FORTUNE — Here’s yet another risk the Federal Reserve might want to consider as it exits its bond buying program: Could the growing rout in emerging markets create a financial crisis back home?
Rising interest rates in the U.S., sparked by indications that the Fed may slow its bond buying, have translated into a summer of pain for emerging markets. India’s rupee has plunged 20% against the dollar since May. And Turkey’s lira is down 15%. Stock markets in both countries have taken hits as well. Brazil’s stock market, too, long a darling of Wall Street, is down 20% this year.
Right now, bank investors don’t seem too concerned. Shares of bank stocks have fallen 4% in the past month as the situation in emerging markets has gotten worse. But investors often stay in denial long after they should. “In general, bank investors haven’t been overall concerned,” says Credit Suisse analyst Moshe Orenbuch, who follows bank stocks. “If all of a sudden one of these markets explodes then everyone will be rushing to look at exposures.”
In early June, bank analysts in JPMorgan Chase’s London office wrote a report titled “Fed Tapering: Who is Afraid of EM [emerging market] Selloff? We Are!” The report said that rising interest rates would dramatically slow bond sales in emerging markets and work for the big banks. The report was focused on the European banks and said that British banks Standard Charter and HSBC stand to lose the most business.
In the U.S., that bank could be Citigroup (C). According to the bank’s most recent earnings presentations, Citi generated nearly half of all its earnings in the emerging markets. Already a number of banks say they’re pulling back from Brazil, where a number of Wall Street firms, including Goldman Sachs (GS), had ambitions plans to expand just a few months ago.
But what really drives financial crises, or shocks in the market on fears of them, is not lower revenue, but how much banks could lose if those markets continue to tumble. Figuring out that number can be tough.
Banks do disclose in the notes to their financial statements how much money they could lose, either because of investment or loans, by country. They only disclose that figure for countries where they have significant holdings or lending operations. And they generally don’t tally up all the exposures they have to emerging markets around the world.
Morgan Stanley (MS), for instance, says in its financial statements it could lose as much as $4.6 billion if all its bets and loans in Brazil went bad, and another $3 billion in China. But those figures are after hedges and adjustment. Ignore those — hedges don’t always work like they should, just ask JPMorgan’s London Whale — and Morgan Stanley’s worst case Brazil scenario looks more like $17 billion in losses, according to figures from the Federal Financial Institutions Examination Council. In South Korea, the bank could lose $10 billion, according to the same government stats. South Korea isn’t one of the nations that Morgan Stanley highlights in its own financial statements. Add all those potential losses up, and emerging markets sound like something Morgan Stanley investors should be watching. Losses in those three markets alone, again in the worst case scenario, could put a significant dent in the bank’s overall capital of $66 billion.
In its financial statements, JPMorgan Chase (JPM) includes China, Brazil, India, and Malaysia among the countries where it says it has the biggest exposures. The bank says it could lose slightly more than $50 billion in those four countries, or about a quarter of its total capital.
As of the end of last year, Citi said its potential losses in the emerging markets were minimal even in a worst case scenario. It put its total exposure to Brazil and India at $6.2 billion. But, again, that’s after hedges. Go back to the government’s figures, and total outstanding investment in those two countries is more like $54 billion, which if it all went bad would wipe out a third of Citi’s capital.
And that’s not all the money banks could lose in emerging markets. In its most recent quarter, Goldman Sachs said based on the bets it makes in in the currency markets and trades it executes for clients, the firm could lose as much as $26 million in foreign exchange markets a day. That’s less than $59 million it could lose a day buying and selling investments, like bonds, that fluctuate with interest rates. But it’s not nothing. If Goldman were to hit its maximum losses on half of the days in the quarter, and break even on the rest of the days, that could cost the bank $780 million, or roughly 40% of what it earned in the entire fourth quarter.
The good news is that few people see us headed for a major emerging market blowup. Most strategists believe the most likely scenario is a gradual slowdown in China and other markets, at a time when developed nations like the U.S. are starting to grow faster again. Brazil could be stuck in slow growth mode. The situation in India might be the toughest to resolve, but again, few are talking default. And that’s what will likely happen. The bad news, though, is that there will also likely be days in the coming months and year, when investors are too nervous to remember that.