Just when the sluggish economy had started to show some encouraging signs, the news of the U.S. hitting the debt ceiling of $14.29 trillion reared its head. There have been several debates on whether to raise the ceiling. But now the only way out seems to be a hike in the debt limit, or else what would follow would be "catastrophic economic consequences," as Treasury Secretary Timothy Geithner has warned.

The debt crisis has almost gobbled up economies such as Greece, Ireland, and Portugal. At the moment, it's staring us right in the face. And in case you think this debt demon would shy away from pouncing on the world's biggest economy -- you are being a bit too complacent. The U.S. budget deficit last year stood at 8.9% of gross domestic product. Standard & Poor's has already lowered its outlook for the U.S.' long-term credit rating to negative from stable, and the looming debt default poses a serious threat to its coveted AAA credit rating. While this is a huge concern, there are other problems gnawing at the edges.

The colossal debt burden is already projecting a negative image for the U.S., and this is prompting major foreign securities holders to trim their treasury holdings. China, the biggest foreign owner of U.S. debt, reduced its holdings by $9 billion in March, as compared to the previous month. This was a fifth consecutive monthly reduction.

Banks on the brink
Needless to say, almost all the industries would take a hit. One wrong move, and it could spell disaster. But at this point in time, the banking industry looks more vulnerable than others. The beleaguered American banks had somehow managed to keep themselves from collapsing during the ugly financial crisis. And now, when they are rebounding from the crisis, the possibility of the country defaulting on its debt raises an unavoidable question -- would the magnitude of the effects be a repeat of Lehman Brothers? Or something even worse?

U.S banks have been coming back strong after going through one of the worst phases in history. They are now focusing on declining provisions for loan losses. In fact, this has been a wide-ranging trend across the industry and has enabled both big banks such as Bank of America (NYSE: BAC) and Citigroup (NYSE: C) and regional banks such as BankAtlantic Bancorp (NYSE: BBX) and Hudson City Bancorp (Nasdaq: HCBK) to witness a significant improvement in their credit quality. Interest rates are at an all-time low at the moment and banks are reluctant to lend now.

If the U.S. defaults on its debts, interest rates will soar drastically and will hamper all commercial activities. Costs of credit ranging from business and consumer loans to home mortgages, auto financing, and credit cards would go through the roof. More importantly, a default would inevitably call for measures like cutting down on federal spending. Banks that buy bonds directly from the Federal Reserve, either to hold or resell to consumers, would take a severe hit, and this will subsequently cripple the whole economy.

The Foolish bottom line
But even if the U.S. manages to escape a default, which is more than likely to happen, the key question remains unanswered. How many times is the U.S. going to raise its ceiling? The massive public debt going out of control definitely remains a huge concern. In fact, as pointed out by JPMorgan, any delay in hiking the debt ceiling may have an adverse effect on the markets. Watch out, Fools.

Fool contributor Zeeshan Siddique does not own any of the stocks mentioned in the article.The Fool owns shares of Bank of America and also holds a short position in the stock in a different portfolio. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.