'Icon of Systemic Risk' Haunts Industry Decades After Demise

Thirty-seven years ago this month, the failure of a small German bank sent shock waves through the system, costing banks from New York to Singapore some $620 million in losses.

The collapse of Bankhaus Herstatt in Cologne made the front page of the June 27, 1974, issue of American Banker, which we've republished today on our 175 anniversary Flashback site. While technology has made a repeat of this particular transcontinental foreign-exchange debacle unlikely, the broader theme of contagion is as salient as ever.

"The Herstatt Bank was for many years regarded as the major example of failure where counterparties were hurt," said Steven Schwarcz, a professor of law and business at Duke University.

"It illustrates an example of counterparties not being paid" regardless of the circumstances, Schwarcz said. "Its lesson is symbolic in that it was the icon of systemic risk at the time."

This week regulators and policy minds met to hammer out measures that would spare the government from having to make a painful choice of the kind Lehman Brothers forced them to make in 2008. In that light, a quick trip back to 1974 may hold a useful lesson.

Doubtless, Lehman was much larger than Herstatt, and made its boldest bets in a different era, but there are similarities between the two banks. Herstatt was overleveraged in foreign currencies when that market was in its infancy, while Lehman was overexposed in the subprime mortgage space before investors caught up with its accounting gimmicks. Both had weak internal controls and for years enjoyed lax regulation by their respective governments.

Herstatt wasn't large, even by 1970s standards. At the end of 1973, it was ranked as only the 35th largest bank in Germany. Yet its central role in processing foreign exchange orders made it what today might be called a "systemically important" financial institution. Herstatt may not have been too big to fail, but it was too enmeshed in the market to fail without causing widespread damage.

German regulators withdrew its license by the end of the business day on June 26 and forced it into liquidation. But at that point it was still morning in New York, where Herstatt's counterparties were expecting to receive dollars in exchange for Deutsche marks they had delivered. Herstatt's clearing bank, Chase Manhattan (now a part of JPMorgan Chase & Co.) wouldn't fulfill the orders. This triggered a chain of subsequent defaults.

"The importance of Herstatt was that the failure happened in the middle of the business day [in the U.S.], and that this was a major failure of a bank to honor its obligations toward other banks," said Lawrence J. White, a business professor at New York University.

The impact of this event was so great that someone coined the term "Herstatt risk" to describe the danger in foreign-currency transactions posed by the difference in time zones and the possibility of one party failing to carry out its end of a deal during banking hours. Today, such a lag between delivery and payment of currency seems archaic.

"I think this made everyone sensitive to clearing and netting issues and that a major bank's failure can have serious consequences for other financial institutions," White said.

Gergana Koleva is a freelance writer in New York