Euro zone banks should prepare for risk of dollar squeeze, ECB says

FRANKFURT (Reuters) -Euro zone lenders with big dollar businesses should bulk up their liquidity and capital cushions to withstand any squeeze in a U.S. currency made more volatile by President Donald Trump's actions, the European Central Bank said on Wednesday.

The ECB has been telling banks to watch their dollar exposure since Trump's tariffs and his pressure on the Federal Reserve rattled confidence in the world’s reserve currency in the spring.

In the ECB's latest Financial Stability Review, the message sharpened: the handful of large euro zone banks active in dollars need to prepare.

"Capital headroom could be needed to absorb ... higher currency volatility and counterparty credit risk," the ECB said in the twice-yearly report. "Banks should hold liquid U.S. dollar assets to counterbalance outflows and act as a stabilising intermediary."

The FSR, compiled by the ECB’s financial stability experts, does not amount to binding recommendations for the banks under its supervision. However, it underscores the depth of policymakers' concern over dollar liquidity.

"Dollar outflows in an extreme scenario could exhaust their capacity to raise cash through repos, FX swaps and the sale of such assets," the ECB said, without spelling out what one such scenario would look like.

One nightmare scenario — not spelled out in the review — would be the Fed shutting its emergency liquidity line to the ECB, removing a backstop banks have relied on since the financial crisis.

ECB VP PLAYS DOWN RISK

Sources have told Reuters some central bank officials had even been thinking about pooling dollar and gold reserves outside of the United States to prepare for such risk.

ECB Vice President Luis de Guindos played down this risk, emphasising that those swap lines are key to keeping markets calm both in the United States and Europe.

"We do not have any sort of information with respect to the modification of the present situation, with respect to swap lines," he told a press conference as he presented the FSR.

"These bilateral swap lines between the Federal Reserve and the ECB are very important factors to keep financial stability in place on both sides of the Atlantic."

New York Fed President John Williams also said earlier this month the swap lines were good for both the United States and its counterparts.

The ECB said dollar operations are concentrated among the bloc’s global heavyweights. These are BNP Paribas, Deutsche Bank, Credit Agricole, Groupe BPCE and ING, Banco Santander and Societe Generale.

The business typically includes borrowing on U.S. money markets to finance hedge funds or selling foreign exchange (FX) swaps to insurers, funds and corporates hedging their dollar exposure.

To offset their own currency risk, these banks often take the opposite side with global lenders via swaps that rarely show up on balance sheets.

"Rolling over these positions can become challenging during periods of stress in FX swap markets," the ECB said.

For now the ECB sees only a "limited" mismatch between dollar assets and liabilities, with some banks using repurchase agreements (repos) to align maturities. But it warned these strategies "do not fully eliminate liquidity risk".

Euro zone banks held 681 billion euros ($788.53 billion) in dollar securities and lent the equivalent of 712 billion euros in the U.S. currency as of the end of last year, ECB data shows.

($1 = 0.8636 euros)

(Reporting by Francesco Canepa and Balazs Koranyi; editing by Mark Heinrich and Ros Russell)