The Growing Dependence on US Dollars Puts Eurozone’s Financial System at Risk
EUROZONE financial institutions are increasingly using US dollar markets for liquidity, creating risks to financial stability if US funding dries up, according to the European Central Bank.
US Dollar Repos Surge
The use of US dollar repos – a form of short-term lending secured by collateral such as US Treasuries – by eurozone banks has almost doubled in the past two years to 1.6 trillion euros (S$2.3 trillion), a ECB report published on Wednesday (Nov 20) showed. Greenback-denominated assets now accounts for 17 per cent of these institutions’ funding.
Banks and Non-Banks: A Stronger Link
At the same time, eurozone banks have significantly expanded their role as net providers of US dollar liquidity to the bloc’s non-banks, with volumes tripling over the past five years, the ECB said. The surge was led by transactions with investment and pension funds, though activity with other financial corporations also picked up recently.
Risks to Financial Stability
The growing dependence on US dollars and the stronger link between banks and non-banks pose risks to the eurozone’s financial system, according to the ECB. That’s because US wholesale funding tends to dry up in times of market turbulence.
“Such an environment might compromise the ability of financial institutions to fund their foreign currency investments, potentially leading to forced sales of US dollar-denominated assets, which would serve to amplify market shocks,” ECB’s Benjamin Klaus and Luca Mingarelli wrote in the report.
Mitigating Risks
The authors of the report suggest these risks can be mitigated by central banks providing US dollar liquidity through swap lines during periods of market stress. That happened in March 2023, when a monetary authorities including the Federal Reserve boosted liquidity in US dollar swap arrangements to tackle growing strains in the global financial system.
Conclusion
The growing dependence on US dollars and the stronger link between banks and non-banks pose significant risks to the eurozone’s financial system. It is essential for central banks to be aware of these risks and take steps to mitigate them, such as providing US dollar liquidity through swap lines during periods of market stress.
FAQs
Q: Why are eurozone financial institutions increasingly using US dollar markets for liquidity?
A: Eurozone financial institutions are using US dollar markets for liquidity due to the ease of access to funding and the relatively low interest rates.
Q: What are the risks associated with the growing dependence on US dollars?
A: The risks associated with the growing dependence on US dollars include the potential for US wholesale funding to dry up in times of market turbulence, compromising the ability of financial institutions to fund their foreign currency investments.
Q: How can central banks mitigate these risks?
A: Central banks can mitigate these risks by providing US dollar liquidity through swap lines during periods of market stress.
