Continental Illinois National Bank and Trust Company Too Big to Fail

Continental Illinois National Bank and Trust Company

Continental Illinois National Bank

"Too Big to Fail"

The purpose of this work is to show whether or not Continental Illinois rescue and restructuring successful and if so why it was successful. Further using hindsight and consideration of Professor Kaufman's report, this work will attempt to discover if the decision to restructure was justified and explain why or why not. Furthermore, this work will attempt to discover to what extent did the OCC contribute to the management failing of Chairman and CEO, Mr. Roger E. Anderson & the management team of Continental Illinois and what short- and long-term benefits were expected to raise from appointing David Taylor as the new CEO and Edward Bottum as President in the run-up to the restructuring of Continental Illinois. Finally the current status of Continental Illinois will be examined, the main sectors of banking and how these sectors have changed since the collapse of Continental Illinois National Bank and Trust Company.

Introduction

Continental Illinois National Bank and Trust Company was a large successful bank that was considered to be 'too big to fail.' Nevertheless, Continental Illinois National Bank and Trust was rescued by the Federal Deposit Insurance Company (FDIC) after several runs on the bank's deposits in order to avoid the risk of collapse and along with it the collapse of confidence in the banking system in the United States. Professor G. Kaufman questioned in 1995 whether there was justification in the rescue of Continental Illinois National Bank and Trust Company arguing that the bank should have been allowed to collapse. Professor Kaufman's opinion was that the only justification for the rescue was if the Office of the Comptroller believed that virtually no assets at all would have been otherwise recovered. As it were 97% of the assets were recovered.

Called the 'most significant bank failure resolution in the history of the Federal Deposit Insurance Corporation (FDIC), Continental Illinois National Bank and Trust Company (Continental) was provided with interim financial assistance by the FDIC on the date of May 17, 1984 as well as receiving financial assistance of a permanent nature in September of the same year.

Background and Overview of Continental

Continental is a subsidiary of Continental Illinois Corporation (CIC) an organization that has been in existence for over 124 years. Continental was an institution that prior to 1984 was 'striving for growth'. The bank had previously received assistance during 1933 due to over-investment in loans for utilities as well as out-or-territory lending. Development of international operations on an extensive basis, establishment of internal divisions for rendering of specialized services for the oil, utility and finance company customers as well as the development of a department for separate real estate loans for home and commercial loans. In 1982 the bank peaked ranking sixth among the multi-national banking organizations as well as being the leader among domestic, commercial and industrial lenders.

Continental employed over 12,000 and held the approximate amount of $40 billion in assets. In May of 1984, at the time of near collapse the company had office in 14 states as well as 29 foreign countries with offices numbering 57. During the years 1976 and 1981 CCI experienced a jump in lending from $5 billion to over $14 billion with the company's total assets increasing from $21.5 billion to $45 billion with the loans-to-assets ration increasing from 57.9% to 68.8% between 1977 and 1981. The organizations return on assets stayed at 0.5% during the same time span and the return on equity was approximately 14.4% during those same years. (FDIC, 1997) The problems came under notice during 1982 when the Penn Square Bank, N.A. In Okalahoma City closed. The loans were underwritten poorly and it was clear that Continental had not used due diligence on the purchasing of the loans as well as Continental's loan portfolio beginning to experience problems specifically in the energy sector. It was reported by Continental in the second quarter of 1982 an amount of $1.3 billion in loans and assets that were 'nonperforming'.

By May 15 the FDIC had a meeting with the Federal Reserve and the Office of the Comptroller of the Currency (OCC) to explore various alternatives for the situation with Continental whose insured deposit accounts equaled $3 billion and its uninsured deposit accounts and claims of creditors equaled more than $30 billion. Risk involved in the potential failure of Continental were extended far beyond the bank including a potential liquidity crisis for other banks with significant foreign deposits as well as a decrease in confidence in U.S. institutions of foreign investors. Severe damage to the depositor banks that were unaffiliated was a possibility as well as a negative effect on financial markets. Furthermore there were smaller banks with correspondent bank accounts and federal funds that were sold to Continental whose funds would be at risk should Continental fail. Continental also had lawsuits and other troubled loans to consider. The FDIC decided to continue funding Continental at the discount window of the Federal Reserve and the OCC.

The reliance of Continental on the Eurodollar market for funding along with the condition and earnings made the bank vulnerable to the bank run in May 1984. Stated in the work "Continental Illinois and Too Big to Fail" is that, "In an effort to calm the situation, the Comptroller of the Currency, departing from the OCC' policy of not commenting on individual banks, took the extraordinary step of issuing a statement denying the agency had sought assistance for Continental and noting 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 rumors about Continental." Reportedly a House Banking Subcommittee report in 1985 "expressed reservations about both the OCC' and the Federal Reserves' supervision of Continental" stating that the OCC had not taken a decisive action in order to slow down the growth of the bank or to increase the bank's equity-to-assets ratio before 1983. Furthermore there had been failure before 1982 to require Continental to remedy known problems in its loan management system. Further stated was the even though OCC was aware of the growth of concentration in oil and gas on the part of Continental that the OCC did not "consistently and forcefully. point out potential dangers to management, and that OCC examination reports in general were too ambiguous to provide a clear message to the bank about its problems." Finally it was stated that the OCC's sampling technique for loan evaluation was also thought to be insufficient in the case of Continental because it relied too much on the banks own internal controls, which in this case were themselves woefully deficient." This very likely contributed to the failure of management and Chairman and CEO Roger E. Anderson in the time of trouble for Continental Bank. (Continental National Bank & Trust Company, 1984)

The interim assistance contained the following components:

The FDIC issued an explicit guarantee that all depositors (insured and uninsured) and other general creditors of Continental would be fully protected and that service to the bank's customers would not be interrupted in any subsequent resolution. The FDIC asked a group of seven commercial banks to provide a $2 billion interim capital infusion through a subordinated note purchase. Four years earlier, 27 large commercial banks had participated in the assistance provided to First Penn to demonstrate the banking community's faith in the bank's recovery. Therefore, seven of the nation's largest banks agreed to share equally in $500 million of the $2 billion interim capital infusion.

The FDIC provided the remaining $1.5 billion in subordinated debt. Continental accepted FDIC restrictions related to hiring, replacement, or removal of members of senior management and of Continental's board of directors, as well as to general control of the bank. CIC, Continental's holding company, guaranteed that under certain circumstances assets in the holding company would be used to repay the FDIC.

To further augment the financial resources available to Continental, a group of 24 major U.S. banks agreed to provide more than $5.5 billion in funding on an unsecured basis throughout the period during which a permanent solution was developed. The agreement was arranged between Continental and the group of commercial banks for which Morgan Guaranty Trust Company of New York acted as agent. Without the FDIC's explicit guarantee to depositors and general creditors of Continental, that line of credit likely would not have been available.

Because there was no partner to merge with the bank as well as a deposit payoff being undesirable, open bank assistance was judged to be the only solution that was viable in respect to the Continental problem. The issues that needed resolution were:

Problem loans had to be removed from the bank to stem its losses;

Provisions had to be made for funding the bank's operations, including arrangements necessary for its future borrowing from the Federal Reserve;

The bank's capital had to be increased; and Continental had to strengthen its management staff and board of directors.

Results of the Method used by FDIC in the Rescue

The Federal Deposit Insurance Corporation (FDIC) has stated that, " The methods used in the Continental transaction for handling the problem assets appear to have worked out reasonably well. The servicing agreement between the FDIC and Continental, under which Continental worked the FDIC's assets with FDIC oversight, was viewed as an effective way of handling large volumes of assets that had to be liquidated. The servicing costs were relatively low, and the FDIC needed only a relatively small staff to provide oversight. That agreement became the basis for many subsequent transactions in which an assisted or acquiring bank's employees worked FDIC receivership assets under FDIC oversight."

Critics Opinion of the Open Bank Assistance

Critics of the open bank assistance method believe that the FDIC's transaction should have been one that protected only insured depositors which would have caused a loss to Continental's uninsured depositors and general creditors which would have equaled only the $3 billion in insured deposits.

. For example reported is that the shareholders in Continental Illinois" lost most of the value of their investment immediately after the FDICs stock purchase. They lost the rest of the value of their investment later on, when the FDIC exercised an option to purchase the remaining shares." (Continental Case Study, 2002) Kaufman, before a Senate subcommittee stated that, "Would permitting a combination of banking and commerce represent a threat to the safety and soundness of banks by increasing their risk exposure? This question is particularly important because the existence of a safety net under banks could permit large losses to be passed on to the taxpayers. The new powers may be used by banks either to increase or decrease risk."

Professor Kaufman believes that systemic risk in banking is perceived to be more dangerous in risk than it actually is. Bank runs too are overstated in terms of danger. Kaufman states that:

"For one thing, a bank run is unlikely to cause insolvency. Suppose that depositors, worried about their bank's solvency, start a run and switch their deposits to other banks. If their concerns about the bank's solvency are unjustified, other banks in the same market area would generally gain from recycling funds they receive back to the bank experiencing the run. They would do this by making loans to the bank or by purchasing the bank's assets at non-fire-sale prices. Thus, a run is highly unlikely to make a solvent bank insolvent." (Kaufman, 2000)

Kaufman states that there are three alternatives in the event of a bank run that there are three options available.

1. They can redeposit the money in banks that they think are safe, known as direct redeposit.

2. If they perceive no bank to be safe, they can buy Treasury securities in a "flight to quality." But what do the sellers of the securities do? If they deposit the proceeds in banks they believe are safe, as is likely, this is an indirect redeposit.

3. If neither the depositors nor the sellers of the Treasury securities believe any bank is safe, they would hold the funds as currency outside the banking system. A run on individual banks would then be transformed into a run on the banking system as a whole.