Report on Continental Illinois and “Too Big to Fail”

AKANSHA JAIN(93005)

AKSHAY TALWAR(93006) AMBA PRASAD TIWARI(93007)

AMIT SINGHAL(93008)

Factor responsible for collapse of Continental Illinois:

Highly aggressive growth strategy which was highly leveraged: Continental was following

below- market pricing strategy. Continental return on asset was .51% with higher portion of asset

in loan, the average loan to have been earning less at the end of the period. i.e. Continental loans

with lower interest rates than in books in 1978.

Increase in the loan to asset ratio over the years: Continental’s loan-to asset ratio increased

dramatically- from 57.9% in 1977 to 68.8% by year end 1981 which was the highest among top

10 USA bank. The large portion of its portfolio it holds in loan leads to more exposure of bank to

default risk due to increase the chance of bad loan.

Risk of high exposure by providing loans to a particular sector: Penn Square acted as a

business scout in the ‘oil patch’ for Continental and others. When Penn Square booked loans and

reached its lending capacity, it simply offered a share of the action to the larger banks, collected

the equivalent of a finder’s fee, then turned around and went out to find more oil prospectors

who needed money. In the late 1970s and early 1980s, Continental bank lend loan to Penn

Square in large-scale energy-related investments (high-risk energy loans to Oklahoma and Texas

oil boom). Irresponsible lending practices in connection with the sale of over $1 billion in "loan

participations" to other banks throughout America, coupled with falling energy price burst Penn

Square's bubble in July 1982, Continental was stuck with more than $1 billion in bad loans. That

disaster led in 1984 to a run on Continental by institutional funders and a liquidity crisis and lead

to a situation of insolvency.1

Heavy reliance on purchased funds from abroad:

After its increase in bad debt Continental unable to finance its domestic operations from

domestic market turn to foreign money market(at higher rate).Continental’s reliance on the

Eurodollar market for Funding, leads to its vulnerability to the high-speed electronic bank run in

1984.

Negative image created due to association with three of the largest bankruptcies in 1982:

Continental lending to 3 largest corporate bankruptcies turn perception of bank increasingly

negative. Continental little presence in retail banking leads to very small core deposit. due to

restriction of federal banking law on expansion unit banking in the state it has to depend on fed

fund and large CDs. But with bank abysmal rating force it to take deposit on higher rate.

LDC Debt crisis: Continental banks (like most of other USA banks) troubles began when it lost

its big corporate customers to the commercial paper market early in the 1970s.This reduced share

of one of the banks primary staples, the working capital loan, placed pressure on banks to seek

new sources of revenue and provided an impetus for them to turn to the lucrative overseas loan

markets. In order to expand it is tempted to extend credit more generously than is prudent, while

its loan concentration is more on Mexico. In august 1982 when Mexico and other Latin

American countries default nonperforming loans increased from $40 million to $2.3 billion

results in loss of credibility in bank and investors start taking their money out from the bank1

After going through the case, it was seen that apart from continental’s own fate that was

responsible for its problems, there were certain other extraneous features that accounted for these

problems, though majority of the crises was attributable to its own actions only.

CONTINENTAL ILLINOIS’S FAULTS

These were the mistakes committed by continental Illinois which shows that continental’s own

fate was responsible for its problems.

Continental’s first mistake was its aggressive growth strategy that it followed during

mid 1970s. During that time continental was blindly moving towards achieving growth

many folds. For this very reason, they were moving towards a non conservative growth

approach, which eventually caused the maximum amount of damage to it.

Secondly, as a part of its aggressive growth strategy, continental resorted to an

aggressive commercial lending. Also, in 1980s, continental went on to becoming the

biggest commercial and industrial lender. It was seen that continental was indulging into

everything it could to give out loans, which led to exaggeration of continental’s

problems.

And it was this aggressive lending that prompted continental to take excessive risks

during its growth. This excessive risk taken by the bank was visible from two things. The

loan to asset ratio, which increased from 57.9% in 1977 and 68.8% in 1981, was

indicative of this excessive ratio as the greater the proportion of its portfolio a bank holds

in loans, the more exposed the firm is to default risk. Also, continental had during this

time followed a below market pricing strategy in which it offered loans at a cheaper

rates of interest. During this time, the bank aimed at giving out the most number of loans

it can.

In its attempt to give out huge number of loans, continental made a mistake of giving out

loans to whosoever approached it, ignoring bad credit loans also. Thus in turn it had to

face a number of non performing loans, which added to the bank’s increasing credit

crunch and led to bankruptcy.

Continental’s growth was primarily attributed to occasional transactions that carried more

than the average risk. But despite growth, again this was the reason that brought

downturn to it. Continental’s more than average risk in one of the most significant sector,

the energy sector affected it badly when prices of oil and gas fell. It carried a large

portion of Nucorp Energy’s debt. Apart from this it had also lent $200 million to the

near bankrupt international investor, Harvester.

As is evident from these points, we conclude by saying that it was majorly Continental’s own

fate that was responsible for its problems. Had continental not followed such a liberalization

lending strategy it would have never given loans at such a cheaper rate, which would have not

exposed it to the excessive risk and thus it would have never fallen into the trap of default risk

and bad credit loans.

But there were certain EXTRANEOUS FACTORS that were responsible for continental’s

problems to a certain extent.

A sudden reversal in the fortune of most of the companies in the energy sector, like the

Nucorp Energy, caused a lot of damage to continental as it had a large proportion of its

debt. Since the performance of the energy sector was not in the hands of continental,

hence it was an extraneous factor

Failure of Penn Square Bank, in Oklahoma was again known to bring problems the

continental way. Continental’s purchase of 1$billion in Penn square proved to be

disadvantage to it on a sudden failure of Penn Square, who had initially generated billions

of dollars in speculative oil and gas exploration loans. Thus the failure of Penn Square

could again be taken as an extraneous factor as its occurrence was not in continental’s

hands. Also the refusal of FED, OCC and other large banks to help it out went against the

favor of continental

Apart from this, continental’s lending involvement with three of the largest corporate

bankruptcies of 1982 helped turn perceptions of the bank increasingly negative. It is also

known that for a bank investor perception is highly valuable. Once a bank looses its

credibility in the eyes of its investors, it leads to a case of bank run, which is the most

difficult to control

One another extraneous factor was the advent of the less developed country (LDC) crises

brought on by Mexico’s default in 1982. Since continental had a significant LDC

exposure, hence these crises aggravated continental’s problems.

MANAGEMENT’S ROLE IN CONTINENTAL’S CRISES

The role of the management had been quite significant when it comes to continental’s crises.

Bank’s management was seen to contribute the maximum to the bank’s failure.

To begin with one of the most prominent mistakes was the combination of bad policies

adapted by the company’s management.

Secondly, bank management took extreme and unusual steps in terms of lending

practices. As it has been talked above a strategy of aggressive lending with excessive risk

taking prompted the entire crises situation.

Apart from that management of the bank completely blind folded itself in front of the

alarming loans to asset ratio which was indicative of the high risk the bank was putting

itself into.

Management’s continuous dismissal to objections raised on its aggressive lending style

again brings forth a loophole in its role.

Apart from this. Despite signs of breaking down, Continental’s management kept

defending the bank’s lending policies. This in turn made the gravity of the situation to be

hidden from the investors who couldn’t get a clearer picture of bank’s riskier policies.

The fault in bank’s management can also be seen from its favor towards issuing shorter

term, more volatile but expensive instruments rather than longer term ones that were both

more stable and more expensive. Thus this was the reason, why continental relied on

federal funds and large CDs and thus had little retail banking business and small amount

of core deposits.

Loosening internal controls by bank management on the growth strategy of the bank also

tells about the faults in management of the bank

Lastly, we also see that when chairman of Federal Reserve board advised the

continental’s directors to make changes in both management and lending policy, then the

management refused to do so. Had the management had taken right corrective steps at

that time, then the situation wouldn’t have worsened so much.

All these points throw light on the management role in the entire process of continental’s crises

and tell that management was at a great fault in dealing with bank operations and functions

Role of FED in Continental’s Fiasco

As we have learned about the Continental’ growth story from the period of mid 70’s through till

1982, we have seen that the growth was the result of aggressive strategy followed by the bank.

The efforts from the bank were mainly focused in commercial lending that too was mainly

concentrated in the energy sector.

Most of the indicators of the bank’s condition were good as can be seen from the fact during the

period of 1977 – 1981; the bank’s average return on equity was more than 14%, thus making it

difficult for the people to realize the risk inherent in the Continental’s rapid growth.

However, indicators like loan to asset ratio showed a different story all together where it was

seen that the loan to asset ratio increased to 68.8% in 1981 which suggested that the bank was

riskier because of the higher default risk. It was also seen that the bank was lending at a rate

lower than that prevailing in the market because of its overly aggressive strategy.

Now as we know that Federal Reserve as a regulator should perform following functions:

Supervising and regulating banking institutions to ensure the safety and soundness of the

nation's banking and financial system, and protect the credit rights of consumers.

Maintaining stability of the financial system and containing systemic risk that may arise

in financial markets.

The regulatory authority tried everything it could have to avoid the bank run, though the attempt

was unsuccessful. The authority provided Continental with the assistance packages. The Federal

Reserve was committed to any kind of liquidity that could be needed in the near future by the

bank.

The regulatory authority also searched for a suitable merger partner. All these steps were taken in

lieu of avoiding the liquidation of the bank which was appropriate at that time because the bank

was too big to be liquidated. There were 34 other banks which were directly associated with the

Continental due to their exposure to the bank which would have gone down under in case

continental went bust.

Although, regulatory authorities did their best to help avert this crisis, but they also had a hand to

play in some way. They should have monitored the lending policies followed by the bank that

were too aggressive and should also have advised the bank authorities to correct its ways, like,

they should have advised the bank to diversify its portfolio, which was mainly concentrated in

the energy sector, so as to spread the risk.

The Federal Reserve’s decision to rescue Continental was appropriate because if it would have

been the other way round, it would created the systemic risk and U.S. economy would have

faced economic slowdown scenario. So it can be aptly said that the bank was too big to fail.

REFERENCES

http://en.wikipedia.org/wiki/Federal_Reserve_System

http://en.wikipedia.org/wiki/Too_big_to_fail

http://www.erisk.com/learning/CaseStudies/ContinentalIllinois.asp

http://en.wikipedia.org/wiki/Continental_Illinois

http://www.encyclopedia.chicagohistory.org/pages/2627.html

http://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporation

http://www.time.com/time/magazine/article/0,9171,951108,00.html

http://www.allbusiness.com/glossaries/bank-insurance-fund-bif/4952247-1.html

FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC)

The Federal Deposit Insurance Corporation (FDIC) is a United States government corporation created by the Glass-Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. The FDIC insures deposits at 7,895 institutions.[2] The FDIC also examines and supervises certain financial institutions for safety and soundness, performs certain consumer-protection functions, and manages banks in receiverships (failed banks). Insured institutions are required to place signs at their place of business stating that "deposits are backed by the full faith and credit of the United States Government."[3] Since the start of FDIC insurance on January 1, 1934, no depositor has lost a single cent of insured funds as a result of a failure.

TOO BIG TO FAIL

Entities are considered to be "Too big to fail" by those who believe those entities are so central to a macroeconomy that their failure will be disastrous to an economy, and as such believe they should become recipients of beneficial financial and economic policies from governments and/or central banks.[1] It is thought that companies that fall into this category take positions that are high-risk, as they are able to leverage these risks based on the policy preference they receive

CONTINENTAL ILLINOIS NATIONAL BANK & TRUST COMPANY

One of the city's two largest banks for most of the twentieth century, Continental was the product of a 1910 merger of two Chicago enterprises, the Commercial National Bank and the Continental National Bank. The older of the two was the Commercial National Bank, formed during the Civil War and led by Henry F. Eames. Commercial National Bank had become one of the city's leading banks by the early 1870s. The Continental National Bank, chartered in 1883, was led during its early years by John C. Black. By the turn of the century, both banks had grown by absorbing several competitors. In 1910, the merger of Commercial and Continental created a

new entity, the Continental & Commercial National Bank of Chicago, which had $175 million in deposits, making it one of the largest banks in the United States. It continued to grow during the 1920s. In 1929 it merged with Illinois Merchants Trust Co.; three years later, the bank's name became Continental Illinois National Bank & Trust Co. During the Great Depression, the bank required a $50 million loan from Reconstruction Finance Corp. (a federal government agency) to stay afloat. After World War II, the bank grew: by the beginning of the 1960s, Continental had over $3 billion in deposits and employed 5,000 people. By the early 1970s, when it had 60 branches and affiliates around the world, the bank employed about 8,200 Chicago-area residents, many of whom worked at Continental's main offices on LaSalle Street in Chicago's loop. During the early 1980s, after many of its large loans to companies in the oil and gas industries went bad, the bank experienced a sudden and unexpected crisis. Continental's Great Depression–era experience was repeated as the Federal Deposit Insurance Corp. came to the rescue. In 1994, a diminished Continental was acquired by BankAmerica Corp. of San Francisco.

BANK INSURANCE FUND (BIF)

Deposit insurance fund operated by the Federal Deposit Insurance Corporation (FDIC) , insuring deposits in commercial banks and savings banks up to $100,000 in interest and principal per account. Both the bank insurance fund and the savings association insurance fund were formed in 1989 in response to savings and loan bailout. The 2 funds were merged into the deposit insurance fund in 1983

SYSTEMIC RISK

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system ] It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlink ages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. The easiest way to understand systemic risk is to consider a bank run which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, with a sudden flight to quality, creating many sellers but few buyers for illiquid assets. These interlink ages and the potential "clustering" of bank runs are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk

Importance of transparency in dealings public money is involved

“Transparency is public disclosure of reliable and timely information that enables users of

that information to make an accurate assessment of a bank’s financial condition and

performance, its business activities, and the risk related to those activities”.

Transparency is very much required in banks where public money is involved as it is necessary

to keep the depositor and the public in confidence regarding the financial health of the bank,

maintaining stability in the market and also the transparent system ensures that everyone is aware

of the happenings and developments in a company.

Transparent procedures include open meetings, financial disclosure statements, freedom of

information legislation, budgetary review, audits, etc.

Banking transparency and disclosure of bank activities are suggested to prevent future banking

crises, underground banking, unpublished accounts, money laundering, tax evasion, and other

fraud. Forcing banks to disclose more information about their lending and investment in deprived

areas is suggested as part of the fight against financial exclusion.

Good disclosure should be:

Provided on a regular and timely basis.

Easily and broadly available.

Correct and complete;

Consistent, relevant and documented.

A Committee on Banking Supervision highlights that high-quality public disclosure improves

capability of market participants to make informed decisions by:

Allowing them to more accurately assess a bank’s financial strength and performance;

Increasing the credibility of information disclosed by a bank

Demonstrating a bank ability to monitor and manage its risk exposures, e.g. by the

disclosure of quantitative and qualitative information about its risk measurement

methodologies and Reducing market uncertainty.

Countries around the world have been experiencing serious banking problems, often resulting in

slower economic growth and large taxpayer.

The Asian banking problems have been complicated by the lack of transparency and disclosure

in the banking system, making it difficult to gauge the severity of the situation or propose timely

solutions. As a result, a common policy recommendation by the International Monetary Fund,

the World Bank, the U.S. Treasury and leading academics has been to adopt greater transparency

and disclosure in the banking system.

Disclosure can reduce the probability of a banking crisis and aid in the recovery. Disclosure and

transparency can reduce the costs of banking problems. Financial markets are quick to react to

problems in institutions with large exposures to troubled sectors. This provides an incentive to

limit exposure in any one area, and to quickly reduce exposure as problems emerge.

REFERENCES

1. http://hbr.org/1993/03/how-continental-bank-outsourced-its-crown-jewels/ar/1

2. http://www.fdic.gov/bank/historical/history/191_210.pdf

3. http://en.wikipedia.org/wiki/Too_big_to_fail

4. http://www.erisk.com/learning/CaseStudies/ContinentalIllinois.asp

5. http://en.wikipedia.org/wiki/Continental_Illinois

6. http://www.encyclopedia.chicagohistory.org/pages/2627.html

7. http://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporation

8. http://www.time.com/time/magazine/article/0,9171,951108,00.html

9. http://www.allbusiness.com/glossaries/bank-insurance-fund-bif/4952247-1.html

GLOSSARY

FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC)

The Federal Deposit Insurance Corporation (FDIC) is a United States government corporation created by the Glass-Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. The FDIC insures deposits at 7,895 institutions.[2] The FDIC also examines and supervises certain financial institutions for safety and soundness, performs certain consumer-protection functions, and manages banks in receiverships (failed banks). Insured institutions are required to place signs at their place of business stating that "deposits are backed by the full faith and credit of the United States Government."[3] Since the start of FDIC insurance on January 1, 1934, no depositor has lost a single cent of insured funds as a result of a failure.

TOO BIG TO FAIL

Entities are considered to be "Too big to fail" by those who believe those entities are so central to a macroeconomy that their failure will be disastrous to an economy, and as such believe they should become recipients of beneficial financial and economic policies from governments and/or central banks.[1] It is thought that companies that fall into this category take positions that are high-risk, as they are able to leverage these risks based on the policy preference they receive

CONTINENTAL ILLINOIS NATIONAL BANK & TRUST COMPANY

One of the city's two largest banks for most of the twentieth century, Continental was the product of a 1910 merger of two Chicago enterprises, the Commercial National Bank and the Continental National Bank. The older of the two was the Commercial National Bank, formed during the Civil War and led by Henry F. Eames. Commercial National Bank had become one of the city's leading banks by the early 1870s. The Continental National Bank, chartered in 1883, was led during its early years by John C. Black. By the turn of the century, both banks had grown by absorbing several competitors. In 1910, the merger of Commercial and Continental created a new entity, the Continental & Commercial National Bank of Chicago, which had $175 million in deposits, making it one of the largest banks in the United States. It continued to grow during the 1920s. In 1929 it merged with Illinois Merchants Trust Co.; three years later, the bank's name became Continental Illinois National Bank & Trust Co. During the Great Depression, the bank required a $50 million loan from Reconstruction Finance Corp. (a federal government agency) to stay afloat. After World War II, the bank grew: by the beginning of the 1960s, Continental had over $3 billion in deposits and employed 5,000 people. By the early 1970s, when it had 60 branches and affiliates around the world, the bank employed about 8,200 Chicago-area residents, many of whom worked at Continental's main offices on LaSalle Street in Chicago's loop. During

the early 1980s, after many of its large loans to companies in the oil and gas industries went bad, the bank experienced a sudden and unexpected crisis. Continental's Great Depression–era experience was repeated as the Federal Deposit Insurance Corp. came to the rescue. In 1994, a diminished Continental was acquired by BankAmerica Corp. of San Francisco.

BANK INSURANCE FUND (BIF)

Deposit insurance fund operated by the Federal Deposit Insurance Corporation (FDIC) , insuring deposits in commercial banks and savings banks up to $100,000 in interest and principal per account. Both the bank insurance fund and the savings association insurance fund were formed in 1989 in response to savings and loan bailout. The 2 funds were merged into the deposit insurance fund in 1983

SYSTEMIC RISK

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system ] It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlink ages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. The easiest way to understand systemic risk is to consider a bank run which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, with a sudden flight to quality, creating many sellers but few buyers for illiquid assets. These interlink ages and the potential "clustering" of bank runs are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk