WASHINGTON - The deadlock in Washington over how to avoid a government default increasingly threatens to strike another blow to Europe's ailing financial system because of the tremendous sum of Treasury bonds and other US debt held by banks across the Atlantic.

If the United States defaults and its top-notch credit rating is downgraded, European banks may have to add to the reserves they set aside as a safeguard because of the heightened risk they would lose money on the US bonds. European banks hold nearly $500 billion in US debt.

This demand for a larger buffer would come when many of the banks are under pressure to come up with enough capital in case of losses on bonds issued by Greece, Portugal and other European governments wracked by financial crises. A prolonged period of default by the US could trigger cascading bank failures that upend Europe's vulnerable financial system and in turn wreak even more damage in the US.

Investors have begun looking for a haven beyond the traditional financial centers in the US and Europe, sending the price of gold up to a record high on Monday amid fears that Washington will run out of money to pay all its obligations in two weeks. Gold has been up 10 days in row, increasing 1 percent on Monday to $1605.20 an ounce on the Comex futures exchange.

Major European stock indexes fell by more than 1.5 percent on Monday as European leaders continued searching for a response to the continent's fiscal problems.

In the US, stocks were also down, although less sharply, as investors grew increasingly concerned that President Barack Obama and Congress would fail to reach a deal to raise the borrowing limit before the Aug 2 deadline, confronting the government with a possibly catastrophic default.

Europe's banks held about $479 billion in US public sector debt as of the end of last year, according to the Bank for International Settlements. Much of that was in Britain and Switzerland, which do not use the euro. Among the 17 eurozone nations, French banks held $65 billion; Spanish banks, $27 billion; and German banks, $18 billion.

Not all of that is debt issued by the federal government. In its reports, the Bank for International Settlements includes, for example, bonds issued by US states or cities as part of the "public sector". But Treasury bonds and notes are a popular investment for financial firms, representing a large, liquid market of securities that carry what has been considered an ironclad guarantee of repayment.

Banks can hold top-notch securities such as US Treasury bonds with no "risk weighting" - that is, no impact on the amount of capital the firm has to hold. A credit downgrade could change that, forcing banks to suddenly set aside capital against those hundreds of billions of dollars in US government holdings.

Still, the impact could be limited if the US default is viewed by the markets as brief and any overdue payments are quickly made up. Many investors have been signaling, through the continuing flow of money into Treasury securities and the low interest rates they command, that they think the US government will pay its debts with any interest due.

Unless there is "objective evidence of impairment we do not think that a downgrade of the US will have a significant impact", said Eleonore Lamberty, an analyst with ING.

That contrasts with the immediate repercussions after credit rating companies downgraded Greece, Portugal and Ireland. Those events directly threatened the ability of banks inside the 17-nation eurozone to get the short-term European Central Bank loans many rely on to operate.

A US downgrade would not affect the ability of any of those banks to borrow because the ECB only accepts securities denominated in euros as collateral for its loans. The Swiss central bank also does not accept dollar-denominated collateral. The Bank of England does, but under its rules it would take a cataclysm - a collapse of dollar-denominated capital markets - for it to exclude US Treasury securities as bank collateral.

The threat that Greece or other European countries could prove unable to pay their bills has kept markets on edge for more than a year and a half and threatened to undermine the much larger economies of Italy and Spain. The resolution of Europe's economic problems is vital for the global economic recovery.

A series of European summits continues this week amid efforts to craft a second round of rescue loans for Greece and a dispute among top European leaders over who should bear the cost for that bailout.

German Chancellor Angela Merkel has said she will attend a summit on Thursday on the Greek rescue program only if an agreement on terms is reached beforehand. She is demanding that private investors help Greece out of its financial jam. That position puts her at odds with ECB President Jean-Claude Trichet, who is worried that Greece could be declared in default if banks and others take losses on their holdings of Greek bonds.

The Washington Post