Continental Illinois

The Aggressive Growth of Continental Illinois

Continental Illinois had a history of conservative lending, however in the mid-1970's its managementbegan implementing a growth strategy focused on commercial lending, explicitly setting out to become one of the nation's largest commercial lenders. By the year 1981, Continental Illinois had turned out to be the largest C&I lender in the United States. Between 1976 and 1981 Continental Illinois' C&I lending skyrocketed from around $5 billion to more than $14 billion, a jump of 180 percent. Meanwhile, its totals assets rose from $21.5 billion to $45 billion, about 110 percent. We can see the extent of this growth by comparing it to the rise in Citibank's lending, from $7.7 billion to $12.5 billion, while its total assets rose from $61.5 billion to $105 billion, a hike of 70 percent. Even as its share price was on the decline during late 1981 and early 1982, many stock analysts continued to recommend purchase of Continental shares. From 1977 to 1981, the bank's average return on equity(ROE) was 14.35 percent, second only to Morgan Guaranty's 14.83 percent. Over the same period, Citibank's return on equity was 13.46 percent, whereas FirstChicago, Continental Illinois' cross-town rival, had around 9.43 percent. They had one of the lower equity levels of the large banks with an avergae of 3.78 percent, making it the 7th out of 10. In addition, asset and loan growth at Continental was at least matched by growth in the bank's equity ratio, which rose from 3.55 percent at the end of 1976 to 4.31 percent at the end of 1982.However, there were two important aspects of Continental's financial profile that, with the benefit of hindsight, were indicators of the increased risk the bank took on during its growth period:

1) Continental's loans to assets ratio increased dramatically from 57.9 percent to 68.8 percent between 1997 and 1981

2) Although Continental's return on assets was adequate over this period, it hovered at around 0.51 percent; with a higher percentage of assets in loans, the average loan had to have been earning less at the end of the period than it had been at the beginning, implying that over time, Continental was originating loans with lower interest rates than those on the books in 1978

GIVEN THE LARGE INCREASE IN INTEREST RATES OVER THIS PERIOD, IT IS VERY LIKELY THAT THE BANK MIGHT HAVE ADOPTED A BELOW-MARKET PRICING STRATEGY!!!

This suggests that Continental's lending style might have been overly aggressive. The bank's growth was attributed partly to its zeal for occasional transactions that carry more than the average amount of risk. This monstrous growth was also perceived to stem from aggressive pricing. A Chicago competitor noted in 1981 that "even with a 20% prime they were doing fixed rate loans. I don't know how they do it." Late in 1981, however, problems were beginning to surface. The bank's second-quarter earnings fell 12 percent, a drop that CEO Roger Anderson explained was largely the result of backing interest rates the wrong way. In the first six months of 1982, NuCorp Energy lost more than $40 million, and Continental had a large portion of the company's debt. Continental had also lent $200 million to the near-bankrupt International Harvester. After peaking approximately 42 in June 1981, Continental's share price declined almost 37 percent during the next year. Many stock analysts believed the reaction was over done and the downturn in stock price more psychological than fundamental. Yet in March 1982, when Fitch's Investors Service Inc. downgraded six large banks' ratings, Continental retained its AAA rating.

Penn Square and the Exposure of the Weakness of Continental Illinois

Two events in the summer of 1982 managed to swing people's opinions against Continental Illinois. Those two significant events were the collapse of Penn Square bank in July 1982 and Mexico's August 1982 debt default. Optimism about Continental's condition came to an abrupt halt when the Penn Square Bank in Oklahoma failed. During the 1970's and the early 1980's, Penn Square had made billions of dollars in the rather speculative oil and gas exploration loans, many of which were to prove absolutely worthless, and Continetal purchased $1 billion for participations from Penn Square. While Continental pressed regulators to find a way to prevent a deposit payoff of Penn Square, a course that also would have been preferred by both the Federal Reserve and the OCC, the larger banks involved refused either to inject money into Penn Square or to waive their claims on the bank. The refusal to waive their claims meant that the contingent liabilities the FDIC woudl have incurred militiated against every course except a deposit payoff. Pen Square turned out to be the largest bank payoff in the history of FDIC until 1992. News of Continental's relationship worried the investors and they downgraded their opinions on the company, as well as halving the earnings. During July the share price went down to 16 dollars, a 62 decline from the year before. The LDC debt crisis triggered by Mexico's default in 1982 made the matters only worse for Continental Illinois and its adminsitration.

The External Factors Involved

US Oil Recession: During much of 1981, world wide crude markets were flooded with an increase of 2 million barrels a day more then was actually needed. Oil companies, especially US based firms were increasingly hard hit by the excess supply of crude that was ultimately racking up inventory costs while sitting around in its holding tanks. Tremendous pressure from the US consumers to become more economical and oil efficient, coupled with the surplus of oil ultimately caused prices to drop, bringing the US energy sector into a recession. Numerous US firms who had been profiting from the increased prices at the beginning of the year began to feel the squeeze as they saw many of their retained earnings eaten up. The domestic banks who specialized in funding these local oil research and development firms took dramatic hits with regards to performance as growth within the market was brought to a near standstill. The eventual increase in prices brought on later in the year helped to resurrect parts of the energy sector however, it was by this time that much of the irreversible damage had been done.

Mexico Defaults on Debt: On August 19th, 1982, Reuters began to report on rumors circulating through the financial community that Mexico was going to default on its loans. To 1000 banks worldwide this was not a good sign as Mexico had roughly $81Billion dollars in outstanding debt, much of which was credited by US banks. Continental Illinois happened to be just one of those banks who had invested hundreds of millions within the Mexican pesos, only to hear on August 20th that Mexico had declared that it would not pay any principal or interest payments to foreign firms whose money it had borrowed. Within a days period, Mexico had gone forth and nullified, in many cases, up to 90percent of US banks assets which had been loaned overseas. In addition to the outstanding debt, the Mexican treasury had also asked for an immediate $1-2 Billion credit that the country could use to temporarily stabilize the markets. For many of the US banks, they would never again see the full return of their initial investments.

Liquidity Crisis in the Eurodollar Market: Due to Continental's domestic troubles with bad loans and savvy domestic investors, it found itself paying increasingly high rates on CDs. Squeezed by the market to remain highly liquid, Continental turned overseas to the Eurodollar market for funding. Many international investors were happy to lend to the bank on the terms that it pay relatively high rates of return. As rumors began to spread through the international community that Continental was not performing as well as expected, investors became more and more uncomfortable with the idea of lending money to a non-solvent institution. Ultimately, panic spread throughout the foreign investors as they worried about the liquidity of their investments, subsequently pulling their funds out of the bank, inducing one of Continentals worst fears, a bank run.

The Famous Bank Run

In May of 1984, Continental Illinois endured the worst bank run in the history of the company. Previous financial deterioration and the heightened reliance for funding from the Eurodollar market helped to make Continental as vulnerable as it was the high-speed electronic bank run that eventually ensued. On May 9, Reuters asked Continental to comment on rumors that the bank was on the road to bankruptcy; the bank condemned the story as “totally preposterous”. In addition to the previous rumor, stories started to circulate that a Japanese bank was interested in acquiring Continental, and that the OCC had asked other banks and securities firms to assist the bank. These rumors therefore caused anxious overseas depositors to begin to shift many of their deposits away from Continental. Chicago’s board of Trade Clearing House had also been rumored to be doing the same, causing mass panic within the depositors who had yet to remove their assets. In an effort to calm the situation, the Comptroller of the Currency, departing from the OCC’s policy of not commenting on individual banks, took the extraordinary step of issuing a statement denying that the agency had sought assistance for Continental. He also noted that the OCC was “unaware of any significant changes in the bank’s operations, as reflected in its published financial statements, that would serve as the basis” for these rumors.(Chapter 7) After two days of attempting to slow the run, Continental found itself at the Federal Reserves discount window borrowing $3.6 Billion in order to make up for its lost deposits. During the following weekend, Continental attempted to solve its problems by creating a $4.5 Billion loan package that was supported by 16 different banks. While this attempt ultimately failed to hold off the depositors, it signaled to the Fed that it was time to step in.

Timeline of Events(Continental Illinois's rise and fall)

Timeline

1976 - 1981: Continental grows fast, lending to the energy sector and lesser-developed countries

1981: Continental hits a high point in terms of asset size and by now employs some 12,000 people

1981: The US energy sector, hit by oil price falls, moves towards recession

July 1982: Energy-sector specialist Penn Square Bank fails, causing concern about Continental, a major participant in Penn Squares risky lending programme

August 1982: Mexico defaults on debt, sparking LDC debt crisis

Spring 1984: With non-performing loans rising sharply, Continentals critics are now wondering about its solvency

9 May: Final liquidity crisis begins in Eurodollar markets as rumours swirl about Continentals creditworthiness

11 May: Continental forced to borrow $3.6 billion through Fed discount window

14 May: 16 banks put together rescue package of funding, but the run on Continental continues

17 May: Unprecedented interim assistance package announced by panicked regulators. Uninsured depositors and creditors given FDIC assurances.

July: With it proving difficult to find a purchaser for the bank, regulators work with Continental to devise a permanent solution

26 September: Permanent solution put in place, effectively nationalising Continental using FDIC funds. (FDIC controling 4.5 Billion dollars of bad loans formerly held by Continental)

1991: FDIC sells off its last equity stake in Continental, bringing the rescue programme to a close some seven years after the banks near collapse\

Taken from http://www.erisk.com/Learning/CaseStudies/ContinentalIllinois.asp

Too-Big-To-Fail Doctrine

In 1950 an amendment was added to the Federal Deposit Insurance Act of 1934 that would change the way the central bank acts toward different types of banks. The doctrine says that a bank must be rescued when the "continued operation of such a bank is essential to provide adequate banking service in the community"(Samuelson and Krooss, 354). Because none of these terms were ever strictly defined the central bank has been given the ability to interpret the sentence and act on it as is seen fit. That sentence has come to be understood as the central bank should and must bail out large struggling banks with all the liquidity necessary to keep the whole banking system intact. The Federal Deposit Insurance Corporation or FDIC insures all depositors up to 100,000, but with that additive clause passed in 1950 the Central Bank is now responsible for insuring much larger sums. On September 19, 1984, it was testified to congress that some banks were just "too big to fail." Those included in this protective shield were the 11 largest. The Wall Street Journal soon after identified the 11 as BankAmerica, Bankers Trust, Chase Manhattan, Chemical Bank, Citibank, Continental Illinois, First Chicago, J.P. Morgan, Manufacturers Hanover Trust, Security Pacific and Wells Fargo.

Conclusions

After the experiences of Continental Illinois the idea that a bank could be too big to fail went out the window in the sense that banks had the ability to collapse. This statement rings true because large banks did fail during this period and their shareholders lost their holdings. The government stepped in to prevent extreme spillover effects that could be caused by widespread depositor runs, but the more important effect was psychological. Even though public confidence decreased toward the banking system all depositors were paid back and the situation never reached the levels of bank defaults that were seen in the depression.

The idea that large banks such as Continental were too big to fail was proven to be bogus, but one did learn that during this period in time there were banks that were large enough where in fact they were too big to liquidate. It would have been almost logistically impossible to liquidate such a large bank; the uninsured depositors would be caught waiting for their funds during potentially long proceedings which would be incredibly disruptive to the banking system.

Prevention

Some individuals such as the Federal Reserve Board Governor, Charles Partee stated that if there were steps taken to restrain Continental Illinois, it would have hindered their growth potential. As long as Continental was making good loans, many saw no problem with aggresive banking policy. Others at the Fed feel differently. Federal Reserve Board General Counsel, Michael Bradfield was quoted to say "The real failure of supervision [was that]...nobody did anything about Continental in the late seventies and early eighties."

In order to address the issues that Continental Illinois ran into we must first understand the banking climate during the 1970’s. An article by Randall Krosner and Philip Strahan depict a national banking system after the new deal that was highly regulated until the 1970’s when national and state policies moved to become more lenient. “Since the early 1970s, however all but one of these states have relaxed restrictions on intrastate branching” (Kroszner and Strahan, pg 1440). This statement depicts a climate in which banks were increasingly able to merge and collude. These banks were able to expand and have many branches of a single bank. Banks in one state were also able to purchase banks that existed in other states. This type of deregulation officially began in 1975 when the state government of Maine passed a statute permit out of state holding companies to acquire Maine banks.

The idea that banks from different localities could join together and become more efficient on the surface is very attractive. When one looks deeper into the connection between bank size and unrestrained politic clout that one bank may hold, this deregulation process can be crippling to the banking system as a whole. In one study by Strahan and Wetson, it was found that the availability of credit to small businesses increases in the years following a small scale bank being taken over by a large bank (Kroszner and Strahan, 1444). Therefore, if large banks become more prevalent, more risky loans will be given out and the risk of the borrowing defaulting becomes greater, making the banking system less solvent.

Contential Illinois attempted to expand in the late 1970s and early 1980s. Contential’s adverse selection process loosened during this period because of deregulation making it very easy for the bank to expand. This expansion occurred in an unstable way. The bank's primary assets to fund loans were not from retail depositors, but from the sale of short term certificates of deposit on a wholesale market. These wholesale markets saw a great deal of volitility and left the basis of Continental Illinois's funds exposed to public opinion. Eventually public opinion turned on the high flying energy stocks of the 1970's and the bank found itself looking else where for money to back its loans. Even though Continental Illinois's growth would have been hindered regulators should have taken action to make sure that the basis of the company is solidly funded. At many point in the early 1980's Continental's retail deposit monies totaled a mere 20% of all the bank's funds. Many authors implyed in our research that 1/5th is not a sustainable percentage and that it should be a much larger proportion in order for the bank to be more insulated from the business cycle.

Works Cited

Bennett, Robert A. . "MEXICO SEEKING POSTPONEMENT OF PART OF DEBT ." New York Times 12/08/1982 11/2/06 <http://select.nytimes.com/search/restricted/article?res=F10913F8345D0C738EDDA10894DA484D81>.

Case Study: “Continental Illinois” taken from http://www.erisk.com/Learning/CaseStudies/ContinentalIllinois.asp on 11/28/06.

History of the Eighties—Lessons for the Future. “Continental Illinois and ‘Too Big to Fail.’” Chapter 7.

Lamy, Robert E. and Moyer, R. Charles. “‘Too big to fail’: rational, consequences, and alternatives – banking.” Business Economics. July, 1992.

Martin, Douglas. "U.S. ECONOMY AIDED BY WORLD OIL GLUT ." New York Times 02/05/1981 11/2/06 <http://select.nytimes.com/search/restricted/article?res=FA0E1EF93D5C0C718CDDAC0894D9484D81>.

Samuelson, Paul A. and Krooss, Herman E.. Documentary History of Banking and Currency in the United States, Volume IV. New York: Chelsea House Publishers, 1983. Pg. 354.