Ben Norman
In June of 1974, a small German bank, Herstatt Bank, failed. While the bank itself was not large, its failure became synonymous with fx settlement risk, and its lessons served as the impetus for work over the subsequent three decades to implement real-time settlement systems now used the world over. Documents from the Bank of England’s Archive shed light on a lesser known aspect of Herstatt’s failure – the chain reaction it caused across financial centres as banks in different countries delayed settling their payments to each other. The lesson for policymakers today to grapple with is: when a bank fails, could we still expect surviving banks to delay making payments, with a potential chain reaction in the payment system?
Context
After incurring sizeable losses in foreign exchange (fx) trading, HB had its banking licence withdrawn on 26 June 1974 by its Supervisor in Germany, the Bundesaufsichtsamt für das Kreditwesen. HB was not large: at the time it was the country’s 35th biggest bank. On this basis, its failure should have been a parochial affair. It was anything but. It precipitated a chain reaction across financial centres, which threatened to gum up the international payment system, as banks in different countries delayed settling with finality their payments to each other.
The historical record of this international contagion in mid-1974 has been overshadowed. Instead, a related aspect of HB’s failure has made it an eponymous bank failure. The Supervisor’s action occurred after close of banking business in Germany, but (because of the time difference) still during the business day in the US. Several banks had struck fx deals with HB, and they paid out in Deutschmarks, but did not receive the corresponding US$ payment in New York. HB’s counterparties stood to lose the principal amount of these deals. Thereafter, such fx settlement risk was also referred to as “Herstatt risk”.
This latter aspect of the failure prompted work over the subsequent three decades to reduce settlement risk in financial market infrastructures. This has been well documented by policymakers (e.g. CPSS (1996); CPSS (2008)), and modelled by economists (e.g. Kahn & Roberds (2001); Schanz (2009)). Other research has taken HB as a case-study for early warning signs of bank crises (Blei, 1984), and for analysing changes to German depositor protection arrangements (Kaserer (2000)). But while Capie (2010) touches upon material in the Bank’s Archive that relates to HB’s failure, the story of serious disruption arising from cross‑border payment delays in mid-1974 has remained largely untold, apart from short passages in e.g. Reid (1982) and Goodhart (2011).
Repercussions
At the Bank for International Settlements in early July 1974, Charles Coombs (Federal Reserve Bank of New York) explained to fellow central bankers how, following HB’s failure, “New York banks’ first reaction was to hold up out payments until the relevant accounts were sufficiently in credit. This had the effect of virtually freezing up the clearing process, which on two or three consecutive days ran until 1am.” Concerned by these delays, the members of the New York Clearing House (NYCH) Association then met – and, as reported by their Chairman, Gordon Wallis, “…on July 1st…the Clearing House Committee implemented a procedure to enable the system to continue to operate effectively[:] …payments…may be recalled…on the morning of the business day following the date on which such payment was released… . The effect of this…is that international payments…are not final until the business day following the date on which the payment order is released.”
Coombs commented that “so far only two/three payments a day had been recalled and these…only…of small banks”. In response, John Sangster, from the Bank of England, reported that “…London clearing banks had not reacted to the New York measures in the hope that they were temporary. They had however refused to accept ‘conditional’ orders from other continental banks – i.e. sterling payments subject to recall if the New York counterpart were not delivered.” (Examples of such conditional orders – from two Swiss banks – can be seen in the payment confirmation messages in Figures 1 and 2.)
Figures 1 & 2 – payment confirmation messages, July 1974
Sangster’s words diplomatically downplayed the tension arising in London following the NYCH change. In fact, as early as 5 July, members of the Committee of London Clearing Banks (CLCB) met to discuss it. They reconvened a week later, following Sangster’s feedback “that the recent measures…were likely to remain in force for some considerable time. In view of this…a direct approach might be made to…the New York Clearing House.” On 16 July, Sir John Prideaux, Chairman of the CLCB telexed Walter Wriston, Chairman of the NYCH, expressing concern “…at the modified arrangements permitting recall of items on the day following issue. The resulting uncertainty is communicated to London where severe financial and commercial repercussions are felt. We feel moreover that other centres will be bound to follow your action. In order to avoid damage to the international payment system, we would request members of the New York Clearing House to revert immediately to the arrangements whereby inter-bank payments are issued without any conditions concerning the right of recall.”
Financial institutions began approaching the Bank of England to explain their increasing difficulties. Among others:
- On 16 July, “although Schroders could still get all the money they wanted it was now taking them, say, half a day to get six months deposits, whereas previously it had taken five minutes. … Herstatt was very much the cause of the present troubles.”
- On 17 July, two Slater Walker directors “were far more worried about the [foreign] exchange market where the freezing out of all but the giants was creating great difficulties for all lesser banks… . They feared that a bank could be forced to a temporary default… .”
- On 25 July, Charterhouse Japhet reported that “they have experienced a great deterioration in the ability to deal in foreign exchange markets since Herstatt… . In America they can deal only spot; in Switzerland they can obtain no quotations; in Germany they can deal normally in Hamburg but cannot deal in Dusseldorf or Frankfurt; only in the Netherlands is it as easy to deal as it was before Herstatt. With a number of overseas banks they are asked to provide cover until counter value is given; this they are refusing to do. In London…some banks have excised their name from their dealing lists and others have reduced their limits; even other Accepting Houses are less willing to deal with them… .”
Japhet’s observation that the Dutch were unscathed was misleading. The chairman of the Netherlands Bankers’ Association had also telexed Wriston, on 23 July, to say they were “…seriously concerned at the possible consequences of the recently introduced arrangements… [which] may lead to severe dislocations in the International payments system and in the foreign exchange markets…[and] therefore…strongly request you to reconsider the situation… .”
In response to the feedback from individual financial institutions in London, indeed as early as 18 July, Bank of England Governor Richardson gave his approval to a proposal that the Bank should let it be known, albeit “delicately”, that it “…would decide what help could be given…if we judge it appropriate…[to] any U.K. bank that spoke to us about difficulties in the [foreign] exchange markets.”
The relevance for today
So why might present-day policymakers want to reflect on this episode? Surely the introduction of real-time, gross settlement of payments, including so-called “payment-versus-payment” through CLS Bank for fx transactions – which was the ultimate response to mitigating Herstatt risk – means that the sort of seizing up of the payment system witnessed in 1974 would not recur in future bank failures? Not necessarily. In the days just before the UK authorities intervened in October 2008 to rescue the Royal Bank of Scotland (RBS) and Halifax / Bank of Scotland (HBoS, by then, part of Lloyds Banking Group), there was evidence of non-trivial payment delays in the most critical UK payment system, CHAPS (see Chart; also Bank of England (2009); Benos, Garratt & Zimmerman (2012)).
That these payment delays did not threaten the stability of the payment system is arguably because the authorities were forced to step in quickly to bail out those too-big-to-fail (TBTF) banks. Recalling the events of 7 October 2008, Alistair Darling, then Chancellor of the Exchequer, revealed how “…RBS Chairman, Tom McKillop…sounded shell-shocked. I asked him how long the bank could keep going. … ‘A couple of hours, maybe.’ …if we didn’t act immediately, the bank’s…cash machines would be switched off, cheques would not be honoured, people would not be paid.”(Darling (2011))
Central banks are working to prevent banks from being TBTF. When that has been successfully achieved, and a failing bank is no longer bailed out by the authorities, we could expect surviving banks still to delay payments. The risks from such delays are not of the same order of magnitude as the credit risk arising from banks failing. The authorities may, nevertheless, find it prudent at least to manage expectations in advance – that while they are doing everything feasible to make resolution of a large bank unremarkable, when such an event happens it will be difficult to avoid some messy consequences.
Additional references
Bank of England Archive – file 3A49/2
Blei, R (1984), ‘Früherkennung von Bankenkrisen dargestellt am Beispiel der Herstatt-Bank’, unpublished PhD Thesis, Berlin
Capie, F (2010), The Bank of England 1950s to 1979 Cambridge University Press
Darling, A (2011), Back from the Brink Atlantic Books
Goodhart, C A E (2011), The Basel Committee on Banking Supervision – A History of the Early Years, 1974-1997 Cambridge University Press
Reid, M (1982), The Secondary Banking Crisis, 1973-75 MacMillan Press
Author: Ben Norman works in the Bank’s Independent Evaluation Office.
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