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Introduction
The collapse of the Continental Illinois National Bank and Trust and its
subsequent bank assistance by Federal Deposit Insurance Corporation (FDIC)
was a watershed event in the modern banking history that holds valuable lessons
for modern bankers and regulators. The problem arose with the revelation of the
of the credit problems in the bank that ultimately turned into a huge liquidity
problem for it. The existence of this well regulated bank as well as the entire
financial system of U.S.A. was threatened. The bank still serves as an example of
systematic risk had it been not rescued by FDIC. The run on Continental Illinois
was global and received financial assistance from FDIC on May 17, 1984 and till
date remains the largest bank in the history of U.S.A. to receive a financial
assistance from FDIC. The event was noteworthy for several reasons. The first
was that FDIC made a public statement to restore confidence in the bank that all
the creditors and depositors wouldnt be affected thus guaranteeing that there
would be no loss that would be suffered by them. Secondly, FDIC acquired a
major ownership in the bank, thus making Continental a government owned
bank. Third, the assistance provided to Continental affirmed that there are
certain banks that were simply too big to fail. The resolution of Continental Ban
became a prototype for many good and bad bank restructurings around the
world. It also influenced the design of financial safety net around many banks all
over the world especially in United States. With dissatisfaction arising from the
doctrine of too-big-to-fail, the event led to several regulatory reforms imbibed in
the Federal Deposit Insurance Improvement Act of 1991. Maintaining adequate
capital adequacy, increasing market discipline for large creditors and uninsured
depositors were some of the endeavours that were provided in the act.
Rise: 1974-81
Continental historically focused on domestic corporate lending due to restrictions
on branching which limited the expansion of significant retail customer base.
After the recession of 1974-75 many lending opportunities emerged which made
Continental to set ambitious business goals to make it a world class bank.
Between 1974 and 1981, Continentals aggressive strategies made its assets
grow by over 13 per cent per year. Its total assets reached $45.1 billion at the
end of 1981 thus making it the sixth largest bank in the nation, up from the
eighth largest in 1974. The following charts reveal the phenomenal growth of
Continental compared to other financial institutions in the same period.
With low non-interest expenses to assets ratio than its competitors, Continental
was able to achieve one of the best ROA ratio than compared to many leading
money centre banks.
Since the end of 1981 the energy drilling industry had declined significantly. The
loans that Continental took from Penn Square were poorly underwritten and also
adequate due diligence was not conducted by Continental. Continentals also
started suffering on its own loan portfolio. With the failure of Penn Square on July
5, 1982, Continentals problems surfaced. It was the largest borrower of oil and
gas loans at Penn Square and with the failure of both Penn Square as well as
decling energy industry, Continental suffered large losses on those borrowings.
In the second half of 1982 after the failure of Penn Square, Continental reported
$1.3 billion in non performing loans and assets. Since a major funding of
Continental came from federal funds, CDs which were purchased in the
secondary market; after the failure of Penn Square, Continental found itself in a
difficult position to fund its domestic operations from domestic markets. It thus
turned to foreign money markets at higher interest rates to fund its operations.
Stock analysts by then had degraded their estimates for earnings on Continental
which resulted in crashing of its stock price to about 62% from its peak the year
before. Major credit agencies also downgraded the banks credit ratings.
Continental had also made large loans to less developed countries (LDCs) and
when Mexico defaulted on its loan in 1982, Continental troubles grew. Other
troubled LDC loans made Continentals non-performing assets grow to $2.3
billion in the first quarter of 1984. By the end of 1983 two of the major
shareholders of Continental had also sold all their stock. Continentals asset
quality and income continued to decline throughout 1983 and into 1984. A large
part of their positive net income came from selling off its credit card business.
Continentals stock price further dropped in April 1984. In response to rumours of
imminent failure of the bank, large foreign depositors became nervous and thus
an electronic deposit run ensued in May 1984. The reports of U.S. investment
banks inquiring in Japan to see if there were any banks interested in buying
Continental further degraded the Continentals reputation which also
exacerbated the deposit run. Reuters, the British news agency picked up the
news that the banks in West Germany, Netherlands, Japan and Switzerland had
increased their interest rates on loans to Continental. On May 9, large amount of
Japanese and European money was quickly withdrawn. Withdrawal by foreign
bankers had reached $6 billion before May 9. On Friday, May 11, Continental
borrowed $3.6 billion from Federal Reserve Bank of Chicago to make up for its
lost deposit. On May 14 Continental announced that 16 of the nations largest
banks had put together $4.5 billion for Continentals assistance with a 30 day
line of credit. On May 17, FDIC announced an unprecedented interim assistance
package to Continental. Four months later, On September 26, 1984 FDIC
restructured the Continentals organization and laid down the regulations for
good bank/ bad bank restructuring. This meant that Continental was effectively
nationalised.