Geopolitical Uncertainty Could Challenge Euro Area Banks' Forex Funding

Impact of Geopolitical Turbulence on Banking

FRANKFURT, Jan 22 (Reuters) - Euro area banks might find it hard to finance themselves on the market, particularly in U.S. dollars and other foreign currencies, if high geopolitical uncertainty persists, the European Systemic Risk Board warned on Thursday.

Historical Context of Geopolitical Shocks

The ESRB report came just as tensions between Europe and the United States escalated this week over U.S. President Donald Trump's designs to take over Greenland, a semi-autonomous part of the Kingdom of Denmark.

Effects on Bank Borrowing and Funding

Looking at history, the European Union's top financial risk watchdog found that geopolitical shocks tend to reduce banks' borrowing on the wholesale market, particularly in foreign currencies.

Credit Supply Tightening Trends

This is likely due to the international funding market becoming more expensive at times of stress, as buyers of bank bonds and other such instruments turn more averse to risk.

"Looking ahead, a sustained period of uncertainty may test the limits of absorption of bank market wholesale funding, especially for instruments denominated in foreign currencies," the ESRB said. 

Specifically, the study found a trade-policy uncertainty shock led to a reduction of around 5 percentage points in wholesale funding issuance denominated in U.S. dollars and other currencies excluding the euro.

Banks also reduced their borrowing of foreign currencies in the face of rising geopolitical risk and economic policy uncertainty -- by 2 and 6 percentage points respectively.

The analysis also showed that sales of bank bonds and covered bonds were more stable following these shocks, while funding through asset- and mortgage-backed securities, as well as short-term debt, was more vulnerable. 

Finally, the study found banks tend to tighten the supply of credit when U.S. economic policy becomes more uncertain, with a decline of about 4.5% in total lending and an increase of about 90 basis points in interest rates among the banks that are most exposed to the United States.

(Reporting by Francesco Canepa; Editing by Toby Chopra)