Critical History: The Nixon Shock and the Herstatt Risk

On June 26, 1974, German regulators revoked the license of a medium-sized bank, Bankhaus Herstatt, in Cologne. The repercussions of this event, that came to be known as the Herstatt Risk, changed the world of banking supervision forever. In this post will take a look back at some of the critical events that shaped how the financial sector is currently regulated. And in order to appreciate the full implications of this event, we need to start a bit earlier with the Bretton Woods conference:

The Post-War Bretton Woods Order

In July 1944, as World War II (WW2) was still unfolding, representatives of 44 Allied nations gathered at the Bretton Woods Conference in New Hampshire to design a new monetary order to shape the postwar world. The goal was to set the rules that also took into account pre-war events. The interwar years between WWI and WW2 saw the collapse of the gold standard, currency devaluations, trade barriers, capital flight, and financial panic. The result of these was a prolonged period of significant economic downturn, that we refer to as the Great Depression.

Bretton Woods debates were intense. John Maynard Keynes, a leading figure at that time and representing the UK, proposed the creation of a supranational currency, the *Bancor*, to prevent global imbalances. The United States, that emerged from the war as the dominant economic power, used its leverage in the Bretton Woods conference and managed to secure a system centered on the dollar. The conference established a fixed but adjustable exchange rate regime where currencies were pegged to the U.S. dollar, and the dollar itself was convertible into gold at $35 per ounce. Central banks committed to keeping exchange rates within narrow bands through intervention in foreign exchange markets. To oversee this framework, the International Monetary Fund was created, alongside the International Bank for Reconstruction and Development (IBRD) (later known as the World Bank) to support post-war reconstruction and development.

Under Bretton Woods, strong exchange rate adjustments were rare. Currency devaluations or revaluations were multilateral decisions achieved through long negotiations rather than market outcomes. As a result, exchange rate risks for banks and corporations was limited. For nearly 25 years, the system delivered monetary stability while global trade expanded rapidly. Banking during this period remained largely conservative, domestically oriented, and nationally supervised. Foreign exchange trading existed, but it was primarily tied to trade settlement.

The Implications of a Fixed Exchange Rate for the United States

The Bretton Woods system placed the United States at the center of the postwar monetary order. The U.S. dollar was the “world reserve currency” held by foreign central banks as the primary reserve asset. Unlike other countries, which had to earn or borrow foreign exchange, the United States could supply the world with its own currency. This arrangement later became known as the dollar’s exorbitant privilege.

In the immediate postwar years, this position also reflected economic reality. The United States emerged from World War II with its industrial base intact, unlike much of Europe and Japan, whose infrastructure and production capacity had been devastated. By 1945, the U.S. accounted for a significant share of global industrial output (estimates range close to half of world manufacturing production). It also held the majority of the world’s official gold reserves, accumulated during the war as countries paid for imports in gold and dollars. As a result, the financial center of gravity had shifted decisively from London to New York.

The dollar being the core of the new monetary system was also the main currency of trade and reconstruction. It was stable, liquid, and widely trusted because it was backed by both gold convertibility and the productive capacity of the American economy. European and Japanese reconstruction under the Marshall Plan reinforced this centrality. U.S. financial aid flowed to war-torn economies largely in dollars, embedding the currency in trade settlements, reserve holdings, and development finance. As European economies rebuilt and reindustrialized, they did so within a system in which access to dollars was essential for importing machinery, raw materials, and food.

But the architecture of Bretton Woods also had a structural asymmetry. For the global economy to grow, international trade required liquidity where that liquidity was denominated in dollars. The United States therefore had to supply dollars to the rest of the world. In practice, this meant running persistent balance-of-payments deficits. In other words, U.S. dollars flowed abroad through trade deficits, foreign aid, military spending, and overseas investment.

Over time, foreign central banks accumulated increasing quantities of dollar reserves. Yet U.S. gold reserves, which were supposed to guarantee convertibility, did not expand in proportion. The more dollars circulated internationally, the weaker the gold backing became relative to outstanding claims. This inherent tension was formalized by economist Robert Triffin and became known as the Triffin dilemma:

• If the United States stopped running deficits, global liquidity would contract, threatening economic growth.
• If it continued running deficits, confidence in dollar–gold convertibility would erode.

In other words, the success of the Bretton Woods system was undermining its own credibility. By the 1960s, this contradiction was also becoming increasingly visible. U.S. fiscal expansion, driven by domestic social programs and the Vietnam War, increased inflationary pressures. At the same time, Europe and Japan had recovered economically and were no longer dependent on U.S. dominance. Confidence in the dollar’s fixed gold parity began to weaken.

Some foreign leaders openly criticized the arrangement. France, under President Charles de Gaulle, questioned the fairness of a system that allowed the United States to finance deficits in its own currency while other countries had to bear adjustment costs. French authorities began converting dollar reserves into gold, physically repatriating bullion from U.S. vaults. This event, known as the Vide-Gousset Operation (1963–1966), also helped weaken the dollar’s hegemony. By the late 1960s, the gap between outstanding dollar liabilities and U.S. gold reserves had widened significantly. Markets increasingly doubted whether the United States could maintain convertibility if all foreign holders demanded gold simultaneously.

By the end of the decade, the Triffin Dilemma was a very visible problem confronting policymakers in Washington and central banks around the world. This also set the stage for the dramatic decision that would follow in 1971. We will come back to what happened next. But let’s move to to Germany for now:

Germany’s Wirtschaftswunder

In the aftermath of World War II, West Germany’s economic reconstruction unfolded with remarkable speed. Central to this recovery was the Marshall Plan initiated by the United States in 1948. American financial assistance, combined with domestic currency reform and industrial restructuring, stabilized prices, restored production capacity, and reconnected West Germany to global trade networks.

The 1950s and 1960s became known as the *Wirtschaftswunder (also known as Miracle on the Rhine), *or the era of the economic miracle. Industrial output surged and exports expanded rapidly. The Deutsche Mark developed a reputation for stability and monetary discipline. Rising productivity and integration into European markets turned West Germany into one of the world’s leading export economies.

This environment also reshaped the financial landscape. While large institutions such as Deutsche Bank re-established themselves as national champions, the broader economic boom also created space for smaller and regional private banks that often specialized in trade finance, corporate lending. In short, these banks were serving the needs of an ever expanding industrial firms that were the backbone of Germany’s export sector.

One of the banks that emerged precisely from this environment was the Bankhaus Herstatt, founded in 1955 in Cologne. The financial system during the Wirtschaftswunder was characterized by prudence and regulation. And Herstatt Bank also initially operated within the conservative banking culture. At that time, exchange rates were stable under Bretton Woods, capital movements were more controlled, and banking profits were closely tied to the real economy. Banks like Herstatt therefore thrived through client proximity and integration into Germany’s industrial expansion.

The success of the German export model also meant increasing engagement with international markets. As firms traded more intensively abroad, banks also expanded their cross-border activities. Even smaller institutions began to develop foreign exchange departments to facilitate international payments and manage currency exposure for clients.

Herstatt Bank was ambitious and eager to grow alongside the country’s expanding global presence, riding the wave of the broader transformation of West Germany from a war-torn region into an export powerhouse. And this transformation eventually took small to mid-sized private banks to the intersection of global markets and international finance.

The Nixon Shock and the rise of currency speculation

When President Richard Nixon announced on August 15, 1971 that the United States would suspend the convertibility of the dollar into gold, the decision was framed as a temporary defensive measure to protect the dollar against “international money speculators” together with two other themes; inflation and unemployment. In reality, this decision marked the structural end of the Bretton Woods monetary regime. A recording of broadcast can be viewed here:

[embed]Source: Richard Nixon Presidential Library YouTube Channel

The announcement was unilateral and delivered in a nationally televised Sunday evening address while financial markets were closed, leaving allies little room for consultation or immediate response. Foreign governments were informed rather than involved. The gold peg disappeared overnight, and with it the anchor of the postwar system.

Even though the move seemed sudden in execution, it was not entirely unexpected. For years, mounting U.S. deficits, declining gold reserves, and growing foreign dollar holdings had strained the system. European central banks, most notably France, had already begun converting dollar reserves into gold. The crisis had been building leading up to the announcement which was the breaking point. There are of course, countless books written on this topic but let’s focus on the key economic repercussions of this decision:

First, exchange rates were driven by market prices rather than policy instruments. Once major currencies began floating (formally by 1973), they also started responding continuously to macroeconomic data, inflation differentials, oil shocks, monetary policy divergence, and capital flows. Expectations themselves became a tradable commodity in currency markets.

Second, volatility became structural rather than exceptional. The early 1970s were characterized by stagflation, oil embargos, and sharply divergent monetary policies across advanced economies. Exchange rates moved dramatically within short time horizons. And market players loved this volatility as it created systematic opportunities for both hedging and speculation.

Third, financial innovation accelerated in response to uncertainty. Banks expanded forward markets, currency swaps, and eventually options to manage exchange rate risk. These instruments allowed institutions not only to hedge but also to take leveraged directional positions. Currency dealing became an active, revenue-generating business especially for banks that were sitting on large pile of capital. Where previously, banks profits were mostly from lending and borrowing interest-rate differentials. But now they could themselves now actively invest.

The Nixon Shock allowed speculation to rise because the system’s architecture now permitted and incentivized continuous currency positioning. Banks like Bankhaus Herstatt expanded into this environment precisely because volatility made it profitable to do so.

Herstatt exposes a structural flaw in global finance

Foreign exchange transactions involve two separate payments. If a German bank agrees to exchange Deutsche Marks for U.S. dollars, it delivers Marks in Frankfurt while receiving dollars in New York. These payments occur through different national clearing systems operating in different time zones. In the 1970s, settlement systems were slower, largely manual, and not synchronized. There was no real-time global clearing platform and payments were processed sequentially.

On June 26, 1974, German regulators withdrew Bankhaus Herstatt’s banking license at 4:30 p.m. Cologne time. The decision was not sudden. In the weeks leading up to the closure, supervisory authorities had uncovered the full scale of the bank’s foreign exchange losses. Herstatt had accumulated massive open dollar positions that moved sharply against it as the U.S. currency depreciated. Losses had grown so large that they exceeded the bank’s capital base, rendering it effectively insolvent.

Under German banking law, once a bank’s liabilities exceeded its assets and it could no longer meet its obligations, regulators were required to intervene. Authorities had already attempted to stabilize the institution by encouraging shareholders to inject additional capital, but the gap proved too large. When it became clear that Bankhaus Herstatt could not honor its settlement obligations, supervisors revoked its license and froze its activities to prevent further losses and disorderly payments.

The timing, however, proved critical. By late afternoon in Cologne, European counterparties had already delivered Deutsche Marks to Herstatt earlier in the trading day as part of routine foreign exchange settlements. The corresponding U.S. dollar payments were scheduled to be processed later through the New York clearing system, once U.S. markets opened. When the license was withdrawn and payments were halted, those dollar transfers never took place.

This exposure, where one side of a foreign exchange transaction settles while the counterparty fails before completing the reciprocal payment, became known as the **Herstatt Risk** or the principal-settlement risk. Several structural factors amplified the problem:

1. Absence of Payment-versus-Payment (PvP) mechanisms: Modern systems ensure that one currency is delivered if and only if the other is simultaneously delivered. In 1974, such mechanisms did not exist.
2. Fragmented National Supervision: Each jurisdiction oversaw its own banks, but no authority monitored the full cross-border exposure of foreign exchange positions.
3. Increased Transaction Volume: Following the move to floating rates, foreign exchange trading volumes expanded rapidly. Larger gross flows meant larger settlement exposures.

The Herstatt episode caused immediate market disruption. In the days following the closure, banks grew wary of settling foreign exchange transactions in the usual sequential manner. Institutions that had previously released payments on trust began demanding greater assurances before transferring funds. Some delayed settlements until confirmation of reciprocal payment arrived, while others reduced their exposure limits to counterparties altogether. Interbank liquidity tightened as uncertainty spread through currency markets. Trust, the invisible foundation of the financial system, was shaken. What had appeared to be a technical settlement issue quickly revealed itself as a systemic risk.

The disruption was particularly alarming because Herstatt was not one of Germany’s largest banks. If a mid-sized institution could trigger cross-border payment failures, the implications for larger and more interconnected banks were obvious. Supervisors and central banks recognized that the problem was not merely insolvency risk, but structural settlement risk embedded in the architecture of global finance.

The main lesson from this episode was clear. Once finance operates continuously across time zones, settlement infrastructure must operate globally as well. Payment systems designed for nationally segmented banking were inadequate for 24-hour currency markets. Over the following decades, central banks and market participants worked to reduce the principal-settlement risk.

In that sense, the Herstatt shock did more than disrupt markets for a couple of days. It effectively reshaped how the global financial system and its infrastructure thinks about settlement risks and other forms of systemic stability.

Post-Herstatt: The birth of modern banking supervision

The collapse of Bankhaus Herstatt in 1974 made it clear that banking had become global, and that national-level supervision was inadequate. In response, central bank governors from major industrial economies convened at the **Bank for International Settlements (BIS)** in Basel. Although the BIS itself had been founded in 1930 as a forum for central bank cooperation, Herstatt gave it a renewed and far more consequential role in shaping international banking oversight.

Later in 1974, the **Basel Committee on Banking Supervision (BCBS)** was established under the BIS umbrella. Its mandate was to ensure that internationally active banks would be subject to effective supervision, prevent regulatory gaps between jurisdictions, and strengthen cooperation between “home” and “host” country authorities.

The Committee set several principles and common standards designed to clarify supervisory responsibilities across borders, promote minimum capital adequacy, improve risk management practices, and reduce systemic spillovers from bank failures. These efforts marked the beginning of coordinated global banking regulation. Over time, the work of the BCBS would evolve into the Basel Accords, the key frameworks that continue to define financial risk governance worldwide. These Accords have created their own interesting dynamics, but we will continue this story in another post!

About the author

Asjad Naqvi is an economist based in Vienna, Austria. He has been teaching, doing research, and policy work on macro-financial-climate topics for over a decade. You check his profile and projects on GitHub or on his personal website. You can connect with him via Medium, Twitter/X, BlueSky, LinkedIn, or simply via email: asjadnaqvi@gmail.com.

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