Doomday Planning: How Big Banks Prepare for a Potential U.S. Debt Default

Sunday - June 11 2023, 22:04 UTC - 1 year ago

Big banks and financial regulators are preparing for potential default on U.S debt through convening war rooms, planning speedy bailouts and raising house-on-fire alarm bells. Preparations include reducing exposure to Treasury securities and buying credit default swaps to hedge their exposure to a sell off.

Convening war rooms, planning speedy bailouts and raising house-on-fire alarm bells: Those are a few of the ways the biggest banks and financial regulators are preparing for a potential default on U.S. debt. "You hope it doesn’t happen, but hope is not a strategy – so you prepare for it," Brian Moynihan, CEO of Bank of America, the nation’s second-biggest lender, said in a television interview. The doomsday planning is a reaction to a lack of progress in talks between President Joe Biden and House Republicans over raising the US$31.4 trillion debt ceiling – another round of negotiations took place on May 16, 2023. Without an increase in the debt limit, the U.S. can’t borrow more money to cover its bills – all of which have already been agreed to by Congress – and in practical terms that means a default. What happens if a default occurs is an open question, but economists – including me – generally expect financial chaos as access to credit dries up and borrowing costs rise quickly for companies and consumers. A severe and prolonged global economic recession would be all but guaranteed, and the reputation of the U.S. and the dollar as beacons of stability and safety would be further tarnished. But how do you prepare for an event that many expect would trigger the worst global recession since the 1930s? .

Preparing for panic .

Jamie Dimon, who runs JPMorgan Chase, the biggest U.S. bank, told Bloomberg he’s been convening a weekly war room to discuss a potential default and how the bank should respond. The meetings are likely to become more frequent as June 1 – the date on which the U.S. might run out of cash – nears. Dimon described the wide range of economic and financial effects that the group must consider such as the impact on "contracts, collateral, clearing houses, clients" – basically every corner of the financial system – at home and abroad. "I don’t think it’s going to happen — because it gets catastrophic, and the closer you get to it, you will have panic," he said. That’s when rational decision-making gives way to fear and irrationality. Markets overtaken by these emotions are chaotic and leave lasting economic scars.

Banks haven’t revealed many of the details of how they are responding, but we can glean some clues from how they’ve reacted to past crises, such as the financial crisis in 2008 or the debt ceiling showdowns of 2011 and 2013. One important way banks can prepare is by reducing exposure to Treasury securities – some or all of which could be considered to be in default once the U.S. exhausts its ability to pay all of its bill. All U.S. debts are referred to as Treasury bills or bonds. The value of Treasurys is likely to plunge in the case of a default, which could weaken bank balance sheets even more. The recent bank crisis, in fact, was prompted primarily by a drop in the market value of Treasurys due to the sharp rise in interest rates over the past year. And a default would only make that problem worse, with close to 190 banks at risk of failure as of March 2023. Another strategy banks can use to hedge their exposure to a sell-off in Treasurys is to buy credit default swaps, financial in­struments that pay out in the event of a default. That could provide some protection against losses from a sell-off.