Continental Illinois and the Origin of “Too Big to Fail”

The pace of bank failures in the United States picked up in the 1980s and one of the largest of these came in 1984, when Continental Illinois had to be rescued. The bank was a Chicago lender that was growing rapidly starting from the late-1970s. Yet, this growth was driven by loans to clients far from its home market and funded by deposits secured from equally far away. This introduced scale and vulnerabilities to the bank that, as it was going under, introduced the term “too big to fail” to banking.

Continental Illinois

The Chicago-based Continental Illinois National Bank and Trust Company was formed from predecessor banks that dated to the U.S. Civil War. One of these had run into trouble during the Great Depression but was bailed out and survived. Thereafter, the bank grew to a fairly considerable $21.5 billion in assets in 1976.

Still, the management team in place had greater ambitions for the bank. In the mid-1970s, Continental Illinois set a goal to become one of the country’s largest commercial lenders. To win more business, the bank searched for borrowers interested in receiving loans further afield from its home market and began making loans at lower interest rates. Continental Illinois made new loans at rates well below the benchmark ‘prime rate’ of the rest of the industry in a bid to win more business. To extend its lending capacity, the bank shifted its asset portfolio to include more loans relative to cash and securities.

Continental Illinois Bank Building at 231 S. LaSalle St., Chicago

Oil Deals and Growth

One of the outlets for the bank’s credit creation was the oil and gas industry, which became more attractive in the energy-scarce 1970s. Continental Illinois made more loans to energy clients and these were often extended liberally to clients on generous terms. Of course, Chicago is far from oil producing regions of the country and few banks had genuinely national footprints at the time. So, Continental Illinois sourced many of these energy-client loans through an Oklahoma firm, Penn Square Bank, with which Continental Illinois partnered. Besides loans to oil and gas companies, Continental Illinois also made real estate and international construction finance loans.

The expansion continued into the early-1980s. By 1981, Continental Illinois became the largest commercial and industrial lender in the U.S. and the seventh-largest American bank overall; it has grown to $45 billion in assets. Compare this to the ‘mere’ $25 billion in assets that the bank possessed in 1977.

Few banks can increase their deposits from loyal clients so quickly. Enticing small depositors to place more money with the bank is a slow way of accumulating more funding with which to make loans. So, Continental Illinois funded its enlarged portfolio with borrowing from other banks and large-balance certificates of deposit, essentially institutional money, rather than from the savings of small retail depositors in its home market of Chicago. The bank’s own ‘core’ deposits, sourced from its own client base, made up just 30% of total deposits in 1977 and a mere 20% of total deposits in 1981. The rest of the funding largely came from banks and other institutions, many of them from abroad.

Specifically, the bank raised much of this funding from the sale of short-term certificates of deposit to large institutions, certificates that needed to be rolled over frequently, but this constituted a cheaper form of funding than longer-term deposits. Between 1977 and 1981 these large-balance deposits grew over 100% from $4.5 billion to $9.2 billion while its small deposits were nearly flat over the same period, growing just around 4%. Yet, the low funding costs and somewhat high financial leverage, or ratio of assets to equity capital, meant Continental Illinois was very profitable in these years of strong growth. The bank’s return on equity of 14.35% in the five years from 1977 to 1981 was the second-best among large commercial banks in the country.

On The Brink

The turn of fortunes for Continental Illinois originated in the downturn of both energy lending and foreign loans. Oil prices fell a bit in 1981 but continued to slide thereafter. Thus, the oil and gas industry struggled through 1982. Nucorp Energy, a firm to which Continental Illinois had over $170 million in exposure, went bankrupt.

Penn Square Bank, the firm through which Continental Illinois had acquired many energy loans, failed in July 1982. The Penn Square problems brought negative attention to more speculative loans for energy industry borrowers. Several banks garnered more scrutiny as a result, and Continental Illinois was the most notable among them, both because of its size and the fact it had bought $1 billion in participation interests in loans originated by Penn Square.

The energy loans were only part of the problem; Continental Illinois also had exposure to emerging market debts and other large corporate bankruptcies of 1982. International Harvester, which owed Continental Illinois $200 million, was nearly bankrupt and a loan provided to a very large Mexican conglomerate, Grupo Industrial Alfa, also went bad. In 1982, new provisions for loan losses came to $477 million as compared to between $52-65 million per year between 1977 and 1979. Net income contracted sharply in 1982, though perhaps amazingly, was still positive at $70 million. This still constituted a considerable drop from $231 million the prior year and was lifted by certain non-recurring profits, like the gain recorded on a sale of a credit card business.

The credit rating agencies downgraded Continental Illinois’s securities. Nonetheless, from mid-1982 to mid-1983, the bank’s stock price recovered. Unfortunately, the stabilization of the bank’s equity value did not help on the liability part of the bank’s balance sheet. Continental Illinois was forced to pay more to its depositors to keep their money at the bank; it was paying as much as 1% more for deposits than other banks. Despite this, large institutional deposits fell from $9.2 billion in 1981 to $6.2 billion in 1982. The bank raised money from international sources to supplement lost domestic deposits; these grew from $14.9 billion in 1981 to $15.7 billion in 1982 and $16.4 billion in 1983. Helping things, large-balance deposits at Continental Illinois actually recovered a bit, to $6.8 billion, in 1983.

Rescue

In early 1984, the bank reported a further $400 million in non-performing loans, bringing the total volume of these positions to $2.3 billion. The majority of this increase came from Latin American loans. In the wake of such a poor first quarter, rumors circulated that the bank or its regulators were seeking a buyer for Continental Illinois, rumors that were denied both by the bank itself and its regulators. Still, by early May, some believed the collapse of the bank was in sight.

Depositors, many of them from outside the U.S., withdrew money from the bank, particularly after May 9; $1 billion was withdrawn by Asian depositors, largely in Japan, on a single day. The bank’s managers tried to dispel the rumors but it didn’t work. Before long, Continental Illinois turned to the Federal Reserve’s discount window to replace this lost foreign funding, borrowing $3.6 billion from the Federal Reserve by Friday, May 11. A financing package worth $4.5 billion was extended to Continental Illinois by other banks. This consortium, led by Morgan Guaranty, announced its plans on May 14 but deposits kept being withdrawn.

There were concerns about systemic risk because so much of Continental Illinois’s deposits came from other banks that might themselves be imperiled by its failure. The Federal Deposit Insurance Corporation and a group of banks extended $2 billion in emergency financing, provided to the bank in the form of purchases of subordinated notes, on Thursday May 17. A group of twenty-four banks increased the private capital previously committed from $4.5 billion to $5.3 billion in additional funding.

By month-end, the FDIC had promised to protect all of Continental Illinois’s depositors without limit. Had the $100,000 FDIC coverage limit been maintained, 90% of the bank’s deposits would have been uninsured. This decision safeguarded the deposits of banks and other large institutions placed with Continental Illinois. This was unusual though as many other banks were failing around the same time without prompting such a commitment by the FDIC. Indeed, bad banks were occupying the attention of other banks and their regulators in May 1984, a year that had already seen thirty-two American banks fail by May 18 that year.

Their deposits now insured, the run on Continental Illinois came to an end. This bought substantial time for regulators and the financial system generally but no permanent solution, most notably an acquirer for the bank, was found. Eventually, the FDIC invested $1 billion in preferred stock in the bank, accounting for an 80% ownership stake; the existing private shareholders of Continental Illinois retained a 20% stake. The FDIC also bought $4.5 billion in non-performing loans for a price of $3.5 billion. Combined with prior efforts, the volume of support came to $12 billion. The final resolution came a decade later when Continental Illinois was sold to Bank of America in 1994.

Lesson

Two things stand out about the Continental Illinois story. One was the amazing growth of the bank between 1977 and 1981. Its assets doubled in just five years and its portfolio of commercial loans, the bank’s principal area of focus, grew 150%. Yet, the money for this was raised from skittish sources and deployed into areas that quickly became troubled. The other legacy of Continental Illinois was the increased frequency of bank rescues that saw previously unusual maneuvers resorted to by regulators. These two aspects of the story are fused in the phrase “too big to fail” which was coined by a U.S. Congressman in the wake of Continental Illinois’s rescue.

More from the Tontine Coffee-House

Read about the failure of Franklin National Bank in 1974 and the wave of bank failures that turned a stock market crash into a depression over 1930-33. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.