Eurozone Banks Face Funding Challenges Amid Ongoing Geopolitical Risks

The European Systemic Risk Board (ESRB) has raised alarms about potential difficulties euro area banks could encounter in securing market financing, particularly in U.S. dollars and other foreign currencies, if geopolitical uncertainties persist. This concern arises amid growing tensions between Europe and the United States, exemplified by recent disputes involving Greenland. Historical data analyzed by the ESRB reveals that geopolitical disturbances typically cause a contraction in banks' wholesale borrowing in foreign currencies due to increased risk aversion among investors. Such dynamics may exert pressure on banks' credit supply and funding stability in the eurozone financial system.

Key Points

Persistent geopolitical uncertainty can significantly hamper eurozone banks' ability to raise wholesale funding, particularly in foreign currencies such as the U.S. dollar.
Historical analysis shows that geopolitical shocks reduce banks’ borrowing in foreign currency markets by several percentage points, contributing to higher funding costs and risk aversion among investors.
Certain funding instruments like bank bonds and covered bonds demonstrate greater resilience during geopolitical stresses, whereas asset-backed securities and short-term debt are more susceptible to disruption.

Eurozone financial institutions may face heightened difficulties in obtaining market financing, especially in U.S. dollar and other foreign currency denominations, if the current geopolitical volatility continues, according to an alert issued by the European Systemic Risk Board (ESRB) on Thursday. This warning coincides with escalating diplomatic strains between Europe and the United States, including reactions to the latter's interest in acquiring Greenland, which holds semi-autonomous status under Danish sovereignty.

Drawing from historical patterns, the ESRB's investigative report indicates that episodes of geopolitical turmoil usually result in a significant reduction in banks' wholesale market fundraising efforts, particularly in foreign currencies. This trend is attributed to an increase in risk aversion among purchasers of banking debt instruments such as bonds, making international funding markets more costly during periods of stress.

"Looking forward, a prolonged phase of geopolitical uncertainty could severely test banks’ capacity to absorb wholesale funding pressures, especially for financial instruments denominated in currencies other than the euro," stated the ESRB.

The study specifically quantifies the impact of a trade-policy uncertainty shock, revealing a roughly 5 percentage point decline in wholesale funding issuance in U.S. dollars and other foreign currencies excluding the euro. Additionally, banks demonstrated a cautious approach by lowering their borrowing in foreign currencies amid rising geopolitical and economic policy uncertainties by approximately 2 and 6 percentage points, respectively.

Further insights from the ESRB highlight contrasting stability levels across different funding instruments. Issuance of bank bonds and covered bonds remained relatively stable following geopolitical shocks, whereas reliance on asset- and mortgage-backed securities, along with short-term debt instruments, displayed greater vulnerability under these conditions.

The analysis also uncovered that banks exposed heavily to U.S. economic policy fluctuations tend to restrict credit provision, observed as an approximate 4.5% contraction in total lending coupled with a near 90 basis point increase in lending rates under heightened uncertainty.

These findings underscore the potential strain on euro area banks' foreign currency funding capabilities and credit availability as global geopolitical tensions persist, with implications for stability in cross-border financing markets and the broader European financial ecosystem.

Risks

Ongoing geopolitical and trade-policy tensions may raise the cost and restrict the availability of foreign currency funding for euro area banks, affecting liquidity and operational flexibility in the banking sector.
Heightened uncertainty linked to U.S. economic policies could lead to banks tightening credit supply, resulting in reduced lending volumes and increased borrowing costs for businesses and consumers.
Vulnerabilities in more sensitive funding channels such as asset-backed securities could exacerbate funding instability, posing risks to financial intermediaries dependent on these instruments.

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