The crisis that changed it all…- Prof. Ankit Sharma

29th January 2026http://Medium Link: https://medium.com/@ankitpolistya/the-crisis-that-changed-it-all-2b01a3d2c8c4

Course Relevance

This caselet is designed for the following PGDM / UG courses:

• PGDM Term 3 Indian Financial System and Financial Markets (IFS&FM):
  • Explains settlement risk, foreign exchange markets, and systemic banking failures.
  • Highlights the role of central banks in crisis coordination and liquidity support.
• PGDM T5 RegTech and Financial Compliance:
  • Traces the origin of global banking regulation through the Basel framework.
  • Highlights the role of central banks in crisis coordination and liquidity support.
• BBA Sem 3 Indian Financial System (IFS):
  • Explains settlement risk, foreign exchange markets, and systemic banking failures.
  • Highlights the role of central banks in crisis coordination and liquidity support.

Academic Concepts

This caselet draws on multiple organizational and psychological theories:

• Settlement Risk (Herstatt Risk): Risk arising from time-zone differences in cross-border transactions.
• Systemic Risk Theory: The failure of one institution threatening the stability of the entire financial system.
• Too Big to Fail / SIFI Framework: Identifies institutions whose collapse can destabilize the economy.
• Basel Capital Adequacy Norms (Basel I–III): Minimum capital requirements to absorb unexpected losses.
• Market Discipline vs Regulatory Control: The balance between trusting markets and enforcing oversight.
• Moral Hazard: Risk-taking behavior encouraged by weak regulation or excessive trust.

Background

In June 1974, the global financial system faced its first international banking crisis of the computerized era.
At the center of the storm was Herstatt Bank (Bankhaus Herstatt), a mid-sized German bank aggressively trading in foreign exchange markets.

The crisis unfolded against the backdrop of the collapse of the Bretton Woods System in 1971, when currencies became free-floating and exchange rates were determined by market forces rather than gold-backed pegs. While this shift created opportunities, it also introduced unprecedented volatility and risk.

Situation: What Went Wrong at Herstatt Bank

With floating exchange rates, banks began engaging in currency arbitrage—buying currencies at lower prices and selling them at higher ones. Herstatt Bank rapidly expanded its forex trading operations, placing large speculative bets on the belief that the US dollar would weaken against European currencies.

However, between 1973 and 1974, the US dollar strengthened instead. The losses Herstatt incurred were so massive that they exceeded the bank’s entire equity base.

Despite warnings, German authorities relied on the assurances of Mr. Iwan Herstatt, the bank’s head, who dismissed concerns as rumors born out of jealousy. Regulation lagged behind innovation, and trust replaced control.

The Crisis Unfolds: A Matter of Time Zones

On 26 June 1974, Herstatt Bank received millions of Deutsche Marks (DM) from customers to be converted into US dollars.
At 3:30 PM in Germany, regulators shut down the bank permanently.

But in New York, it was only 10:30 AM—the US banking day had just begun.

As a result:

• Customers and banks had already paid DMs to Herstatt
• The dollar leg of the transaction had not yet been settled
• Herstatt Bank ceased to exist before completing the exchange

Millions vanished into a regulatory vacuum.
Around 1,900 employees were sent home, customers had no recourse, and global banks were exposed to severe losses—Chase Manhattan Bank alone reportedly faced exposure of USD 156 million.

This phenomenon came to be known as Herstatt Risk.

Impact: From One Bank to a Global Crisis

The consequences were immediate and severe:

• Global foreign exchange trading volumes fell by 60–80%
• Banks stopped trusting counterparties
• International payment systems faced collapse
• The crisis threatened a deflationary depression similar to 1929–30

For the first time, central banks recognized that isolated bank failures could trigger global instability.

Regulatory Response and Turning Point

Central banks responded with swift, coordinated action:

• Provided unlimited liquidity to domestic banks
• Assured markets that international payment systems would be supported
• Began cross-border coordination in crisis management

This crisis directly led to:

1. The formation of the Basel Committee for Banking Supervision (BCBS)
2. The creation of the Bank for International Settlements (BIS) framework
3. The introduction of Basel I, the first global capital adequacy standard

Today, these norms have evolved into Basel III, followed by banks across participating countries, including India.

Outcome

The failure of one mid-sized German bank reshaped the global financial architecture:

• Banking regulation shifted from national to international coordination
• Capital adequacy became a global priority
• Settlement risk was formally recognized and managed
• Trust between banks was restored through regulation, not goodwill alone

Epilogue: Lessons from Herstatt Bank

The Herstatt crisis offers enduring lessons:

1. Financial innovation without regulation invites disaster
2. Trust is insufficient without oversight
3. Systemic risk can originate from seemingly small institutions
4. Time-zone and settlement risks are real and costly
5. Global financial systems require global governance

As historian Emmanuel Mourlon-Druol aptly summarized:
“Trust is good, control is better.”

Teaching Note

Learning Objectives

After engaging with this blog, students will be able to:

• Understand settlement risk and systemic risk in global banking
• Analyze the causes and consequences of regulatory failure
• Explain the origins and importance of Basel norms
• Evaluate the role of central banks during financial crises
• Reflect on trust versus control in financial markets

Key Discussion Points

• Could the Herstatt crisis have been prevented with better regulation?
• How do time-zone differences amplify financial risk?
• Should regulators trust market participants during innovation phases?
• Are Basel III norms sufficient to prevent future crises?

Suggested Classroom Activities

1. Case Analysis:
   Map the sequence of events leading to Herstatt’s collapse.
2. Debate:
   “Market discipline is more effective than regulatory control.”
3. Simulation Exercise:
   Students role-play as regulators responding to a cross-border banking crisis.

Discussion Questions

1. How did the collapse of Bretton Woods contribute to Herstatt Bank’s failure?
2. Why is settlement risk particularly dangerous in foreign exchange markets?
3. How does the Herstatt crisis justify the existence of Basel regulations?
4. In today’s digital banking era, what new forms of Herstatt risk may emerge?