Financial Contagion and Herstatt Risk
"When the thunderclap comes, there is no time to cover the ears" -
- Sun Tzu
What is financial contagion?
A large number of bank failures occurred in the 1930s, accompanied by declines in asset markets, mostly triggered by common adverse business conditions. This seriously weakened the US financial system, and left it unable to support economic activity effectively through financing. Consequently, there was a continuing vicious circle of economic decline and financial weakness.
When asset bubbles burst, or economies suffer a severe downturn, weak banks can become insolvent, and their failure then further weakens other banks causing the problem to spread.
In testimony before the U.S. Senate Committee on the Budget on September 23, 1998 Alan Greenspan said:
"Developed countries' banks are highly leveraged, but subject to sufficiently effective supervision both by counterparties and regulatory authorities, so that, in most countries, banking problems do not escalate into international financial crises. Most banks in emerging market economies are also highly leveraged, but their supervision often has not proved adequate to forestall failures and a general financial crisis. The failure of some banks is highly contagious to other banks and businesses that deal with them, as the Asian crisis has so effectively demonstrated."
But regulation and supervision of individual financial institutions, however much they may be effective, may not necessarily guarantee the stability of the financial system as a whole. Problems in one bank may spread to other parts of the financial system by the common involvement of other banks in one particular risky business area that turns bad, through counterparty exposure to events such as the Baring Brothers crisis of 1995 or the Long Term Capital Management (LTCM) crisis of 1998, or loss of confidence in one institution may result in funding problems for other institutions if they are perceived to have something in common.
Banks are interconnected through interbank deposits, loans, payment systems, and common markets. An adverse event that drives one bank into insolvency may then cascade to other interconnected banks by generating losses for them. If the losses generated for the next bank in the chain exceed their availability of capital to absorb the losses, then a domino effect of contagion can occur that threatens the whole financial system.
In May 1931, the Austrian Credit-Anstalt bank failed after customers withdrew funds on worries over the soundness of the bank's loans. A cascade of financial problems ensued, which contributed a great deal to the economic problems of the 1930s.
It started when the bank's depositors grew concerned about the Austrian economy and the state of the bank's non-performing loans. After it failed, general confidence in banks was damaged and there were runs on banks in Czechoslovakia, Germany, Hungary, and Poland. The top four banks in Germany declared themselves bankrupt and the Berlin Stock Exchange closed for two months. British investors in Europe and exporters lost money, the UK suffered a rapidly growing deficit, and foreign investors withdrew, deserting the Pound Sterling for gold and other currencies. The British government raised taxes to try to restore confidence, but investor confidence collapsed, and the pound was allowed to float, declining by over 20% against gold.
Comparisons have been made between the Credit-Anstalt crisis and potential risks in China's banking system:Analysis: China, today's Creditanstalt? By MARTIN HUTCHINSON UPI Business and Economics Editor [16th October 2003]
What is Herstatt Risk?
"Herstatt Risk" is a phrase used in certain economic circles to describe a greatly-feared sequence of cascading cross-defaults amongst banks and other financial institutions, in a kind of domino effect, particularly in relation to foreign exchange settlement where there may be a time difference between the hours in which the separate institutions trade.
Herstatt Risk is named after Bankhaus Herstatt, which was a small German bank highly active in foreign exchange dealings, and it was a string of losses in these dealings that caused its demise in June 1974. It left $620m of unsettled forex trades, where counterparties had paid up but had not received the exchange currency- the time difference between settlements in different countries meant that, unfortunately for those on the wrong side of the deal, the Herstatt bank had already been closed down by the time that the payment of currency owed was due.
Herstatt's default set up a terrifying domino effect of payment defaults throughout the international banking community- of the kind that they never want to see again, at all costs. The problems highlighted by the Bankhaus Herstatt were considered so serious that it was considered necessary to set up the Basle Committee on Banking Supervision, the Secretariat for which is provided by the Bank for International Settlements. Because of the fears over Herstatt Risk, monetary authorities are sensitive to too-rapid change in forex rates... such as, for example, the Yen/Dollar rate.
Did Alan Greenspan have more than ordinary financial contagion in mind when he commented on the rescue operation for LTCM, on October 1, 1998, such as the spectre of Herstatt Risk spreading contagion through interconnected time zones and countries?
"It was the judgment of officials at the Federal Reserve Bank of New York, who were monitoring the situation on an ongoing basis, that the act of unwinding LTCM's portfolio in a forced liqudiation would not only have a significant distorting impact on market prices but also in the process could produce large losses, or worse, for a number of creditors and counterparties, and for other market participants who were not directly involved with LTCM. In that environment, it was the FRBNY's judgment that it was to the advantage of all parties--including the creditors and other market participants--to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation following a set of cascading cross defaults."
Greenspan also alluded to the domino chain of linkages between banks and businesses when he said this on September 23, 1998:
"The failure of some banks is highly contagious to other banks and businesses that deal with them"
Exchange Rate risks
Here are some factors affecting international currency exchange and trading between financial entities, any of which might cause problems to an individual financial entity that has become unduly exposed in that area:
- A falling dollar (or pound?) could lead to heavy dollar claim repatriation, the funds that those claims provided becoming lost to the economy. The reversal in currency exchange could be dangerous to those who have not made allowance for the trend reversal. The economic damage could cut profits at banks.
- Interest rates are forced to rise to tempt investors back with increased returns on investments, but increasing the cost of servicing external debt repayments. This could also cut profits at banks as some businesses go under with the increased costs and loans go sour. Imports become more expensive, increasing price inflation and depressing consumption.
- Collapsing asset prices causing a negative "wealth effect" - for instance, in housing. People end up owning assets that are worth much less than their loan obligations. They must stay put and hope for a recovery, or they may become a foreclosure statistic. The mortgage lenders fail to recover all their loans.
- A practically non-existent savings rate leaving nothing to fall back on in a crisis- when income is lost, consumption must fall rapidly, or perhaps bankruptcy may be unavoidable.
