Here's What Banks Are Doing In Preparation For The Doomsday Scenario

us treasuryThe U.S. Treasury building in DC.

Photo: Addy Cameron-Huff

Alec Phillips, a political economist at Goldman Sachs, warned clients on a conference call on Wednesday that financial sector banks might have higher capital requirements if Treasuries are downgraded.To bankers, a default coupled with higher capital requirements is the “doomsday scenario” we spoke about yesterday. Now we have a better indication of what they’re doing to prepare.

Alec said he didn’t want to be too specific, but that under Basel I and Basel II, there wouldn’t be much of an effect on financial sector banks in the event of a default (because there’s 0 risk to anything AA and above), but under Basel III on the other hand… He said effectively:

The complicated factor comes in with some of the larger firms, there could be a slight uptick in the calculated capital required to be set aside related to holdings. But a very minor change in capital requirements.

(Click here to see a summary of the call.)

And today, the Wall Street Journal says that “according to one banking industry representative, there are indications banks are beginning to take steps to adjust their holdings of Treasurys to prepare for the possibility of default.”

So it sounds like banks are preparing to dump Treasuries in the event of a default, because ratings agencies have indicated that they will downgrade the U.S. if there is a default. In fact, they’ve said that ratings agencies might downgrade the U.S. to AA within 90 days even if there isn’t a default. If there’s isn’t a “credible” plan, S&P says it will downgrade the U.S. (long-term only) to AA.

But of course there’s a good change they won’t. If the U.S. avoids a default, there would be no need. And even if the U.S. does get a downgrade, the WSJ says “it’s unclear whether regulators would require banks to raise capital against Treasurys in the case of default. Most observers believe regulators wouldn’t do this, but regulators haven’t said.”

Also because if they dump them, what’s left to buy?

And people seem to be criticising the ratings agencies for saying that they would downgrade the U.S., so perhaps they’ll backtrack. Also on the Goldman conference call, Former Senator Judd Gregg said, “The ratings agencies put themselves in a corner that’s foolish. I’ve always found them to be incredibly naive about the political process. To be so definitive is foolish.”

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