The Continental Illinois bailout in 1984 sent the message that large banks would not be allowed to fail, eliminating market discipline at large banks and resulting in a two-tier banking system in the United States.
Continental Illinois National Bank and Trust Company was rescued by the U.S. government in 1984. Continental Illinois was the sixth-largest bank in the United States at the time, with total assets of $41 billion. It experienced serious problems during the severe recession in 1981-1982, when many of its loans to less developed countries and to Latin American countries defaulted. In addition, the bank’s ability to diversify its loan portfolio was severely limited by state regulations that prohibited branch banking. Moreover, Continental Illinois had bought some energy-related loans from Penn Square National Bank, which failed in 1982. Many of those borrowers defaulted in 1984. In the first quarter of 1984, nonperforming loans were 7.7 percent of the bank’s loans outstanding.
Rumors about the quality of Continental Illinois’s overall loan portfolio spread among depositors and caused a serious run on deposits in May, 1984, as depositors made sure that they got their money out of the bank. The Office of the Comptroller of the Currency
Continental Illinois, headed by Roger E. Anderson from 1973 to 1984, had pursued a rapid growth strategy. It expanded from being the nation’s eighth-largest bank in 1981 to being the sixth-largest bank in 1984. The rumor about the bank’s insolvency in May, 1984, threatened uninsured depositors’ confidence in the bank, causing them to withdraw more than $6 billion in a one-week period ending on May 17, 1984. As deposits shrank, the bank faced a “liquidity crisis” that is, it did not have enough assets that could be converted quickly to cash.
During this massive deposit withdrawal, William Michael Isaac, chairman of the Federal Deposit Insurance Corporation
To prevent a possible collapse of the bank as a result of the liquidity crisis, the chair of the Federal Reserve Board, Paul A. Volcker, announced that Continental Illinois would have unlimited access to low-interest loans. The FDIC also arranged an emergency assistance program, including a $7.5 billion loan package, on May 17, 1984. The FDIC itself loaned $1.5 billion, and twenty-four major banks, led by Morgan Guaranty, provided the rest.
Continental Illinois’s deposits shrank by more than half by July 19, 1984, indicating that the emergency assistance program had not restored depositor confidence. A week later, on July 26, 1984, the FDIC arranged a permanent bailout program for Continental Illinois. The FDIC bought $1 billion of the bank’s preferred stock and assumed $3.5 billion of its troubled loans. In exchange, the FDIC acquired an 80 percent interest in Continental Illinois Corporation. As Continental Illinois’s performance improved over time, the FDIC received income from selling loans it had assumed, thereby reducing the net cost of the rescue. Although the FDIC infused $4.5 billion in cash, the net cost to the FDIC was approximately $1.7 billion.
The federal government, through the Federal Reserve system,
In the case of Continental Illinois, failure was likely to cause serious deposit runs on other banks. At the time, Continental Illinois held deposits from many other banks, including money-center banks such as Bank of America and Manufacturers Hanover. Deposits at Continental Illinois at that time represented more than half of the capital of more than one hundred small banks. If Continental had been allowed to fail and not pay back those deposits, the small banks would have been in serious trouble.
In addition, it has been argued that because of the nature of banking, a run on a solvent bank could actually cause the bank to fail. Banks generally borrow short-term and lend long-term, so even a healthy bank would not have sufficient cash to meet depositors’ withdrawal demands during a deposit run. The bank would be forced to liquidate assets to meet the withdrawal demand. Bank loans, however, are not traded in the secondary market and are relatively illiquid compared with other types of securities. They are difficult to sell in a short amount of time without incurring substantial losses. Such losses associated with a liquidity crisis could potentially cause an otherwise healthy bank to fail.
To prevent a widespread series of bank failures, which could occur in a domino effect and potentially disrupt the overall functioning of the nation’s financial markets, the federal government bailed out Continental Illinois. The bank was nationalized in July, 1984, and continued its business as a going concern. As a result, all depositors and creditors of the bank and its holding company, both insured and uninsured, were effectively protected from losses.
OCC chairman C. Todd Conover stated in September, 1984, that the “too-big-to-fail doctrine” would be applied to eleven of the nation’s largest banks. The FDIC stated in October, 1987, that the federal government could not permit a large bank failure to be handled in a way that would result in losses to depositors, because the effects and costs of deposit runs on other large banks if uninsured depositors lost confidence would be too large.
The way the federal regulatory agencies handled the Continental Illinois crisis left the public with the perception that large banks, especially money-center banks, are too big to fail. FDIC insurance, which was originally intended to protect only insured depositors up to a deposit limit, was extended to cover large accounts and creditors of large banks. In addition, the federal insurance was extended to protect bank holding companies’ creditors in the Continental Illinois situation.
The too-big-to-fail doctrine has been the subject of criticism, even among members of Congress during hearings of the House Banking Committee on May 24, 1984. It has been argued that the policy would result in a two-tier banking system in which small banks subsidize large banks. That is, large banks do not pay higher deposit insurance premiums than small banks, but their depositors and creditors receive better protection, given that large banks will not be allowed to fail. Government funds to bail out large banks could deplete the FDIC insurance fund, resulting in larger deposit insurance premiums for all banks, including small ones. One counterargument was that large banks are much less likely to fail because they diversify their business.
The way the federal government handled the Continental Illinois case sent an important message to the public that large banks are considered to be too big to fail. The perception that the federal government will not allow large banks to fail had significant impacts both on bank management (in terms of attitudes toward risk taking) and on depositors and creditors (in terms of concerns about bank risk). Knowing that the federal government would not allow them to fail, large banks were encouraged to take risks that would allow them to earn high rates of return if the risks worked out. If not, the federal government would bail them out, so the risks were transferred to the government. This reward system encouraged banks on the verge of failure to take large risks.
On the depositors’ side, the too-big-to-fail doctrine diminished discipline at large banks. If market discipline were in force, safe banks would be able to raise funds at a lower cost, and risky banks would have to pay a premium (higher interest rates) to their depositors and creditors to compensate for the extra risk. That is, the market would penalize risky banks. A lack of market discipline at large banks could develop as depositors become less concerned about bank risk, because they know that the government will not allow the banks to fail. The policy effectively protects all depositors and creditors at large banks, including depositors with accounts larger than the FDIC ceiling for coverage. The reduction in market discipline also encourages banks to make riskier loans, as they can profit from the higher interest rates charged to borrowers without having to compensate depositors.
The lack of market discipline may have contributed to an explosive growth in off-balance-sheet activities undertaken by banks in the mid- and late 1980’s. Banks became active in off-balance-sheet activities as a way to increase risks, and therefore profits, if successful, without having to increase capital, as would be required to expand regular banking activity. These off-balance-sheet activities included standby letters of credit, interest rate and foreign currency swaps, options, and futures and forward contracts. The lack of market discipline has been blamed for contributing to a large number of bank failures in the 1980’s.
Some people believed that Continental Illinois’s situation and problems were unique rather than indicative of banking generally. In this case, the implicit insurance was extended to cover not only the bank’s large depositors but also the bank holding company’s creditors. It is interesting to examine how the federal government handled potential failures of other large banks following the Continental Illinois crisis and to observe whether all creditors of the banks and their holding companies were fully protected.
Statistics suggest that all depositors, including those with accounts larger than the FDIC insurance ceiling of $100,000, at other large banks were also fully reimbursed. Examples include First Bank of Texas (total assets of $11 billion), which failed in 1988; MCorp of Texas (total assets of $15 billion), which failed in 1988 and was later acquired by Banc One in 1989 with financial support from the FDIC; and Bank of New England (total assets of $22 billion), which failed in 1991. No depositors suffered losses, reflecting an implicit insurance beyond the limit at large banks. Depositors at small banks whose accounts exceeded the insurance limit did not receive such protection. For example, depositors at Freedom National Bank, which failed in November, 1990, received 50 percent of their deposits exceeding $100,000. Depositors at Capital Bank, which failed in December, 1990, received 45 percent.
The too-big-to-fail policy was applied when the First Republic Bank of Texas,
Regarding the implicit protection to creditors of bank holding companies, all creditors of Continental Illinois Corporation were protected from losses in 1984. The FDIC proved unwilling to protect creditors of bank holding companies a few years later. For example, creditors of First Oklahoma Bancorporation suffered significant losses when First National of Oklahoma City went under in July, 1986, and creditors of MCorp of Texas also suffered significant losses when the bank was in trouble in 1988. The FDIC explained that its goal was to minimize depositor losses and disruption in the community and the nation, but to do so at minimum cost. Implicitly it recognized that shareholder losses would not be as damaging as runs on deposits. The FDIC may also have wanted to retain a form of market discipline through shareholders overseeing the risks undertaken by banks.
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Federal Deposit Insurance Corporation. The First Fifty Years: A History of the FDIC, 1933-1983. Washington, D.C.: Author, 1984. Provides almost everything one might want to know about the FDIC, including its background, its operation, its policies in handling bank failures, statistics relating to the operations, and the process of bank examination and supervision. -
Gup, Benton E., ed. Too Big to Fail: Policies and Practices in Government Bailouts. Westport, Conn.: Praeger, 2004. Collection of essays addresses the issue of government bailouts in various industries but devotes substantial discussion to banking. Includes discussion of the Continental Illinois crisis. -
Johnson, Richard B., ed. The Bank Holding Company, 1973. Dallas: Southern Methodist University Press, 1973. Collection of conference papers is devoted to issues related to bank holding companies, with a focus on regulatory issues. Intended for readers with background in banking and finance. -
Kane, Edward J. The Gathering Crisis in Federal Deposit Insurance. Cambridge, Mass.: MIT Press, 1985. An expert in bank regulations and deposit insurance discusses weaknesses and problems under the flat-rate FDIC premium system. Provides many statistics about the FDIC insurance fund, the fund’s risk exposure, and bank mergers arranged by the FDIC. Well written and accessible to general readers. -
Klebaner, Benjamin J. American Commercial Banking: A History. Boston: Twayne, 1990. Presents a well-organized review of the development of American commercial banking. Easy to understand, even for readers who do not have special background in finance or economics. Includes a chronology of forty-seven important events in banking from 1781 to 1989. -
McCollom, James P. The Continental Affair: The Rise and Fall of the Continental Illinois Bank. New York: Dodd, Mead, 1987. Provides thorough coverage of the Continental Illinois crisis, starting with the background of the bank. Presents detailed descriptions of characters and important conversations involved in the events of the crisis. The author served the Continental Illinois Bank for fourteen years and wrote this book from his personal experience. Written in a lively style. -
Stern, Gary H., and Ron J. Feldman. Too Big to Fail: The Hazards of Bank Bailouts. Washington, D.C.: Brookings Institution, 2004. Two officers with the Federal Reserve argue that too-big-to-fail protection for banks is problematic and suggest ways to address the issue more effectively. Includes discussion of the Continental Illinois crisis.
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