Threat to Banks

A major risk to banks is internal control weakness on the part of firms to whom they lend funds. A lack of organizational control including but not limited to control over financial reporting has been found to increase the risk of external financing (Kim, Song & Zhang, 2008). Firms with such weaknesses are more likely to default on loans. Even though many banks are attempting to combat the potential weaknesses with the imposition of higher rates and requiring additional collateral, it remains likely that control issues will lead to unexpected defaults.

Another threat to banks is their reliance on the value of municipal bonds in their portfolios. Municipal bonds have been considered a safe investment and nearly immune to default, but that may change with the expected fallout from the impending debt ceiling crisis. If the United States defaults on its obligations it is quite likely that the country's credit-worthiness could be downgraded which would lead to higher interest rates being charged to the United States and its municipalities and lower interest rates being paid by the United States to hold those debts. This would render the municipal bonds currently being held by the banks as essentially worthless due to their lesser interest rate payment (Harding).

References

Barba, R. (July 28, 2011). Banks Brace for Default Fallout, Credit Quality Hit. American Banker. Retrieved July 30, 2011 from

http://www.americanbanker.com/issues/176-146/banks-brace-for-default-fallout-1040702-1.html

Harding, J. (July 29, 2011). Boehner Bill Passes House; Senate Says No. Retrieved July 30, 2011 from

http://dailycapitalist.com/2011/07/29/boehner-bill-passes-house-reids-move/

Kim, J.B., Song, B.Y. & Zhang, L. (2008). Internal Control Weakness and Bank Loan Contracting; Evidence from SOX Section 404 Disclosures. Retrieved July 30, 2011 from http://ssrn.com/abstract=108049