The largest banks of Europe received a clear warning message from the European Central Bank, ECB, do not assume that the US dollar will remain calm, a monetary storm is coming, and make sure you have the required liquidity in case it does not.
This message is recorded in the latest Financial Stability Review of the ECB, and although these semiannual reports are usually filled with cautious language, this one does not mince its words.
With the dollar becoming more unpredictable, partly due to the political turmoil around Donald Trump and the pressure on the Federal Reserve, the ECB states that some lenders of the eurozone must strengthen their reserves now, not later.
Why the ECB is worried about the dollar
The ECB has for months been dropping hints, urging banks to monitor their dollar exposure as global markets are shaking.
But this time the tone changed. The report of the Fed warns that banks handling large dollar transactions may need additional capital and liquidity to withstand periods of intense volatility.
Put simply, if the dollar market unexpectedly tightens, these banks must remain able to continue lending, transacting and operating, even if funding from elsewhere dries up.
Liquid assets in dollars
The ECB states that banks must hold more liquid dollar assets so they can cover sudden funding gaps and act as stabilizers if markets display unpredictable turbulence.
This matters because eurozone banks rely on repos and swaps in the foreign exchange market to access dollars.
If these taps of dollar supply close, the monetary pressure may come very quickly.
The nightmare scenario no one wants to know
The report avoids describing exactly what a severe stress scenario would look like, but people in the banking market have been whispering for months one possibility,
What would happen if the Federal Reserve cut the emergency dollar swap line with the ECB?
This liquidity safety line in dollars, created during the 2008 financial crisis, provides the ECB with access to dollars when global markets freeze.
Losing it would be a major shock, forcing banks to chase liquidity at the worst possible time for financial markets.
Dollar and gold reserve
According to Reuters, some central bankers have even proposed creating a joint reserve of dollars and gold outside the US as an emergency plan.
Nevertheless, Luis de Guindos tried to calm the rumors, telling journalists that there is no indication that the Fed plans to change anything, while John Williams, President of the New York Fed, has given similar assurances.
Dollar activities within the eurozone are concentrated in a few major financial groups,
1) BNP Paribas
2) Deutsche Bank
3) Crédit Agricole
4) Groupe BPCE
5) ING
6) Banco Santander
7) Société Générale
These banks borrow dollars from American markets to finance hedge funds and other clients, and they sell FX swaps to European insurers and companies hedging their dollar risks.
To hedge this risk, they often take the opposite side with international banks, transactions that do not always appear clearly on balance sheets and may be disrupted when conditions are not calm.
At the end of last year, eurozone banks held 681 billion euros in dollar securities and had issued 712 billion euros in loan claims also in dollars, totaling slightly under 1.4 trillion, according to ECB data.
The central bank insists that the asymmetry between dollar assets and liabilities remains limited.
But it also warns that even the best liquidity strategies do not fully eliminate the risk.
In other words, translated from central bank language, if the dollar market freezes, some banks may feel the shock very quickly and financial panic may be triggered.
The alternative scenario
European financial stability officials are discussing the possibility of creating an alternative solution to the dollar provision programs of the Federal Reserve, pooling dollars held by non-US central banks in an attempt to reduce their dependence on the US under the Trump 2.0 administration, according to five officials with knowledge of the matter, as reported by Reuters.
These discussions, revealed here for the first time, are a reaction to the policies of President Donald Trump, which have overturned long-standing ties, have cast doubt on the independence of the Fed, and have highlighted the dominant role of the US in the global financial system.
The use of the monetary weapon
Interviews with more than a dozen European central bankers and supervisory officials highlight their concern that these monetary tools could be used as a weapon by the Trump administration.
They said concerns peaked in April, when the Liberation Day tariffs of Trump on imports shocked the global financial system and revealed weaknesses in banks’ funding plans.
Concerns have since eased, partly due to reassurances from the Fed, officials said. Jerome Powell, head of the Federal Reserve, stated at a conference organized by the European Central Bank in July that the Fed does not intend to change the way it provides dollar liquidity to other official institutions.
Kush Desai, spokesperson for the White House, said that Trump had reiterated his commitment to maintaining the strength and power of the dollar.
Representatives of the ECB and the Fed declined to comment.
The limitations of protection mechanisms
Some sources said that pooling dollar reserves would face practical difficulties and may not be sustainable.
However, discussions continue at staff-level (not top ECB policymakers) and involve central banks both inside and outside the eurozone, four officials with direct knowledge said.
One said that some national central banks of the region are pushing in this direction.
Other countries have already tested joint support mechanisms.
ASEAN, together with China, Hong Kong, Japan and Korea, pooled resources to help members through the Chiang Mai Initiative.
Asked in July about the risks of financial fragmentation, Kazuo Ueda, then Governor of the Bank of Japan, referred to the initiative, which has been operating since 2014 and has reached 240 billion dollars.
“It is important to continue a multi-layered approach on issues such as swap lines. Doing something similar, or continuing something similar, would be important,” he said.
In Europe, however, several officials said the initial analysis of the viability of such a common pool was not encouraging.
Although non-US central banks collectively hold hundreds of billions of dollars, this does not compare to the bottomless resources of the Fed as the issuer of the global reserve currency.
Pooling reserves could help during episodes of instability, but it could hardly contain a generalized market turmoil, they said.
Additionally, such an effort would face accounting and political challenges.
A senior central banker told Reuters that even the suspicion that the Fed might stop swap lines could itself trigger widespread pressure on the global financial system.
In such a case it would be difficult for a central bank to justify providing its dollar reserves to third parties.
European officials are also considering other measures to strengthen resilience, such as increased scrutiny of banks.
This includes requiring banks to prepare plans to find dollars in other markets, such as Asia and the Middle East, as well as stress testing, two eurozone bank executives said.
One of the officials involved in the discussions said that the issue of resilience without dependence on the US is raised at every meeting between central banks.
The extreme scenario may happen
Demand for dollars rises during market turmoil and shortages can worsen the problem.
The Fed facilities not only mitigate this but also serve broader US interests.
By providing dollar liquidity, the Fed ensures that instability abroad does not turn into full-blown crises that could also affect the US itself.
Use of swap lines peaked at 449 billion dollars during the COVID-19 pandemic in 2020.
At a meeting of the ECB Governing Council, Klaas Knot, then head of the Dutch central bank, raised the issue of dependence on swap lines as part of a long list of possible risks, an official said.
Knot was also Chair of the Financial Stability Board at that time.
The discussion on finding an alternative has continued among European officials responsible for financial stability, including the ECB and several central banks, five sources with direct knowledge said.
One said they worry about what will happen when Powell’s term ends in May.
Trump has stated that he may choose the next Chair by the end of the year.
One of the interlocutors said that European officials must consider the worst-case scenario.
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