The time zone difference meant that the banks sending the money never received their US. dollars, on June 26, 1974, German regulators forced the bank into liquidation.
11th October 2013
The world has seen failure of banks and corporates due to creative accounting strategies such as Repo-105 in case of Lehman Brothers, transferring accumulated losses to SPE’s (special purpose entities) in Enron’s case and using off-balance-sheet transactions to hoodwink regulators. In this article, let us discuss the causes for the fall of Herstatt Bank, reasons for the fall of the bank, origin of the term “Herstatt risk “and steps taken by banks worldwide to avoid forex risks
Cross Settlement Risk
Herstatt Risk or cross currency settlement risk or forex risk is the risk that a party to trade fails to make payment even though it has been paid by the counter party. The name “Herstatt” comes after the German bank Herstatt whose license was withdrawn by German regulators on June 26, 1974 due to its inability to cover its liabilities.
Herstatt bank was a privately owned bank in the German city of Cologne, started by Iwan David Herstatt with his friend Hans Gerling in June 1956. The risk emanated from its forex trading desk, headed by Danny Dattel which used to work to a large extent without control and communication with the other departments of the bank, the incident started in 1973 when the US. Dollar began to rise due to the oil crisis- taking advantage of this – banks started to trade in forex and Herstatt was also involved in trading forex. The forex division headed by Danny and his young team made huge profits from forex trading, but the bank suffered losses four times higher than the size of its own capital due to an unanticipated appreciation of the dollar and the collapse of Bretton Woods Agreement in 1973, the free floating of currencies provided Herstatt with additional incentives for risky bets on foreign exchange, however, the strategy adopted by the bank while speculating the movement of dollar proved to be faulty – the bank failed to settle a contract after having received the payment from a counter party – that failure caused a string of cascading defaults in a rapid sequence, totalling a loss of $ 620 million to the international banking sector. The time zone difference meant that the banks sending the money never received their US. Dollars, on June 26, 1974, German regulators forced the bank into liquidation. The collapse of this medium sized bank sparked a deep crisis in the foreign exchange market, on which it was very active- the New York interbank market came to a standstill, leading to a collapse of a number of other institutions.
The impact of this event was so great that it had repercussions throughout the world, the term “Herstatt risk” was used 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.
Calculation of Herstatt Risk
Herstatt risk = Value of transaction * time lag in hours
In order to mitigate settlement risks in the foreign exchange market, many large banks in the world got together to establish continuous linked settlement (CLS), in September 2002- these efforts paved way for the establishment of CLS Group Holdings AG, owned by the world’s leading financial institutions- CLS settles payment instructions relating to underlying forex transactions in 17 major currencies and certain other transactions that result in one way payments in a sub set of those currencies.