The "Next Really Big Risk" to Banks

The next really big risk to banks is already upon us -- or at least, that's what the chief executive officer of Zions Bancorp claimed in a speech earlier this month:

By our calculations ... we believe that even at this point in time, even as we've seen some back up in the 10-year rate and it's done some damage over the last few months, that if you got a 2% parallel shift across the yield curve, that has the potential to erode just short of 20% of the equity in the industry given the size of those portfolios. And that kind of impact, we think, is -- it could do the kind of damage that will have everyone out scrambling to raise capital.

If that didn't disturb you sufficiently, here's a chart Zions included to illustrate the point:


Source: Zions Bancorp.

As you can see, depending on the increase in interest rates, the Utah-based regional bank estimates that tangible common equity in the industry will fall anywhere from 11% if rates move up by 100 basis points, to over 25% if rates rise by 300 basis points.

Needless to say, this is a pretty scary scenario given what it portends about further dilution in the banking industry. But is it true?

While I'm not privy to Zions complete analysis, it appears to be predicated on two things.

First, as its CEO rightly points out, many of the nation's largest banks have considerable exposure to mortgage-backed securities, the value of which is inversely correlated to long-term interest rates -- as rates go up, MBS values go down. When this happens, capital is eroded by debits to "other comprehensive income," which is a line item in the equity portion of a bank's balance sheet.

The banks that Zions seems to believe would be most affected by this are SunTrust Banks and Regions Financial , both of which hold significant amounts of MBSes relative to their portfolios of earning assets. You can see this in the chart below, which is also from Zions' presentation.

Source: Zions Bancorp.

But here's the catch -- and this is the second thing Zions' analysis appears to be predicated on -- Zions seems to assume that these banks haven't hedged their MBS exposure.

In my opinion, this is a dubious assumption at best. In SunTrust's case, for example, it has a total of $142 billion in notional derivatives outstanding, most of which are for hedging purposes. Regions, meanwhile, has notional derivatives exposure of $90 billion -- again, these are intended to hedge against, among other things, changes in interest rates.

Given this, is it possible that the entire industry (including SunTrust and Regions) didn't foresee a rising interest rate environment, and therefore decided against hedging their balance sheets? Sure. But is it probable? Not in my opinion.

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The article The "Next Really Big Risk" to Banks originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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