Bankhaus Herstatt

Bankhaus Herstatt was a privately owned German bank based in Cologne that famously collapsed on June 26, 1974. Its failure is one of the most cited cautionary tales in modern finance, primarily because it exposed a critical vulnerability in the international financial system. The bank had engaged in massive and reckless speculation in the foreign exchange market (forex), betting on the direction of the U.S. Dollar. When these bets went catastrophically wrong, the losses wiped out the bank's capital. German regulators, the Bundesbank, were forced to revoke its banking license and shut it down. The timing of this closure created chaos. The bank was closed after it had received payments in Deutsche Mark from its counterparty banks but before it had made the corresponding U.S. Dollar payments to them due to time zone differences. This left its counterparties with huge, unsecured losses and gave a name to a specific financial danger: Herstatt Risk, a classic example of settlement risk.

In the early 1970s, Bankhaus Herstatt was a respectable and significant player in West Germany's banking scene. However, behind the scenes, its forex trading department was operating more like a casino than a bank. Following the collapse of the Bretton Woods system in 1971, currency exchange rates were no longer fixed, creating a new and volatile market. Herstatt’s dealers made enormous, leveraged bets that the U.S. Dollar would fall. Instead, it rallied strongly, inflicting losses estimated at over ten times the bank's entire capital. The bank had dug a hole so deep that it could never climb out.

On the fateful day of June 26, 1974, the Bundesbank discovered the scale of the losses and acted decisively. At 4:30 PM German time, they shut the bank down and appointed a liquidator. Here’s where the time zones delivered the knockout punch:

• By the time of the closure, Herstatt had received all its Deutsche Mark payments from counterparties through the German financial system.
• However, in New York, it was only 10:30 AM. The U.S. payment system had not yet processed Herstatt’s outgoing U.S. Dollar payments to those same counterparties.
• When U.S. banks tried to collect their dollars, they found Herstatt was out of business. The money was gone.

The resulting losses for international banks were staggering, and the event sent a wave of panic through the global financial markets.

The collapse gave birth to the term Herstatt Risk (also known as cross-currency settlement risk). It is a specific type of counterparty risk and refers to the risk that arises during the settlement of a forex transaction when payments are made at different times. Simply put, it's the danger that one party pays out the currency it sold but never receives the currency it bought because the other party defaults in the interim. Before 1974, this was a theoretical risk; Bankhaus Herstatt made it painfully real.

The Herstatt crisis temporarily froze the interbank market as banks grew terrified of trading with one another. This “gridlock” forced central banks around the world to cooperate and find a solution. The most important innovation to emerge, albeit many years later in 2002, was the Continuous Linked Settlement (CLS) system. CLS acts as a trusted third party for major currency transactions and operates on a payment versus payment (PvP) principle. This means a currency transaction only settles if both legs of the exchange happen simultaneously. If one party fails to deliver its currency, the other party's currency is not released, effectively eliminating Herstatt Risk for the vast majority of global forex trades today.

For an ordinary investor, the downfall of a German bank 50 years ago offers timeless wisdom that aligns perfectly with the value investing philosophy.

• Know Who You're Dealing With. The Herstatt saga is a powerful reminder that it’s not just what you invest in, but who you do business with. The financial health and integrity of your bank, broker, and other financial partners are critical. Never assume your counterparty is risk-free.
• Speculation is a Ticking Bomb. Bankhaus Herstatt was not destroyed by its core, conservative lending business. It was obliterated by wild gambling outside its area of expertise. This is a stark lesson in staying within your circle of competence and distinguishing between prudent investing and pure speculation. Betting on short-term market movements is a dangerous game.
• Systems Can Fail. The failure of one mid-sized bank nearly paralyzed the entire global financial system. This is a perfect illustration of systemic risk. It teaches us that even if your own investment choices are sound, external shocks can cause widespread damage. This is why a margin of safety is the bedrock of intelligent investing—it provides a cushion to protect you from the unexpected storms you can't see coming.