Case Study - Continental Bank

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     The Collapse of Continental Illinois National Bank and Trust Company: The Implications for Risk Management and Regulation    THE COLLAPSE OF CONTINENTAL ILLINOIS NATIONAL BANKAND TRUST COMPANY: THE IMPLICATIONS FOR RISKMANAGEMENT AND REGULATION 1   The collapse of Continental Illinois National Bank and Trust was a watershed event inmodern banking history that holds lessons for both bank risk managers and regulators. Itshowed how quickly the revelation of credit problems at a well-regarded bank could turninto a liquidity problem that jeopardized not only the survival of the bank itself, but also,in the view of the US regulators, the financial system. It is widely, if controversially,cited as a prime modern example of systemic risk.The run on Continental was global and began when traders in Tokyo refused to roll-over their inter-bank placements with Continental. By the time markets opened in the US,Continental Illinois was no longer a viable institution. The U.S. authorities improvised aseries of increasingly desperate bail-out measures including the guarantee of uninsured depositors and creditors of the bank, but these measures failed to restore confidence inthe institution. Continental remains the largest institution ever to have been rescued bythe Federal Deposit Insurance Corporation. Indeed, during Congressional testimonysurrounding the intervention in Continental, the regulatory authorities admitted that theten other largest US banks were also “too big to fail.” The ultimate resolution of Continental Illinois – the so-called Continental divide – has become the prototype for numerous good bank/bad bank restructurings around the world.The collapse of Continental also influenced the redesign of the financial safety net in theUnited States. Widespread dissatisfaction with the too-big-to-fail doctrine and a series of subsequent bailouts of troubled institutions during the late 1980s and early 1990s led tothe regulatory reforms embodied in the Federal Deposit Insurance Improvement Act of 1991. These included attempts to increase market discipline of large banks by creditorsand uninsured depositors, to strengthen capital adequacy, and to reduce regulatorydiscretion to forbear.The background material for this case was srcinally submitted by the Comptroller of theCurrency, C.T. Conover, to the House Banking Committee four months after the collapseof Continental. As the official with principal supervisory responsibility for Continental,Conover had the awkward task of explaining to Congress why Continental collapsed despite the superb quality of supervision it received. Although the Comptroller’sstatement reflects this special perspective, the facts are clearly stated. 1 These materials were assembled by Richard J. Herring, Jacob Safra Professor of International Banking,The Wharton School, University of Pennsylvania. An earlier version of this case appeared in the NewYork University Salmon Center Series.   The Collapse of Continental: A Chronology   1976–1981 Rapid growth in assets, specialization in lending to theenergy sector and corporate lending more broadly1981: Became 6 th largest US bank with $45.1 billion in assets,12,000 employees.July 5, 1982 Failure of Penn Square Bank, run on Continental1982-1984 Rise in non-performing loansMay 9, 1984 Run begins in TokyoMay 11, 1984 Borrows $3.6 billion through Fed discount windowMay 14, 1984 16 banks provide Continental with a $4.5 billion 30-dayline of creditMay 17, 1984 Regulators announce unprecedented interim assistance packageSeptember 26, 1984 FDIC implements good/bank bad bank restructuring,effectively nationalizing Continental1991 FDIC sells last of equity stake in Continental, seven yearsafter collapse   Based on your reflections on the Comptroller’s statement below, please formulateanswers to the following questions:1. Why did Continental experience a run in 1982? How did it manage to survivewithout recourse to official assistance?2. After the run in 1982, what did Continental do to reduce its vulnerability to a fundingshock? What else could it have done?3. Why was the run in 1984 more devastating?4. Why did the Federal Deposit Insurance Corporation guarantee all of Continental'screditors against loss? What alternative policy could the authorities haveimplemented?5. After the closure of BCCI on July 5, 1991, the United Kingdom experienced a flight to quality in which wholesale depositors--and even some retail depositors--shifted their funds from small banks to the largest banks. When the Bank of England tried to enlist the aid of the four largest banks to provide financial supportfor smaller banks experiencing liquidity problems the clearing banks refused saying Why should we risk our capital to prop up competitors? Note how this incidentdiffered from the behavior of large US banks after the collapse of ContinentalIllinois. What may account for the difference in the behavior of the large UK banksand the large US banks?6.   During the mid-eighties Bank of America was the subject of market rumors thatwere eerily reminiscent of the Continental episode. Why was Bank of America ableto withstand shocks similar to those which destroyed Continental?7. Bank of America acquired Continental in January 1994. It made two principalarguments about how it could add value to Continental: 1. It could sell a broader range of products to Continental’s existing customer base and 2. It could fund Continental Illinois at substantially lower cost. Why did the market find the second argument especially plausible?
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