George Soros, in a speech at Davos, stated that we know very little about how financial markets work(click here). 61 years after Harry Markowitz's famous paper, and 50 years since Samuelson and Fama developed the efficient markets hypothesis, and 40 years after the Black-Scholes-Merton model, we are still no further forward in understanding financial markets according to Soros! What are we to do? Some scholars think that behavioural finance is the way to go. The application of psychology to financial markets is certainly interesting and potentially fruitful. However, my own hunch is that we need to understand better the role of government in manipulating and influencing financial markets.
As an undergraduate, I was taught about the failure of Herstatt Bank in 1974 and Herstatt risk. This bank was only the 35th largest bank in Germany at the time so why would anyone be interested in studying its failure? Herstatt failed because of its involvement in risky foreign exchange business. When it closed its doors on 26 June 1974, counterparty banks (mainly in New York) had not received dollars due to them because of time-zone differences - this is known as settlement risk. The cross-jurisdictional implications of its failure resulted in the Bank for International Settlements setting up the Basel Committee on Banking Supervision and Herstatt's failure was a key reason for the establishment of real-time gross settlements systems, which ensures that payments between two banks are executed in real time. The Bank of England's Ben Norman has an interesting post on Herstatt over at the Bank's new blog ( Bank Underground ). As well as giving an excellent overview of