Regional banks are taking hits this week and investors are increasing their bearish bets on the sector. I’ll break down the perceived problem with the industry and whether there is a buying opportunity or more downside ahead. And how to lower your risk by making the potential trade with options. The SPDR S & P Regional Banking ETF (KRE) , traded 155,647 put contracts Wednesday, more than three times the 20-day average volume. The fund’s objective is to replicate the equal-weight S & P Regional Banks Select Industry Index which has underperformed the S & P 500 by more than 18% year-to-date after falling nearly 5% Wednesday. KRE YTD mountain SPDR S & P Regional Banking ETF (KRE), YTD Higher inflation and rising interest rates can pose significant challenges to businesses and individuals alike, but the challenges inflation and higher short-term rates pose for the financial health and operational dynamics of regional banks is particularly significant. Higher rates impact Higher interest rates increase the cost of borrowing money. Regional banks borrow money via deposits, so higher interest rates mean they must pay more to attract them, a problem felt more acutely by regionals than “too big to fail” money center banks which may be perceived as “safer” and consequently may be able to attract deposits at lower rates. As banks typically rely on these deposits to fund lending activities, higher rates squeeze their net interest margin (NIM), which is the difference between the interest income generated by lending and the amount of interest paid out to depositors, relative to the amount of their assets. Higher interest rates can also reduce demand for loans, as borrowing becomes more expensive for consumers and businesses. This can slow down the growth of a bank’s lending operations, a primary source of revenue. Moreover, existing adjustable-rate loans may see higher default rates as borrowers struggle with increased payment burdens. As inflation increases the cost of living and operating a business, borrowers may find it more difficult to meet their loan obligations, leading to a higher risk of loan defaults. This can deteriorate the asset quality of regional banks, increasing the need for loan loss provisions, which are expenses set aside to cover potential loan losses. Banks assets are typically portfolios of loans and securities, including government and corporate bonds, as part of their assets. Rising interest rates decrease the market value of fixed-income securities. As the market value of their assets drop, this results in unrealized losses. Banks are able to apply accounting rules to portions of these assets that are designated as “held to maturity” such that unrealized losses on those assets aren’t recognized for accounting purposes, but even if the bank doesn’t need to sell the securities to satisfy other liabilities, or mark them to market, investors will likely recognize that the true value of the banks assets may have declined materially. Rising interest rates and inflation can pressure banks’ capital adequacy ratios, a measure of a bank’s capital relative to its risks. Increased loan loss provisions, potential write-downs on securities, and other factors may reduce a bank’s capital, necessitating measures to bolster capital reserves to meet regulatory requirements. The need to bolster reserves can further hamper a bank’s ability to lend. Regional banks also tend to have larger exposure to commercial real-estate lending. What form of commercial exposure certainly matters. Multi-family rental buildings are seeing high demand, but commercial office space emptied out during the pandemic and has not recovered to pre-pandemic levels, and in some areas hasn’t recovered at all. The trade Banks are, by their nature, leveraged institutions. The equity market capitalization of a regional bank is generally a fraction of the size of its balance sheet. Consider Zions Bancorp — which I selected at random — which has a $6 billion equity market cap compared to an $87 billion balance sheet of which about $13.3 billion is commercial real-estate loans and about $10.4 billion is held-to-maturity securities and about $21.4 billion is other commercial loans. A 10% shift in the value of any of those assets is material relative to the bank’s equity market capitalization. The largest trade we saw on Wednesday was a purchase of 10,000 June 45 puts for 1.54/contract. This represented an outlay of $1.54mm in total premium, as each contract represents 100 shares. While one can certainly buy puts to make bearish bets, KRE would need to fall below $43.46 for the buyer to see profits, a decline of another 7.4% or more from Wednesday’s closing price. Because this trade requires a big move lower, it is relatively low-probability, and may represent a hedge. As an alternative, those who prefer to sell options premiums might consider selling an upside call spread instead betting that pressure will cap a near-term recovery in the space. The trade Sold May $49 KRE call Bought May $50 call As of Wednesday’s close, the KRE May $49/$50 call spread could be sold for ~$0.32/contract 32% of the difference between the strikes. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. 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