Euro zone banks may come under pressure if US dollar funding - the lifeblood of financial markets - were to dry up, the European Central Bank's chief economist Philip Lane said today amid concern over US President Donald Trump's policies.
Dollar funding fears have been at the back of central bankers' minds since Trump announced a wave of trade tariffs and began putting pressure on the Federal Reserve earlier this year.
Professor Lane said euro zone banks had navigated the turmoil well but could still find themselves in a tight spot given their significant exposure to the dollar, which accounted for anywhere between 7% and 28% of all their liabilities and 10% of assets in the second quarter of the year.
Any sudden changes in these net exposures could not be ruled out and could potentially limit banks' lending to the economy, he said.
"An increased probability of such a risk event would then generate pressures on both sides of banks' balance sheets and potentially downward pressure on on-balance sheet exposures like loans to the real economy," Lane added.
European banks typically borrow dollars from US banks and other financial institutions. This makes this form of funding less reliable in a crisis than deposits, which tend to move more slowly.
ECB supervisors have been telling banks to watch their dollar exposures and reduce any mismatch between their assets, such as loans, and liabilities - each bank's own borrowing.
Central bankers from outside the US have even toyed with the idea of pooling their dollar reserves to backstop banks in case the Fed were to withdraw its emergency swap lines.
But any such cooperation, as well as being politically difficult, was unlikely to suffice given the multi-trillion-dollar size of the international market for loans denominated in the US currency.
In a bid to avert a dollar squeeze, the Federal Reserve has kept swap lines with other central banks since the last financial crisis. These facilities essentially let commercial lenders outside the US borrow dollars from their own central banks when they cannot source them on the market.
Philip Lane noted that euro zone banks had built up their cash buffers in US dollars, with their liquidity coverage ratio, or LCR, rising from some 85% at the end of 2021 to well above 110% now.
A ratio above 100% indicates that a bank has enough high-quality, easily sellable assets to cover total net cash outflows over a 30-day stress period.
This allowed them to withstand pressure during the market gyrations in April, for example, when US Treasuries sold off at the same time as the dollar weakening, depriving banks of their usual hedge against any losses.
"Since the euro area banking system has made progress in increasing their USD LCRs in recent years...it did not experience sizeable liquidity strains even at the height of the exchange rate volatility in early April, though the episode may have altered the algebra of liquidity management for the remainder of the year," he said.
