Dumb Networks and Smart Capital

Wriston, Walter B.

2007

The Possibility of Systemic Failure

 

Because of all these unknowns, as the global money markets grew and speeded up it was every regulator's--and every participant's--nightmare as to what would happen if a small event like the failure of a bank somewhere severed the weakest link in the payment chain. If that happened, would the music stop and the whole system come crashing down? Or, to use a Washington term, would we have a systemic failure?

This nightmare came true on a Friday afternoon, June 28, 1974, triggered by the failure of a small German bank called Bankhaus, I.D. Herstatt, K.G.a.A. By coincidence that Friday afternoon there was a retirement party going on for the senior credit officer of Citibank, Mr. Lester Garvin. A group of us were in his office drinking champagne from paper cups and wishing him well when the phone rang with the news that the Chase Manhattan Bank, which was acting for Herstatt, had stopped all payments into the Clearing House Interbank Payments System (CHIPS), which then ground to a halt. The party in Mr. Garvin's office was of short duration. The main problem was how to restart the system and let the payments clear so that the participants in the world's banking system would know what their liabilities were. As the evening wore on we learned that the German banking authorities at about 10:30 a.m. Eastern Standard Time had closed down Herstatt.

All the banks that were players in the world market enjoyed a line of credit from other banks. These lines of credit were necessary because quite often payment orders arrived when there was not enough money in an account to cover them. Money would flow into the account from many different areas--from money transfers from the Federal Reserve, from other banks, from the payment of maturing credits, or a dozen different sources. In the meantime, the payments were made by creating an overdraft, the allowable size of which was governed by the credit line. If all worked well, the overdraft was eliminated during the day as payments flowed in--if payments did not arrive, the overdraft continued, creating a credit risk and possible loss.

The German central bank, the Bundesbank, in the spirit of free enterprise, decided to let Herstatt fail, which I believe was the correct decision. As in all disasters, fate played an important role. While the Bonn office of Herstatt had already closed, the Frankfurt office was still open and an officer from Citibank Frankfurt hand-carried the papers to collect a spot foreign-exchange payment. He searched in vain for people to talk to, but the place was deserted. The staff had all left to watch the World Cup soccer matches and never completed the clearing so our officer returned empty-handed.

Back in New York the immediate solution to the problem appeared to us to be quite simple, and that was to permit any bank to return payments for 24 hours after the date on which they were made, in the same manner that a Clearing House bank had 24 hours to return a bad check which was drawn upon it. This simple device gave everyone confidence that they would be able to unravel anything that came along and enough time to do so. The rule required all participants in the system to honor all payment orders and permitted them to recall any the next morning if they had not received funds to cover them. CHIPS started up on Monday and operated smoothly and successfully, but the British banks and some other Europeans took violent exception to the fact that the payments through the CHIPS system were not final until 24 hours after they had been implemented. Long roller-towel cables appeared on the desks of bankers in New York alleging that Eurodollar payments in London were "final" even though everyone knew that the payments could not be final until they were debited or credited to an account in New York.

As long as the sun rises in the East and sets in the West, there will be a five-- or six-hour time difference between London and New York, and that time span between London payments and final settlement in New York constitutes the credit risk. In today's world almost anything can happen in six hours, or six minutes.

Back in New York bankers set to work to build more and more safeguards into the CHIPS system with reciprocal credit lines and such other devices to limit the liability of any one bank. As of January 3, 1997, CHIPS now has in place procedures to cover the simultaneous failure of the two largest participants at their largest net debit position, and still fulfill its clearing function. It is interesting to note that no government agency was involved in any aspect of the Herstatt crisis. It was handled entirely by the New York Clearing House.