The Basel Committee, Basel I and Basel II

In 1974, the German authorities ordered the immediate liquidation of Bankhaus Herstatt, a German commercial bank that, as a result of its closure, failed to deliver U.S. dollars to counterparties with whom it had previously struck foreign exchange deals. This event gave rise to the concept of “Herstatt risk”, which is a kind of operational risk associated with the settlement of foreign exchange transactions. Losses can result from Herstatt risk because currency trading requires the settlement of commitments in two independent national payment systems. The process typically involves the delivery of the currency sold before the receipt of the currency bought. Thus, the bank delivering the currency sold would lose if the bank buying this currency does not deliver the other currency (because of insolvency or liquidation, which is what happened in the Herstatt case). In this case, the selling bank effectively extends unsecured loan to the buying bank. How much of the loan will be recovered depends on the estate in the bankruptcy’s treatment of the bank’s dividend demand. For details of the Herstatt case, see BCBS (2004b, pp. 4 – 6).