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.

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 Continental. These rumors therefore caused anxious overseas depositors to begin to shift their deposits away from Continental. Chicago’s board of Trade Clearing House had 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 and took the extraordinary step of issuing a statement denying that the agency had sought assistance for Continental and 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.

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.