Date: 2024-11-12 Page is: DBtxt003.php txt00020326 | |||||||||
Banking and Finance | |||||||||
Burgess COMMENTARY Peter Burgess | |||||||||
Original article:
https://www.federalreservehistory.org/essays/failure-of-continental-illinois
Your Gateway to the History of the Federal Reserve System Failure of Continental Illinois ... May 1984 The failure of Continental Illinois National Bank and Trust Company in 1984, the largest in US history at the time, and its subsequent rescue gave rise to the term 'too big to fail.' The 1984 failure and rescue of this bank gave rise to the term 'too big to fail' Continental Illinois Bank Building (Photo courtesy of: Bryan Bowser, Federal Reserve Bank of Chicago) When Continental Illinois National Bank and Trust Company failed in 1984, it was the largest bank failure in US history, and it remained so until the global financial crisis of 2007-08. The Chicago-based bank was the seventh largest bank in the United States and the largest in the Midwest, with approximately $40 billion in assets (Federal Deposit Insurance Corporation 1997, 255). Its failure raised important questions about whether large banks should receive differential treatment in the event of failure. The bank, created by merger in 1910, had conservative roots, but its management implemented a rapid-growth strategy in the late 1970s. By 1981, it had become the largest commercial and industrial lender in the United States (FDIC 1997, 236). In 1982, it became clear that the bank had made some risky investments. Regulations at the time prohibited banks and bank holding companies from branching and owning banks across state lines, which led many of them to purchase loans from banks in other states. Continental Illinois had purchased $1 billion in speculative energy-related loans from Oklahoma-based Penn Square Bank, loans that originated from the 1970s oil and gas exploration boom (FDIC 1997, 241). Penn Square Bank failed in July 1982, highlighting Continental Illinois’s exposure to losses. Continental Illinois had also invested in developing countries, which experienced a debt crisis brought on by Mexico’s default in August 1982. These events caused investors to reexamine the bank’s risk-pricing and lending practices during its high-growth period. The bank took actions to stabilize its balance sheet in 1982 and 1983. But in the first quarter of 1984 the bank posted that its nonperforming loans had suddenly increased by $400 million to a total of $2.3 billion (FDIC 1997, 243). On May 10, 1984, rumors of the bank’s insolvency sparked a massive run by its depositors. Prior to the trouble, Continental Illinois held $28.3 billion in deposits, $20.7 billion of which were larger than $100,000, and thus were not insured by the FDIC (Furlong 1984). To avoid losing their funds, depositors withdrew a total of $10.8 billion in 1984 (Swary 1986, 452). On Friday, May 11, the bank borrowed $3.6 billion from the Federal Reserve Bank of Chicago (FDIC 1997, 243), which, like all Reserve Banks, acts as “lender of last resort.” On May 14, Continental Illinois received a $4.5 billion line of credit that had been arranged over the weekend from sixteen of the nation’s largest banks (FDIC 1997, 244). The run continued, however, and regulators feared that the problems would spill over to other banks. The FDIC estimated that nearly 2,300 banks had invested in Continental Illinois, and nearly half had invested funds greater than $100,000, the deposit insurance limit. One hundred and seventy-nine of those banks had invested amounts equal to more than half of their equity capital (FDIC 1997, 250). The Federal Reserve also expressed concerns about spillovers in its monetary policy meetings that May. Though several of the policymakers favored tighter monetary policy, Chairman Paul Volcker said that financial market fragility, from both Continental Illinois and the developing country crisis, had taken that option off the table.1 The fear of spillovers led regulators to extend unusual support to Continental Illinois. On May 17, the FDIC announced a $1.5 billion capital infusion into the bank. Most controversially, on May 18, the FDIC announced that it would extend support to creditors not normally protected from a bank’s failure—including depositors with funds greater than $100,000 and the bank’s other general creditors (Swary 1986, 471-472). On July 26, 1984, after an unsuccessful search for a buyer, the FDIC announced that it would prevent the bank’s failure by providing “permanent” assistance. The FDIC committed to purchasing up to $4.5 billion in bad loans from the bank (FDIC 1997, 244). In the end, the FDIC protected all bondholders and depositors from the bank’s insolvency, though holders of stock were largely wiped out. Continental Illinois continued to function under primarily government ownership until the government exited its stake in 1991, and the bank was purchased by Bank of America in 1994. Though the Fed was not technically involved in the rescue beyond its discount window lending, the Federal Reserve was actively involved in discussions with the FDIC, the Treasury, and other regulators on how to handle the situation.2 Continental Illinois’s failure raised questions about how regulators should deal with failing banks. At the time, the FDIC had three options: liquidate the bank and pay insured depositors, arrange for another institution to purchase the bank, or keep the bank alive with FDIC funds. The second option often had the effect of protecting uninsured depositors, and the third option would protect all the bank’s creditors (in the case of Continental, the FDIC also explicitly protected bondholders of the bank’s holding company). The last two options tended to be the routes chosen by the FDIC for larger banks. Between 1986 and 1991, the average asset size of liquidated banks was $65 million, while the average asset size of banks that were sold or given assistance—that is, its creditors given unusual protection—was $200 million (FDIC 1997, 248). The unusual treatment of Continental Illinois gave popular rise to the term “too big to fail.” The term refers to a financial institution whose failure could spill over to other firms or sectors of the economy, and thus is expected to receive government support in the event of trouble. The larger the firm, the more likely the spillovers. As a result, the larger the bank, the more likely regulators may be to rescue the firm rather than liquidate it, and thereby protect all creditors. Moreover, banks may expect that the creditors of larger institutions are more likely to be protected, so they have incentive to become large in the first place. The “too big to fail” problem may lead to greater risk taking. Institutions that expect government support may take greater risks because it is likely that they and their creditors won’t face the full costs of losses. In addition, investors are likely to provide cheaper funding to large firms because investors of those firms need be less concerned about risk. After Continental Illinois, investors had good reason to judge that the creditors of large banks were likely to be protected. In congressional hearingsOffsite link over the event, Comptroller of the Currency C. T. Conover explicitly stated that regulators were unlikely to allow the nation’s eleven largest multinational banks to fail. Congressman Stewart McKinney responded, “let us not bandy words. We have [created] a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank.” Congress attempted to limit rescues of “too big to fail” banks by passing the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. The law limited the FDIC’s discretion to protect bank creditors, and limited the Fed’s ability to lend to troubled banks, which in Continental Illinois’ case had allowed uninsured depositors to escape without losses. The failure of Continental Illinois also raised questions about how to regulate systemic risk—the risk that one institution’s failure can lead to other failures, bank runs, and widespread economic disruption. That question remained largely unaddressed legislatively until after the 2007-08 financial crisis with the passage of the Dodd-Frank Act. -------------------- Endnotes 1 Federal Open Market Committee Meeting Transcripts from May 21-22, 1984, available at http://www.federalreserve.gov/monetarypolicy/fomc_historical.htmOffsite link. 2 See the account provided by Sprague, Irvine H. Bailout: An Insider’s Account of Bank Failures and Rescues. New York: Basic Books, 1986 Bibliography Federal Deposit Insurance Corporation. History of the Eighties, Lessons for the FutureOffsite link, Volume 1. Washington, DC: FDIC, 1997. Furlong, Frederick. “Market Responses to Continental IllinoisOffsite link.” Federal Reserve Bank of San Francisco Weekly Letter, August 31, 1984. Inquiry into Continental Illinois Corp. and Continental Illinois National Bank: Hearings Before the Subcommittee on Financial Institutions Supervision, Regulation and Insurance, 98th Cong. (1984). https://fraser.stlouisfed.org/title/745Offsite link. Sprague, Irvine H. Bailout: An Insider’s Account of Bank Failures and Rescues. New York: Basic Books, 1986. Swary, Itzhak. “Stock Market Reaction to Regulatory Action in the Continental Illinois Crisis.” The Journal of Business 59, no. 3 (1986): 451-73. Written as of November 22, 2013. See disclaimer. Related Essays
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