Continental Illinois National Bank and Trust CompanySubmitted By: Group 4Harshit Gupta PGP14021Jaideep PooniaPGP14074Mudit SinghPGP14081Utkarsh SharmaPGP14101IntroductionThe 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.

Continental: A brief introduction

Continental Illinois was the result of the merger of two Chicago banks, the Commercial National bank, founded during the American Civil War, and the Continental National Bank, founded in 1883. The merger was named Continental & Commercial National Bank of Chicago which had $175 million in deposits. The name was changed to Continental Illinois National Bank & Trust Co in 1932.

Continental was a subsidiary of Continental Illinois Corporation (CIC). CIC had been in operation for more than 124 years and was assisted by Reconstruction Finance Corporation in 1933 due to over investment in utilities loans and out of country lending especially Latin countries. In the 1960s Continental strived for growth. During the period from 60s to early 80s the bank established divisions to provide specialised services to its various customers involved in oil, utility, international operations and finally real estate. With its rapid expansion Continental established its relations with banks all around the world. In 1981, the bank was the largest industrial and domestic lender and was ranked sixth among multi-national bank. As of March 1984, with around $40 billion in assets and deposits, Continental had become the seventh largest bank in United States and the largest bank in Chicago. It employed more than 12000 people, had 57 offices in 14 states and 29 foreign countries. 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.

Starting in 1973, Continental launched an aggressive assault on some selected banking market segments. It rapidly started building its customer loan portfolios, which was implemented by setting up private units that started lending to small companies. It secured a strong foothold in the banking market by also strenghtening its international activities. It started structuring Eurodollar loans, direct lending to European MNCs and actively lending in project financing.

The collapse of the real estate investment trust industry in mid 1970s made many large banks in the industry to suffer which included Continental. However Continentals management handled this problem well and recovered faster than its peers. Hence it was able to actively lend in real estate throughout the 1970s which made its mortgage and real estate portfolio grow from $997 million to $2.3 billion in the short period of 1977 to 1979. Continental, with one of the best loan loss records among its peers after the 1974-75 recession and financial problems amongst its competitors also helped to gain a strong foot hold in the competitve market.

Continentals goal of becoming one of the top three banks lending to corporate America made it to decentralize its lending procedures. In 1972, the loan approval process was freed from a committee framework and authority was expanded to their individual lending officers. This led to fewer levels of review and controls thus eliminating the red tape in the lending procedures thus enabling the lending officers to rapidly take advantage of new lending opportunities. In light of this rapid growth, supervisory concerns were raised by Office of the Comptrollers and Currency(OCC), but were not dealt with any serious intention due to banks historical loan loss experience and its proven ability to deal with such problems.

During 1974 to 1981, Continental began spurring its loan growth by lending to profitable but high risk businesses. They were offered innovative packages by the banks lending officers who were encouraged to take on more loans. Thus Continentals Commercial and Industrial(C&I) loans expanded rapidly from $4.9 billion to $14.3 billion in the said period. Continentals share of the domestic C&I lending increased from 3.9% to 4.4% also in the same period. This was due to aggressive inclusion of numerous MNCs and middle market companies that previously had no business with Continental.

For corporate expansion, Continental started aggressively lending particularly in energy area. It became the first major bank to have energy specialists on their staff and thus special oil lending unit was created by the bank. The oil crisis of 1973 and increase in the oil prices made energy self -sufficiency to be U.S. primary national goals. Thus encouragement of higher investment in U.S. exploration, development and production of energy requirements by the government made Continental a premier energy lending bank. Continental C&I loans along with energy loans were producing high returns for the bank with yields being consistently higher than other money banks.

The financial markets also responded favourably to Continentals phenomenal growth. Analysts regarded the bank as a premier money bank. They cited its stable assets and earnings growth, good records in loan losses and the expertise in energy lending for their reviews of the bank. Such reports made CICc ratio of market price to book value to rise in 1976 which had lagged behind other banks in early 70s.

With restrictive access to retail banking markets and deposits, Continental fuelled its growth through purchased money from sources such as federal funds, foreign funds, negotiable certificates of deposits etc. Purchased fund made approximately 70% of its total liabilities which was much higher than its peers. Concerns regarding the banks liquidity were raised by OCC in 1976. Based on such concerns Continental soon improved its liquidity position and improved its monitoring systems. However Continental reliance on purchased funds made it to service high interest rates on borrowing of such money which were higher than retail deposits. Such high interest offset much of the profits that came from Continentals loan yields reducing its net interest margin well below its peers. Continental nevertheless maintained its superior earnings growth because of low overhead and non-interest expenses. Few domestic and foreign branches, a number compared with many of its peers of comparable size, cut down Continentals overhead expenses. This compensated some of its high funding costs.

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.

Demise: January 1982- July 1984

The involvement of Penn Square Bank with Continental is to be thoroughly studied to understand the reason behind the death of Continental. Penn Square was one of the largest lenders in energy drilling areas of the country. But due to the limitation of its loan generating ability exceeding its funding ability, Penn Square would generally originate loans and sell them to other banks which included Continental and Seattle First National Bank.

Continental began purchasing loans from Penn Square from 1978, with significant growth in purchase beginning in 1981. By the end of 1980 the purchased loans from Penn Square equalled only $167million. The loans increased to in excess of $500 million in 1981 and another $600 million were added to Continentals book by the start of 1982, bringing the total amount to $1.1 billion which amounted to 3% of Continentals total loans and leases.

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.