The collapse last week of Stockwalk, a Minneapolis securities firm, shows in microcosm just how contagious failures can be.
Stockwalk was a relatively small Golden Valley, Minnesota-based stock brokerage that grew rapidly in recent years. It had specialized in underwriting municipal bond issues, supplied venture capital to local high-tech firms and established a competitive clearing system for local stocks. There were no prior indications that it was poorly managed in any way.
It had, however, borrowed stock in a risky telemarketing firm called GenesisIntermedia from another small securities firm in New York called Native Nations. A client of that firm reportedly defaulted on an obligation, and Native Nations then failed to make a required $60 million payment to Stockwalk.
Stockwalk’s owners had to report to securities regulators that it no longer met required capital levels. The regulatory agencies then froze customer accounts until things could be sorted out.
More than 200,000 customers were unable to make any trades from their Stockwalk accounts during the most volatile weeks in equity market history. And anyone who owned shares of the firm itself essentially lost everything.
As far as the national economy goes, this all was a tempest in a very small teapot. Most clients will not suffer any loss of principal, although they lost the potential benefits from any trades they might have made over the 10 days their accounts were frozen. No bank failed, and regulatory agencies worked exactly as they should.
But this example illustrates how quickly a modern financial system can seize up. Thousands of businesses and households have accounts with some reputable financial institution. The institution makes a mistake in managing its risks, or it depends on a normal flow of payments from another financial institution, also of good repute, that makes a mistake. Someone defaults, and a chain of dominos starts toppling. How far the chain reaches depends on the effectiveness of regulators.
Within the wealthy nations of North America and Europe, regulators usually are poised to work quickly and well. Nevertheless, the failure of a large institution can challenge even the best regulators—and that is within national borders.
For an international example, look at the legendary Herstatt case, which began on June 26, 1974, when I.D. Herstatt, a German bank, went broke after losing large sums speculating on exchange rates. That same day, at the 4 p.m. close of business, the Bundesbank stopped clearing payments drawn on the bank.
That hour in Frankfurt was only 10 a.m. in New York. Herstatt had already received payment in Deutschmarks for that day’s transactions but still owed more than 600 million in U.S. dollars to other banks, many in the United States.
Chase Manhattan, Herstatt’s U.S. correspondent bank initially refused to pay claims against it. The Clearinghouse Interbank Payment System, by which large international banks settle amounts due each other, nearly broke down. While the global financial system weathered the crisis, international lending slumped for months and “risk premiums” increased for many international borrowers.
Strictly speaking, “Herstatt risk” refers to a breakdown of payments systems because of the failure of one institution that does business across many time zones. But in more general terms, it refers to a falling-domino chain reaction where one insolvent institution topples another.
There are no international agencies empowered to step in when a chain of financial dominos crosses and recrosses international borders. National regulators talk to each other, as do central bankers. For decades, Alan Greenspan or his predecessors have made monthly trips to Europe to confer with counterparts from the other major economies.
Indeed, Greenspan was in Europe on just such a trip on September 11 and had to be brought back to the U.S. by a military transport when all commercial flights were stopped.
An attack that leveled square blocks of the world’s most important financial district obviously posed some potential of payments system breakdown. The major central banks spoke in unison to indicate their readiness to act. No significant problems emerged.
But the risk of some new, mutant international payments-system breakdown remains the nightmare of every president of a major central bank and the finance minister of every G-8 country. Our local brokerage incident illustrates how, and how quickly, it can happen.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.