Why U.S. Banks Have Little to Fear from Sovereign Debt Downgrade

The downgrading of U.S. government debt by Standard & Poor's Friday evening is a grim milestone in the history of American finance—and one that will be parsed in excruciating detail in coming days—but the ultimate practical impact on financial institutions seems likely to be minimal in the short term. The reasons are many.

The downgrade of the U.S. sovereign debt from AAA to AA+ "will not change" the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government or government agencies,” the Federal Reserve, Federal Deposit Insurance Corp. and other federal banking regulators said in a statement.

"The treatment of Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities under other federal banking agency regulations, including, for example, the Federal Reserve Board's Regulation W, will also be unaffected."

Other reasons that the impact on U.S. banks appears likely to remain muted: No U.S. banks are themselves rated AAA and thus do not risk automatic downgrades as a result of today’s move; the financial troubles of the U.S. government and government sponsored enterprises are already well-known to investors and factored into debt prices and yields; other leading ratings agencies Moody’s and Fitch have not followed suit; the downgrade was signaled three months ago when S&P declared its long-term outlook on U.S. government debt “negative”; interest rates are near record lows and unlikely to rise appreciably as a result of the ratings cut; S&P cut Japan’s sovereign rating to AA- in January, yet its government remains able to borrow at some of the world’s lowest interest rates with a debt-to-GDP ratio that is more than double the U.S. level; the credibility of ratings agencies

have been severely undermined by their failure to accurately rate housing-related securities.

Such qualifiers aside, U.S. bankers have plenty to worry about these days. As my colleague Jeff Horwitz wrote earlier, investors have been rendering a harsh verdict on banks throughout the past week, with a particularly gloomy outcome for the likes of Bank of America and Citigroup.

Sum it up and S&P tonight declared what the financial markets have known for a long time: America's financial house is in a lousy, but not a crisis-level, condition. How that affects its government and banks will ultimately be determined by how well the nation tackles the problem — not by the self-evident declarations of a highly fallible, largely discredited and severely weakened ratings agency.

What effect do you think the U.S. debt downgrade will have on banks? Share your comments below.