A bank in trouble negotiates with its regulatory authorities and other banks for support, but is refused a bail out and closes abruptly, sparking a global contraction as its obligations are left unhonoured. Investors stop trusting international capital markets, which freeze and need a quick injection of liquidity. The date: September 2008? No, June 1974.
The collapse of a little known bank in Germany shocked the international banking system, suspended international dollar clearing in New York and exposed a lack of coordination among national supervisors and regulators.
The failure of Herstatt bank happened in the middle of a rash of bank collapses in the summer of 1974 across the US and Europe. Volatile exchange rates combined with fraud and excessive risk-taking to bring down globalising banks such as Hersatt and Franklin National in the US. Many others were rocked by substantial losses, including branches and subsidiaries of Lloyds Bank, UBS and NatWest.
Unlike 2008, the crisis did not go global, since the banks’ losses were relatively small and markets soon recovered. Franklin National was nursed by the US authorities until its remaining assets could be sold off to a European consortium. Lloyds quickly restored the losses from a rogue trader in its Lugano Switzerland branch and recovered its reputation. But the events of that year had lasting effects on the governance of international banking and identified systemic weaknesses that remained unresolved by 2008.
The 1974 crash exposed the vulnerability of national banking systems to imprudent banking habits in an increasingly globalising network. In the early autumn, the central bank governors of the richest economies in the world came together to calm markets, share best practice, and to consider creating an early warning system that would prevent future crises.
But the warning system never happened, instead downgraded to an informal sharing of gossip. Instead, the committee spent its first years exchanging details of their national practices and trying to ensure that all banks were supervised by at least one national authority.
Rules incur costs for banks so supervision needs to be coordinated to avoid banks slipping into unsupervised and risky territories, and to make sure that there are no gaps between national regulators.
Despite the strong rationale for some form of multilateral oversight because of the vulnerability to cross-border contagion in the context of globalised financial markets, national regulators have been stubbornly resistant to giving up their sovereignty in the years since the first warning tremor in the globalised financial system.
1974 represented the beginning of sustained efforts to develop a coordinated framework for international banking supervision. But these efforts to agree minimum international standards failed to prevent the 1982 sovereign debt crisis that nearly brought down the global banking system, or the 1990s emerging market financial crises, or the 2008 global financial crisis. In 1999 the Financial Stability Forum took up the effort to bring G7 national regulators together, but ten years of meetings failed to forestall the global financial crisis.
Some reforms are taking place piecemeal at national level (for example Dodd Frank in the USA and the Financial Services Act in the UK) and through the EU’s banking union proposals. However, earlier plans in the 1980s for a European banking union faltered on the inability of national systems to be standardised or for national interests to be undermined. This does not bode well for similar proposals in Brussels today.
It’s not as though the relevant actors disagree on basic goals. Since 1974 there has been a general consensus on the need for collective effort to ensure solvency and liquidity in international banking by coordinated and comprehensive supervision and regulation of this global industry. But the landscape remains fractured and confusing.
As we reflect on the uneven progress made to shore up the global financial system, it is worth remembering that many of the key weaknesses and obstacles have been recognised and grappled with over several decades. The design of new solutions needs to bear this long and disappointing history of international banking supervision in mind.