U.S. Debt Default: Avoiding Shock to Our Financial Institutions and Small Businesses

By SBE Council at 24 May, 2023, 3:37 pm

By Karen Kerrigan – 

The recent, but very limited, regional bank crisis understandably raised concern among certain swaths of the small business and consumer community. As regulators sift through the damage, our government leaders need to support policies that strengthen the industry’s competitiveness and resiliency, especially during this period of uncertainty. Similarly, lawmakers must avoid further shocks that would rattle the financial community – that means they need to find a solution to the upcoming debt limit. A potential default would work against this critical industry, which would have an immediate impact on the economy and small businesses.

Protecting the American banking system should be the top priority for our elected leaders as the country inches closer to default. U.S. Treasury Secretary Janet Yellen noted that a breach of the debt limit would be “completely devastating” to the banking industry. It’s a warning to Wall Street, Main Street, and Congress that the foundation of our capital and lending markets are most at risk.

That’s because for many U.S. banks, one of the largest holdings they have is in long-term treasury bonds, which have been historically considered one of the safest investments in the world, and are highly liquid. But that safety and security are at risk if the White House fails to raise the debt ceiling, thereby allowing America to default on our financial obligations.

If the country’s 247-year record of fiscal responsibility was tarnished, investors would immediately demand higher interest rates on Treasury bonds. No longer would U.S. debt be considered “risk-free” and investors would expect a higher return commensurate with their now-increased risk. For American banks with large holdings in outstanding Treasury bonds, the effects are obvious. Much of their investments stored in what are no longer “risk-free” U.S. Treasury bonds would be lost, resulting in a significant strain on the banks’ balance sheets – potentially causing depositors to panic.

We have all seen what this did to Silicon Valley Bank (SVB), which saw its investments in Treasury bonds decimated as interest rates were raised to combat inflation. The effect of a government default on America’s banking system could be much larger than what happened to SVB (which largely generated its own demise through mismanagement and denial). Shockwaves would reverberate throughout the entire financial system.

The stock market, outstanding bonds, and the entire economy would certainly feel the after-effects of a default, and quite rapidly. Once-safe Treasury bonds would quickly lose value, the stock market would slump, and depositors would be looking to protect what was left of their savings and investments. For America’s banking system, the effects would be ugly, as balance sheets go underwater and panicked depositors question whether deposits are still safe.

Although small businesses and startups have increased their use of alternative methods for obtaining capital in recent years, banks remain a significant source of funding. Regional and community banks are particularly important to local businesses and a fallout triggered by debt default would impose enormous strains on this ecosystem. These financial institutions support regional and local communities by offering credit, lending, and depository services. Again, a shock to these institutions would immediately ripple through to local businesses and economies.

Democrats and Republicans must keep working at a solution. There is a clear path forward that will benefit the American people in both the short and long term: raising the debt ceiling and implementing responsible fiscal reforms. By taking these steps, which most Americans view as reasonable, the White House and Congress can assure economic stability during a period of high uncertainty given other challenges – such as relentless inflation and a potential recession.

The White House must be doing all it can to assuage concerns of a potential default, and should use the opportunity to implement policies that would restore stability to the bond market. Important steps that can help to mitigate challenges to our banking system in the short-term while also restoring full calm to promote economic growth and stability for the long-term.

At this important time for the future of our nation’s economy, elected officials should be looking for opportunities to restore healthy growth and secure the fiscal future of the country. The good news is that “both sides” are at the table in an effort to find a solution, now they need to get the job done to implement reasonable solutions for the American people.

Karen Kerrigan is President and CEO of the Small Business & Entrepreneurship Council.