits in the US recently. Deposits at US banks fell by more than $360 billion in the three weeks to April 26, according to seasonally adjusted Federal Reserve data released on Friday, May 5, 2023.
This means that there is an ongoing crisis of confidence of American citizens towards the country’s banking system. It is noted that their footprint in the US Treasury market, amounting to 24 trillion dollars, has quadrupled in the last two decades, to 4 trillion dollars as of March!
Therefore, the main buyers of Treasurys are US banks, which profit from “risk-free” assets. Banks do not need to hold extra capital to cover potential losses as US bonds have been considered a “collateral” since WWII and after when the US became the world’s dominant military, political and economic power.
It is worth saying that the regulatory authorities consider the sovereign debt to have a risk weight of “0%”. But now the possibility of no deal in Washington to raise the federal government’s $31.4 trillion borrowing limit could bring economic chaos.
Because “default” means that government bonds suddenly become “junk”. Even if things are restored the damage will have been done. Trust will be lost.
Now anyone who buys a US government bond will think that he might not get his money. At a time when US regional financial institutions are struggling to hold on to their deposits, there is a question of US bankruptcy!
At the same time, they are trying to avoid forced sales of assets whose prices are falling as the Fed raises interest rates rapidly. Market anxiety can be seen in short-term bond yields.
The yield on one-month notes was around 5.53% on Friday, while the yield on three-month notes had settled at 5.17%, according to FactSet. While banks are encouraged by regulators to hold short-term bonds for liquidity needs, any holder forced to sell those securities in a volatile market could face painful losses.
Furthermore, a US default would make most banks vulnerable to failure, particularly if risk weights on Treasurys rise from zero where they are now.
For example, if there is a 4% surcharge on bonds worth 4 trillion. of dollars held by banks in the US, about $160 billion would need to be raised to offset the exposure to the debt securities. This amount will increase to $320 billion based on a maximum charge of 8%.
The US credit rating is currently in the triple A category, with only S&P Global downgrading its credit rating by one notch to AA+ in 2011 due to fears, again, about the debt ceiling.