In June 1974, Herstatt Bank, a relatively small German bank, was closed by regulators on account of large losses in the foreign exchange market and murky accounting statements. The potential knock-on effects seemed small. The bank was one that few outside the vicinity of Köln would have heard of. However, because of the manner in which foreign exchange trades were conducted, many other banks essentially had their money locked up at the failed Herstatt Bank. The episode changed the way these trades were settled and encouraged a rethink of the scope of bank regulation.
Herstatt Bank
Bankhaus I. D. Herstatt of Köln was a West German bank specializing in serving high-net-worth clients. Except to its customers, this was not a very well-known financial institution. It was just the 35th largest bank in the country, a mid-sized family-owned bank local to the vicinity of Köln and Bonn.
It was also not a particularly well managed bank. Iwan Herstatt had allowed the foreign currency division to operate with substantial freedom. This unit was run by a recognized expert in foreign exchange markets, Daniel Dattel. For Dattel, the end of the Bretton Woods system had created new trading opportunities in foreign exchange markets since the value of more currencies floated freely against each other. Iwan Herstatt was not aware of the risks taken by the foreign currency division. Outsiders had their suspicions though. Regulators had produced critical reports of Herstatt Bank’s situation based on factors like its reserves, difficulties with expansion, and tips provided from others in the same banking circles as Herstatt. By the spring of 1974, several banks were refusing to work with Herstatt.
In 1974, many banks were reporting large foreign currency losses. Herstatt Bank faced particularly large losses which its foreign currency division tried to cover up by falsifying financial statements. Even the management at Herstatt had only come to learn of any losses at all on June 10 that year and the regulator only became apprised of the situation the weekend before the bank was closed. While the scale of the losses was not inconsiderable, it was the questionable financial reporting that wrecked efforts to rescue the bank.
Its banking license withdrawn by the financial supervisor, the Bundesaufsichtsamt für das Kreditwesen, Herstatt Bank failed on June 26, 1974. The bank was estimated to have lost 470 million marks, or about $188 million, in foreign exchange trades. This was in relation to a bank with total assets of approximately 2.4 billion marks, or approximately $960 million, and deposits of $300 million.
Settlement Risk
The failure of such a small bank seemingly local to a small area of Germany turned out not to be a strictly local problem. Herstatt’s currency operations linked it with several much larger banks. Because of differences in time zone, on the day of its demise Herstatt Bank had received millions of deutschmarks from trades in Europe before it had to deliver amounts due to these same counterparties in U.S. dollars in New York time. When the bank was closed at the end of the German business day, counterparties in America were unable to receive payment for their trades though they had already sent payment for their half of the trade before the end of the German business day.
The scale of the losses incurred by Herstatt Bank and the timing of the closure meant many counterparties faced their own large losses. American banks were particularly effected. One of the victims was Seattle First National Bank, which had delivered $22.5 million in West German marks to Herstatt Bank just hours before the bank’s closure. Morgan Guaranty Trust Company in New York faced a possible $13 million loss for the same reason. The list of effected banks included Chase Manhattan Bank and Citibank as well as some European banks. The German regulators did not envision these international consequences before the failure of the bank.
The knock-on effects of the failure were not limited to banks with direct exposure to Herstatt. Banks adopted new measures to limit future losses, with destructive effects to the existing system for global payments. New York banks delayed settlement of payments with one another until their accounts were sufficiently in credit. The New York Clearing House also introduced a one-day settlement period by allowing a payment to be recalled on the morning of the day after the payment was released.
In response to the risk that payments from American firms could be recalled, European banks sent payment orders to clearing houses that were conditional on receiving the countervalue in another currency in a different market. Nervousness about settlement risk, especially with respect to smaller banks, fractured the financial system. Interest rates on U.S. dollars in Europe rose relative to rates in the U.S. The 1.5% gap that appeared suggested either that American banks were reluctant to send dollars abroad, that smaller European banks struggled to borrow, or both.
The global payments system was stalling. Banks were reporting that payments which would have taken just five minutes to execute in the past were taking half a day now. Smaller banks were particularly affected. Banks were trimming the list of approved counterparties or reduced exposure limits. The nervousness was heightened by the fact the financial system had already been weakened by the monetary effects accompanying the oil crisis. These events coincided with the 1974-75 recession. The inconvenience brought by the frictions and delays seemed at the moment preferable to the risk of loss.
This risk of loss in the settlement process of a transaction is still known as “Herstatt risk” today. Many banks experienced Herstatt risk firsthand. In the aftermath of the crisis, some three hundred creditors made claims on the assets of Herstatt. The banks eventually got some of their losses back but not all the money lost was recovered even though Herstatt Bank’s securities holdings rose in value as the liquidation got underway and there was also a sale of its offices at a good price. The gross amount of trading losses was just too great. Still, Seattle First National Bank recovered all but $3 million on its $22.5 million loss.
Supervision
Herstatt Bank’s failure triggered a reconsideration of the nature of bank regulation, or bank supervision was it was more commonly called then. German regulators were unable to get an accurate picture as to the extent of Herstatt’s losses, in part because some of these were at the bank’s Luxembourg subsidiary. They had also overlooked the international repercussions of closing the bank when they did. So, Herstatt Bank’s collapse led to a rethink of the regulatory structure with a greater emphasis on international cooperation.
In the wake of the crisis, the European Economic Community pressed for a controversial mechanism whereby banks would share credit risk information on each other. A less controversial response was the creation of the Basel Committee on Banking Supervision in 1975 within the existing Bank for International Settlements. The Basel Committee was formed to reduce gaps in bank supervision caused by international borders. Of practical importance, a new real-time settlement system was introduced globally. This ultimately culminated in the creation of CLS Bank, which settles global foreign exchange transactions.
Challenges to global regulation remained, many driven by increasing globalization. An example was the growing importance of financial centers with less extensive regulations or less developed regulatory bodies than could be found in the United States or Europe. The 2008 financial crisis came with its own payments-related issues as banks were running out of cash. Alistair Darling, then the U.K.’s Chancellor of the Exchequer, recounted how there was significant risk that the Royal Bank of Scotland was perhaps a couple hours away from needing to suspend payments. Still, settlement risk, at least in foreign exchange transactions, had been mitigated by the reforms undertaken after the failure of Herstatt Bank over thirty years earlier.
Lesson
Herstatt Bank was a small bank with a big legacy, not because of its triumphant successes but the chaotic aftermath of its failure. The bank lent its name to the settlement risk taken by market participants on their trades. More importantly, it also led to the creation of the Basel Committee and by extension the future Basel Accords, important waypoints in the globalization of banking regulation. Herstatt Bank illustrated why globalization of finance necessitated a rethink of banking practices and regulation.
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Further Reading
1. Farnsworth, Clyde H. Failure of Herstatt Disturbs Banking, 29 June 1974.
2. Hershey, Robert D. Herstatt Bank Scars Remain, 26 June 1978.
3. Mourlon-Druol, Emmanuel. “‘Trust Is Good, Control Is Better’: The 1974 Herstatt Bank Crisis and Its Implications for International Regulatory Reform.” Business History, vol. 57, no. 2, 2015, pp. 311–334.
4. Norman, Ben. “BOE Archives Reveal Little Known Lesson from the 1974 Failure of Herstatt Bank.” Bank Underground, 25 June 2015.
