Continental-Illinois

September 8, 1929

“It will be the largest bank in the world to be housed under one roof.”

Second largest bank in the country to National City in New York.

Culmination of a series of Chicago bank mergers spanning 71 years.

September 8, 1929

“It will be the largest bank in the world to be housed under one roof.”

Second largest bank in the country to National City in New York.

Culmination of a series of Chicago bank mergers spanning 71 years.

• From hierarchical structure to “matrix management”• Concern that this led to bad energy loans due to a lack of supervision

If you were going to bank with somebody, you wanted to see them as well as their balance sheet.

It was a ‘relationship’ business, commercial banking. A long-term business. . . . You stuck with the company and the customers through the ups and downs of the business cycles, and they stuck with you.

That was the main problem for Dave Kennedy when he decided the Continental would have to become a great international bank in order to remain a great American bank. There weren’t any international banking people.

-- James P. McCollom, The Continental Affair

If you were going to bank with somebody, you wanted to see them as well as their balance sheet.

It was a ‘relationship’ business, commercial banking. A long-term business. . . . You stuck with the company and the customers through the ups and downs of the business cycles, and they stuck with you.

That was the main problem for Dave Kennedy when he decided the Continental would have to become a great international bank in order to remain a great American bank. There weren’t any international banking people.

-- James P. McCollom, The Continental Affair

Bank A =1958

Bank B =1968

Bank C =1978

Bank A =1958

Bank B =1968

Bank C =1978

Continental vs. PeersContinental vs. Peers

• Much higher reliance on “purchased funds” (> 70%)

• Higher yield on C&I loans (+ 1%)• Higher growth of C&I loans (1.5X)• Lower nonperforming loan (1974-78

-.2%)• Huge growth in energy loans (26% of

C&I in 1979 vs. 47% in 1981).

• Much higher reliance on “purchased funds” (> 70%)

• Higher yield on C&I loans (+ 1%)• Higher growth of C&I loans (1.5X)• Lower nonperforming loan (1974-78

-.2%)• Huge growth in energy loans (26% of

C&I in 1979 vs. 47% in 1981).

1976 - 19811976 - 1981

May 29, 1981

Chairman of Continental-Illinois Roger A. Anderson becomes highest paid banker in the United States, pulling in a whopping $710,440 ($1.6 million in 2009 dollars).

President John Perkins is also on the list with just under $600,000 salary.

May 29, 1981

Chairman of Continental-Illinois Roger A. Anderson becomes highest paid banker in the United States, pulling in a whopping $710,440 ($1.6 million in 2009 dollars).

President John Perkins is also on the list with just under $600,000 salary.

Penn Square Bank CollapsePenn Square Bank Collapse

• Specialized in high-risk loans to the oil and gas industry

• Assets had grown from $62 million in 1977 to $520 million in 1982.

• Failed in July 1982.• Only $207 million of $470 million deposits

were insured. • Serviced $2 billion in loans - $1 billion for

Continental.

• Specialized in high-risk loans to the oil and gas industry

• Assets had grown from $62 million in 1977 to $520 million in 1982.

• Failed in July 1982.• Only $207 million of $470 million deposits

were insured. • Serviced $2 billion in loans - $1 billion for

Continental.

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. This was very profitable for everyone, while it lasted.- William Greider, Secrets of The Temple

Continental’s share went from $25 to $40 in less than two years.

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. This was very profitable for everyone, while it lasted.- William Greider, Secrets of The Temple

Continental’s share went from $25 to $40 in less than two years.

Continental’s response to this plan: “This will be the end of the bank, and you will be to blame.”Continental’s response to this plan: “This will be the end of the bank, and you will be to blame.”

1982 - 19841982 - 1984

“Your chairman is Mr . . . Taylor?”“Yes.”“And Mr. Roger Anderson?”“Mr. Anderson is retired.”“Now the position of Mr. Taylor is -- ?”“He is the chairman of our bank.”“None of our managers seems to be familiar with

that name.”“Mr. Taylor become chairman in February.”“And Mr. Conover?”“Mr. Conover is the comptroller of the currency.”“He is with the Federal Reserve.”“No. His office is in the Treasury Department.”

“Your chairman is Mr . . . Taylor?”“Yes.”“And Mr. Roger Anderson?”“Mr. Anderson is retired.”“Now the position of Mr. Taylor is -- ?”“He is the chairman of our bank.”“None of our managers seems to be familiar with

that name.”“Mr. Taylor become chairman in February.”“And Mr. Conover?”“Mr. Conover is the comptroller of the currency.”“He is with the Federal Reserve.”“No. His office is in the Treasury Department.”

The problems of Continental Bank essentially reflect serious weaknesses in the domestic loan portfolio of a bank that had engaged in aggressive growth and lending practices for some time, including heavy involvement and participation in energy loans of the Penn Square Bank that failed two years ago. These problems, and other credit losses, were reflected in earnings pressures and consequent loss of market confidence.

- Paul Volcker, Fed Chairman, to Senate Committee (July 1984)

The problems of Continental Bank essentially reflect serious weaknesses in the domestic loan portfolio of a bank that had engaged in aggressive growth and lending practices for some time, including heavy involvement and participation in energy loans of the Penn Square Bank that failed two years ago. These problems, and other credit losses, were reflected in earnings pressures and consequent loss of market confidence.

- Paul Volcker, Fed Chairman, to Senate Committee (July 1984)

Bailing Out Continental IllinoisBailing Out Continental Illinois

Discount WindowDiscount Window

$3.6 billion – May 11, 1984– This was not enough to stop the run on

Continental Illinois or make it solvent– Traditionally a short-term device so that

banks can meet capital reserve requirements

Bank Lending GroupBank Lending Group

–Weekend Following the Discount Window Loan

– Group of 16 Banks to Loan $4.5 billion to Continental Illinois

– Again, Insufficient to stop the run– During this time, the bank’s domestic

correspondent banks started withdrawing funds, furthering the run

Federal Assistance PackageFederal Assistance Package• FDIC Provided $1.5 bn• FDIC also participated $500 mn to a Group of

Commercial Banks • Capital Infusion was in form of interest-bearing

subordinated notes– Variable Rate 100 basis points higher than 1-yr T-Bills– Fed Stated it would meet any liquidity needs of Illinois

Continental– Group of 24 Major US Banks agreed to $5.3 in unsecured

funding– FDIC promised to guarantee all creditors and depositors,

even those above the $100,000 limit (TBTF)

12 USCA 1823(c)(1)12 USCA 1823(c)(1)

(c) Assistance to insured depository institutions

(1) The Corporation is authorized, in its sole discretion and upon such terms and conditions as the Board of Directors may prescribe, to make loans to, to make deposits in, to purchase the assets or securities of, to assume the liabilities of, or to make contributions to, any insured depository institution—(A) if such action is taken to prevent the default of such insured depository institution; (B) if, with respect to an insured bank in default, such action is taken to restore such insured bank to normal operation; or (C) if, when severe financial conditions exist which threaten the stability of a significant number of insured depository institutions or of insured depository institutions possessing significant financial resources, such action is taken in order to lessen the risk to the Corporation posed by such insured depository institution under such threat of instability.

(c) Assistance to insured depository institutions

(1) The Corporation is authorized, in its sole discretion and upon such terms and conditions as the Board of Directors may prescribe, to make loans to, to make deposits in, to purchase the assets or securities of, to assume the liabilities of, or to make contributions to, any insured depository institution—(A) if such action is taken to prevent the default of such insured depository institution; (B) if, with respect to an insured bank in default, such action is taken to restore such insured bank to normal operation; or (C) if, when severe financial conditions exist which threaten the stability of a significant number of insured depository institutions or of insured depository institutions possessing significant financial resources, such action is taken in order to lessen the risk to the Corporation posed by such insured depository institution under such threat of instability.

FDIC GuaranteeFDIC Guarantee

• The guarantee of depositors and creditors above the $100,000 limit was controversial

• People worry about the moral hazard problem• Deemed necessary because of many other

financial institutions having funds invested in Continental beyond $100,000

Finding a Merging PartnerFinding a Merging Partner• During this Federal Assistance Period, the Federal

Reserve’s goal was to find someone to merge with Continental Illinois– This is what normally happened when smaller banks

became insolvent in the preceding years• Fed searched for 2 months but could not find a

suitable partner– Continental Illinois was obviously much bigger than

previous banks that had been merged under these circumstances

– The economy was not entirely healthy making it harder to find a merging partner

Government OwnershipGovernment Ownership

• After the failed search for a merging partner, the government purchased $4.5 bn of bad loans from Continental Illinois– The bank had to “charge-off” $1 bn but this was

offset by a cash infusion of $1 bn• The government received non-voting

preferred stock that could be converted to common stock which amounted to a 79.9% ownership stake

Government Actions after the Takeover

Government Actions after the Takeover

• Old Management and Boards of Directors were forced out– One of the perceived benefits of the plan was that it

made ownership and management feel the brunt of the loss. The ownership was harmed but the massive dilution of their shares and management was forced out

• Installed John Swearingen as CEO of the holding company and William Ogden of CEO of the bank

• These New Executives replaced the Boards of Directors, but the Government could veto membership

Bank of America Buys Continental Illinois for $1.9 bn

Bank of America Buys Continental Illinois for $1.9 bn

• August 31, 1994• $939 Million in Cash• 21.25 Million Shares of Stock• $37.50/share• Government began selling stake in 1986, divesting one-third of shares• Completed divestment in 1991

Too Big To Fail?Too Big To Fail?

Moral Hazard• Like many other firms, banks offer a particular bundle of

services (most notably liquidity and lending services)• A bank failure need not signal the failure of the larger

banking system or the regulatory structure• As with any other firm, a bank failure merely demonstrates

that its bundle of products is no longer demanded by the market

• The “existence of failing institutions may be a sign of health rather than a sign of malaise since it indicates either that innovation is driving obsolete firms out of the industry, or that competition is driving inefficient firms out of the market”

• A bank failure also helps speed along the reallocation of the bank’s assets to a more efficient set of enterprises

See Macey & Miller, 88 Colum L Rev 1153 and Fischel et. al., 73 Va. L. Rev. 301

Why Bail out a Bank? Why Bail out a Bank?

Moral Hazard

See Macey & Miller, 88 Colum L Rev 1153 and Fischel et. al., 73 Va. L. Rev. 301

Are Banks “Special”? Are Banks “Special”? • Bank Runs

• Regulatory Costs

• Contagion– “Ripple Effect”

– “Domino Effect”

• Money Supply

• Credit Crunch

Moral Hazard

See Macey & Miller, 88 Colum L Rev 1153 and Fischel et. al., 73 Va. L. Rev. 301

Are Banks “Special”? Are Banks “Special”?

• Bank Runs– Classic example of a prisoner’s dilemma – Yet how is this different than short-term creditors of any

firm?• Ratio of current assets to current liabilities is lower at banks• Yet there are many non-governmental solutions:

– Banks holding more liquid assets, higher premiums paid to depositors, contractual right to stop conversion of deposits

• Regulatory Costs– Cost of failure is paid for by healthy banks and taxpayers– Yet the regulatory structure is premised on banks being

special – circularity problems

Moral Hazard

See Macey & Miller, 88 Colum L Rev 1153 and Fischel et. al., 73 Va. L. Rev. 301

Are Banks “Special”? Are Banks “Special”? • Contagion

– “Ripple Effect”• Bank failure will cause public to lose confidence in the financial system, resulting in

widespread bank runs• Yet bank failures are often firm-specific (ex. fraud) and failure of other firms also has

signaling power (ex. failure of manufacturing company indicates that banks holding certain loans might fail) – banks can recycle the withdrawn funds back to the solvent banks experiencing bank runs

– “Domino Effect”• Many banks hold deposits in the failed bank• Yet the failure of any firm is likely to have systemic effects on other firms (such as the

firms in their supply chain)• Effect of Widespread Bank Failures

– Money Supply• Decrease in money supply can impose high social costs• Yet the Fed Reserve mitigates this problem by serving as lender of last resort

– Credit Crunch• Bernanke paper – importance of banking human capital• Yet failure of other firms also disrupts investment projects by disrupting supply chains

(especially when there are few substitutes for the good or service offered)

Moral HazardWas Continental-Illinois“Special”? Was Continental-Illinois“Special”? – “Ripple Effect”

• Concern that failure of Continental-Illinois would “lead[] to widespread depositor runs, impairment of public confidence in the broader financial system, or serious disruptions in domestic and international payment and settlement systems.”

• Regulators worried about the effects on at least three other financially vulnerable banks (First Chicago, Manufacturers Hanover, and Bank of America)– No clear evidence that this fear was justified– Continental-Illinois’s failures were firm-specific – fraud and participation in highly speculative

loans– G. Kaufman, Federal Reserve Bank of Chicago – indicating that bank runs do not take the

form of currency drains out of the system, but of “redeployment of deposits to other, presumably less risky banks of similar characteristics. A run on a bank no longer translates into a run on the banking system . . . .”

– “Domino Effect”• Continental had an extensive network of correspondent banks, almost 2,300 of

which had funds invested in Continental; more than 42 percent of those banks had invested funds in excess of $100,000, with a total investment of almost $6 billion. The FDIC determined that 66 of these banks, with total assets of almost $5 billion, had more than 100 percent of their equity capital invested in Continental and that an additional 113 banks with total assets of more than $12 billion had between 50 and 100 percent of their equity capital invested– Subsequent empirical study indicated that only six banks would have collapsed as a result of

Continental-Illinois’s failure

• Exacerbated Existing Moral Hazard– Government eliminated the incentive for depositors and

general creditors to monitor banking risk and fraud – FDIC insurance is absolute – thus comes with none of the

traditional mechanisms employed by insurance companies to reduce moral hazard (i.e. deductibles and premiums based on underlying risk)

– Without depositor or general creditor monitoring, risk taking is largely dictated by interaction between preferences of management and shareholders

– While managers are typically more like fixed claimants (due to human capital concerns), shareholders are residual claimants who will push the bank to pursue risky projects

The Inherent Tradeoff in “Too Big To Fail”: Systemic Risk vs. Moral HazardThe Inherent Tradeoff in “Too Big To Fail”: Systemic Risk vs. Moral Hazard

See Macey & Miller, 88 Colum L Rev 1153 and Fischel et. al., 73 Va. L. Rev. 301

• FDIC clearly delineated the reasons for the “Too Big to Fail” doctrine– Failure of large bank leads to higher risk of “ripple effects” on

smaller banks– Failure of small banks more likely to be viewed by depositors as

isolated, firm-specific incidents– Failure of large bank can seriously deplete the FDIC’s insurance

fund and decrease public’s confidence in regulatory regime• FDIC’s employment of purchase and assumption

agreements favored large and medium sized banks• Under this regulatory regime, uninsured depositors are

highly likely to flock from small banks to medium and large sized banks

“Too Big to Fail” and the Incentive for Banks to Grow

“Too Big to Fail” and the Incentive for Banks to Grow

• Can depositors serve as effective monitors of banks financial activity?– Most depositors aren’t “true” investors – they pick bank based

mostly on non-risk related factors such as convenience of location and customer service

– Most depositors don’t want to invest time and effort in researching bank’s activity – free-riding and collective-action problem

– Depositors could suffer from excessive optimism– Depositors will often wait until insolvency is imminent and a

bank run will not provide a meaningful signal to management– Depositors might react to false insolvency information or

rumors and thus send inaccurate signals to management

Moral Hazard in Theory but in Practice?

Moral Hazard in Theory but in Practice?

See Garten, 4 Yale J. on Reg. 129

– Depositors need not view risk as a primary consideration when choosing banks – moral hazard effect on the margin

– Free-riding/collective action monitoring problem can be resolved through ex ante premium payment to depositors

– Even if depositors conduct more research before choosing bank then once their money has been deposited, banks constantly need to attract new depositors who will in turn provide needed monitoring at investment decision phase

– Higher premium payments will send important signal to management/shareholders and this disciplinary mechanism can serve as a substitute to deposit withdrawal

– Withdrawal of funds is not costless and may cost more than investing in research to determine validity of bank rumors

The Argument for Moral Hazard in Practice

The Argument for Moral Hazard in Practice

See Macey and Garrett, 5 Yale J. on Reg. 215

Volcker appeared before the Senate Banking Committee in July 1984, he faced questions about whether the Fed favored big banks like Continental over small banks, and whether the “printing” of money would have to stop.

Sen Riegle: I just hope that we don’t leave the impression that the safety net is infinite in size and we can take any number of failures at once, because I don’t think you believe that and I know I don’t believe that.

Volcker: To the best of my knowledge, there were characteristics of the Continental Illinois Bank that were unique.

Volcker appeared before the Senate Banking Committee in July 1984, he faced questions about whether the Fed favored big banks like Continental over small banks, and whether the “printing” of money would have to stop.

Sen Riegle: I just hope that we don’t leave the impression that the safety net is infinite in size and we can take any number of failures at once, because I don’t think you believe that and I know I don’t believe that.

Volcker: To the best of my knowledge, there were characteristics of the Continental Illinois Bank that were unique.

Initial Congressional Reaction – Worries about TBTF Policy

Initial Congressional Reaction – Worries about TBTF Policy

• Reasons for Reform– Prompted by continuing dissatisfaction with the “Too Big to

Fail” doctrine– Bailout of Bank of New England Corporation ($21 billion)– Higher deposit insurance premiums– Questionable status of Bank Insurance Fund

• Some legislators wanted to prevent protection of uninsured depositors but most legislators and regulators favored flexibility to deal with systemic risk– Alan Greenspan – insured depositors might need to be rescued

“in the interests of macroeconomic stability,” but there would also be circumstances in which large banks fail with losses to uninsured depositors but without undue disruption to financial markets.”

Congress Reacts and Narrows FDIC’s Bailout Powers

Congress Reacts and Narrows FDIC’s Bailout Powers

• Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICA)– FDIC resolutions were now required to proceed according to a “least-cost”

test, which would mean that uninsured depositors would often have to bear losses.

– The FDIC was prohibited from protecting any uninsured deposits or nondeposit bank debts in cases in which such action would increase losses to the insurance fund.

– One important effect of the least-cost provision was that the FDIC would not be able to grant open-bank assistance unless that course would be less costly than a closed-bank resolution

– Exception for systemic risk• At least two-thirds of both the FDIC Board of Directors and the Board of Governors of

the Federal Reserve must recommend that an exception be made, and this recommendation must then be acted upon by the secretary of the treasury in consultation with the president.

• The General Accounting Office then reviews any such actions taken and reports its findings to Congress

– FDICIA limited the discretion the agency had exercised under the old cost test and essentiality provisions of the FDI Act.

Congress Reacts and Narrows FDIC’s Bailout Powers

Congress Reacts and Narrows FDIC’s Bailout Powers

• Effect of FDICIA– From 1986 through 1991, 19 percent of bank

failure and assistance transactions resulted in the nonprotection of uninsured depositors. From 1992 through 1994, the figure rose to 62 percent.

– On the basis of total assets, the average percentage of uninsured depositors suffering a loss was 12.3 percent from 1986 through 1991, but from 1992 through 1994 it increased to 65 percent

Congress Reacts and Narrows FDIC’s Bailout Powers

Congress Reacts and Narrows FDIC’s Bailout Powers

NationalizationNationalization

TerminologyTerminology

• Conservatorship– “Conservatorship is . . . person or entity be subject to the legal control of another person or

entity, known as a conservator. When referring to government control of private corporations such as Freddie Mac or Fannie Mae, conservatorship implies a looser, more temporary control than does Nationalisation.”

• Receivership– When a company is put in receivership, it is controlled by a “receiver[,] a person ‘placed in the

custodial responsibility for the property of others, including tangible and intangible assets and rights.’”

• Nationalization– “act of taking an industry or assets into the public ownership of a national government or

state.”-------------------------------------------------------------------------------------------------------------------------According to Wikipedia, Fannie Mae and Freddie Mac are seen as examples of

conservatorship, receivership and nationalization. The terms are often interchangeable, especially in the situation of government takeover of banks.

Conservatorship and receivership have a connotation of shorter periods of control. http://www.wikipedia.org/

Penn Square Bank: Push Toward Nationalization

Penn Square Bank failed in June 1982.

Penn Square = $450m in assetsContinental Illinois = $33 bn

At the time, Penn Square was 3% of Continental Illinois’ total loans. And, 17% of total oil and gas loans

The chain reaction between Penn Square and Continental Illinois made the government wary of Continental Illinois’ collapse. Penn Square increased awareness adding to the run on Continental Illinois.

Levels of Nationalization

Concerns• William I. Isaac, head of FDIC during Continental Illinois’

Collapse, notes three concerns about using nationalization now:– (1)Any nationalization of a bank will require shrinking the

bank, which is difficult in tough economic times with the fear of deflation

– (2)Nationalization requires a reasonable exit strategy• BofA and CitiBank are simply too big to sell, particularly if foreign

investors are not allowed to purchase. • Continental Illinois only had 2% of nation’s assets, while the top 10

banks now hold over 2/3s of nation’s assets.• Also, Continental Illinois was a “plain-vanilla bank” in comparison.

– (3)Finding people to run these companies while nationalized will be difficult.

http://online.wsj.com/article/SB123543631794154467.html?mod=article-outset-box#

“[Nationalization] is a bit of a fuzzy line. When you have something like AIG, the insurance company, which is 80 percent owned by the taxpayers, has it been nationalized or not? And that's a little bit unclear.”--Paul Krugman

Have we already nationalized?

http://www.pbs.org/newshour/bb/business/jan-june09/banknational_02-24.html

• Total Money loaned by FDIC: $4.5 bn• Total Lost: $1.1 bn• Percentage Lost: 24 percent

How much did the government lose on Continental Illinois?

Unsecured Creditors & NationalizationIn a nationalization, the bondholders will take one of the largest losses

Two problems:• “Bondholders are probably the best-organized investor class

that there is. You're talking about little old ladies, pension funds, and foreign governments.”– R. Christopher Whalen of Institutional Risk Analytics predicts: that bondholders

for BofA and CitiBank will take a 70% loss if not everything.– http://www.msnbc.msn.com/id/29412829/

• Can the government force unsecured creditors to bear the loss outside of bankruptcy?– “With a deposit-taking bank: If the assets are worth less than the liabilities, the

FDIC is authorized to force unsecured creditors to share the loss. “– But the FDIC has no such authority over bank holding companies– For holding companies, the unsecured creditors will bear the loss in

bankruptcy, but after the Lehman Brothers, bankruptcy is usually not considered a good option.

Banks are closed and liquidated almost without exception only when they are insolvent—when their liabilities exceed their assets and when circumstances combine with other severe problems. . . . Considered over the history of the FDIC, bank liquidations with losses to insured depositors and creditors have not been the normal procedure for dealing with problem banks. Normally, a high value is placed on maintaining banking services regardless of the size of the bank, consistent with minimizing the cost to the insurance fund. Continental, however, was not insolvent.

[The Federal Reserve] was founded to serve as a lender of last resort in times of liquidity pressures of this sort, so they don’t spread through the rest of the system to innocent parties not involved in Continental Illinois at all; we were founded so that there should be that elasticity in the system. That’s what a central bank is all about, to provide liquidity in those circumstances. We are just carrying out the most classic function of a central bank.

-- Volcker testimony (July 1984).

Banks are closed and liquidated almost without exception only when they are insolvent—when their liabilities exceed their assets and when circumstances combine with other severe problems. . . . Considered over the history of the FDIC, bank liquidations with losses to insured depositors and creditors have not been the normal procedure for dealing with problem banks. Normally, a high value is placed on maintaining banking services regardless of the size of the bank, consistent with minimizing the cost to the insurance fund. Continental, however, was not insolvent.

[The Federal Reserve] was founded to serve as a lender of last resort in times of liquidity pressures of this sort, so they don’t spread through the rest of the system to innocent parties not involved in Continental Illinois at all; we were founded so that there should be that elasticity in the system. That’s what a central bank is all about, to provide liquidity in those circumstances. We are just carrying out the most classic function of a central bank.

-- Volcker testimony (July 1984).