Herstatt Risk and Collapse of Herstatt Bank

HERSTATT RISK AND COLLAPSE OF HERSTATT BANK
PRESENATATION BY GROUP V
AGENDA OF PRESENTATION
BRIEF HISTORY OF HERSTATT BANK BACKGROUND OF THE COLLAPSE DEFINING HERSTATT RISK DEFINING SETTLEMENT RISK RELEVENCE OF HERSTATT RISK IN MODERN DAY FINANCIAL MARKETS HERSTATT RISK MITIGATION STRATEGIES
BRIEF HISTORY OF HERSTATT BANK

Iwan David Herstatt with his friend Hans Gerling started Herstatt bank in June 1956. By the end of 1973 the bank had an asset of 2.07 DM and it was the 35th largest bank of Germany. Danny Dattel was heading the foreign exchange department which used to work to a large extent without control and with little contact to the other divisions. After omission of the coupling of the European currencies to the US Dollar speculations with foreign exchange developed as the principal item of the banking transaction.
BACKGROUND OF THE COLLAPSE

Herstatt Bank (Germany) failed in 1974 and caused a huge crisis in foreign exchange liquidity. It could clear only those foreign exchange trades which were in one jurisdiction but not in another because of time zone differences. It caused several more bank failures. Whom Herstatt bank owed delivery of foreign currencies

At the core of the problem was the huge foreign exchange exposure of the bank, estimated to be eighty times more than its exposure limit. The faulty strategy adopted by the bank while speculating the movement of dollar is understood to be one of the most important reason for such a huge liability.

The foreign exchange risk was thus three times as large as the amount of its capital (Blei, 1984). The special audit conducted by Federal Banking Supervisory Office (BAK red) prompted the management of the bank to close its open foreign exchange positions.

In June 1974, Herstatts losses on its foreign exchange operations amounted to DM 470 million. On 26 June 1974, BAK red withdrew Herstatt's license to conduct banking activities. It became obvious that the bank's assets, amounting to DM 1 billion, were more than offset by its DM 2.2 billion liabilities.
CAUSE OF THE CRISIS

After dissolution of the fixed exchange rate speculation became a common phenomenon in the foreign exchange transactions of the banks in Europe. This business was of high risk and high return. The faulty forecasting and not so stringent internal regulation resulted in a huge exposure much more than the 25 million DM
RESOLUTION OF THE CRISIS

Three big German banks failed to organise a joint rescue.
RESPONSE OF THE REGULATOR

The Herstatt crisis had many implications for the regulatory framework. In 1974, shortly after the crisis, Principle Ia was introduced In 1976, the Second Amendment to the Banking Act (KWG)came into force. Association of German Banks decided to set up a deposit protection scheme for German banks.
WHAT IS A HERSTATT RISK?

The risk of loss in foreign exchange trading that one party will deliver foreign exchange but the counterparty financial institution will fail to deliver its end of the contract. It is also referred to as settlement risk.
It is the risk arising from the time delivery lag between two currencies.
IS HERSTATT RISK THE REASON FOR COLLAPSE OF HERSTATT BANK?

The Herstatt crisis is well known in international finance because of Herstatt risk. On the eve of closure of the bank, many banks still had foreign exchange contracts with Herstatt for settlement on that date. Hence, Herstatt risk represented operational risk for those banks which were exposed to the default of Herstatt. But, Herstatt risk was not a reason for the Herstatt crisis.
WHAT IS SETTLEMENT RISK?

Settlement risk is the risk arising out of a counterparty default in delivering a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement
RELATION BETWEEN HERSTATT AND SETTLEMENT RISK

Settlement risk- all kind of settlements. Herstatt risk- Foreign exchange settlements. Herstatt risk exists primarily (but not exclusively) in foreign exchange transactions and cross-currency swap transaction.
CALCULATION OF HERSTATT RISK

Risk definition Herstatt risk = Value of transaction X time lag in hours.
CALCULATING THE PROBABILITY OF HERSTATT RISK

P(n) = 1- (1-a)n P(T) = 1 (1-a)T When T, P(T)1
MITIGATION OF HERSTATT RISK

Continuous Linked Settlement (CLS Group Holdings AG and subsidiary companies) was created in September 2002 by a number of the world's largest banks for the purpose of settling foreign exchange flows amongst themselves (and their customers and other thirdparties). Till September 2007 it settled about 325,000 instructions a day in 15 currencies with an average daily value exceeding US$3.3 trillion. A key feature of CLS is the settlement of gross-value instructions with multi-lateral net funding. On average, CLS netting efficiency is in the region of 98%; that is to say, each trillion dollars of gross value settled might require aggregate pay-ins of "only" $20 billion.
Real time gross settlement (RTGS) : RTGS systems are defined as systems in which both processing and final settlement of funds transfer instructions take place continuously. RTGS is a transparent concept. RTGS systems settles task in a quick succession , that creates credibility between the two parties. Over the counter (OTC): a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. It is mostly done via the computer or the telephone
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Central bank payment and settlement services (CPSS) with respect to cross-border and multi-currency: It is dealing with multi-currency delivery-versus-payment (multi-DVP). Delivery-versus-payment means that the final transfer of one asset occurs if, and only if, the final transfer of an(other) asset(s) occurs. Assets could be monetary assets (such as foreign exchange), securities or other financial instruments. It supports the extension of domestic payment systems operating hours, establishing cross-border operational links between domestic payments systems or multi-currency accounts and settlement facilities provided by a central bank. CPSS Strategy : 1. the first step towards reducing settlement risk and containing systemic risk is for each institution to understand the nature and scope of its settlement exposures.
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2. To help banks come to grips with settlement risk, the report outlines a methodology to measure foreign exchange settlement risk 3. steps to shorten the time lags within the settlement process.
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MANAGING RISK REQUIRES FORESIGHT!!!!

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HERSTATT RISK AND COLLAPSE OF HERSTATT BANK

BRIEF HISTORY OF HERSTATT BANK

BACKGROUND OF THE COLLAPSE

BACKGROUND OF THE COLLAPSE

BACKGROUND OF THE COLLAPSE

BACKGROUND OF THE COLLAPSE

CAUSE OF THE CRISIS

RESOLUTION OF THE CRISIS

RESPONSE OF THE REGULATOR

WHAT IS A HERSTATT RISK?

IS HERSTATT RISK THE REASON FOR COLLAPSE OF HERSTATT BANK?

WHAT IS SETTLEMENT RISK?

RELATION BETWEEN HERSTATT AND SETTLEMENT RISK

CALCULATION OF HERSTATT RISK

CALCULATING THE PROBABILITY OF HERSTATT RISK

MITIGATION OF HERSTATT RISK

MANAGING RISK REQUIRES FORESIGHT!!!!

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