Continental Illinois Bank and Trust Company of Chicago ; Bank failures

Frederick T. Furlong

English

Research Papers in Economics

FRBSF
August 31, 1984 WEEKLY LETTER
Market Responses to Continental Illinois
Thehandlingoftroubled Continental Illinois Bank
and Trust Co. bythe federal regulators will be
debated for some time. On the one hand, the
assistance provided may have been the onlyway
ofensuringthatthebank's problemsdid not"spill
over" toother banks and the economy in general.
On the other, critics ofthe assistance packages
argue thatthe aid to Continental diluted market
discipline by sendinga dramatic new message
that large banks would notbe allowed to fail.
Particularly troublesome to the critics was the
proposed arrangementfor restructuringContinen-
tal to give some protection to the bank's
stockholders.
This Weekly Letter provides some perspective on
the problems experienced by Continental Illinois
and the assistance packages provided the bank by
the Federal Deposit Insurance Corporation (FDIC).
In particular, this Lettertakes a look at howthe
marketreacted totheepisodeandexamines some
ofthe evidence on whetherthe treatmentof
Continental affected the market's perception of
the status ofdepositors and stockholders offailed
banks.
The problem
The seeds ofContinental's troubles were sown
some time ago. In the second halfofthe 1970s,
when Continental Illinois expanded rapidly, the
bank accumulated a large volume ofenergy-
related loans through direct lending and loan
purchases, including loans from Penn Square
Bank. The exposure in energy-related lending
proved to be an Achilles' heel when, in July 1982,
Penn Square collapsed and many ofContinental's
holdingsof Penn Square loans were subsequently
found to be in trouble.
Followingthe Penn Squareepisode, Continental's
experience with nonperforming loans only wors-
ened. Perhaps the best indicationofthedimensions
ofContinental's problems came outofthe FDIC's
announcement on July 26, 1984 concerning the
provisions ofthe "permanent" assistance plan for
the bank. Underthe plan, the FDICwouldcommit
topurchase upto $4Y2 billion in loans from Conti-
nental. This would include loans with a face value
of $3 billion, for which the FDIC would pay $2
biIIion with Continental charging offthe other $1
biIIion. As partofthe permanent package, the
FDIC also would committo purchase another
$1 Y2 billion in loans at a later date.
Impact on Continental
The market's awareness ofand concern overthe
financial difficulties ofContinental appeared to
intensify in the early part of1984. Chart 1 shows
the movement in Continental's stock price along
with indexes for the stock prices ofthe bank hold-
ing companies of 12 other money center banks
and the S&P 500. To facilitate comparison, all
three series are indexed at 100 in October 1983
(index values are based on Friday closing prices).
The chart indicates that, from the end of1983 to
the beginning ofMay-before the deposit run at
Continental, the price ofthatbank's common stock
fell by 36% percent. In comparison, the S&P 500
index andthe index for the other large bank hold-
ingcompanies droppedonlyabout3Y2 percenton
balance OVer that same period.
Depositors reacted abruptly to the troubles at
Continental in early May bywithdrawing a sub-
stantial volumeofuninsured deposits. The sources
offundingused byContinental made itparticularly
vulnerabletosuch aliquiditysqueeze. The bank's
quarterly report showed that, atthe end ofMarch
1984, its worldwidedepositscameto $28.3 biIIion,
$20.7 billion ofwhich were in time deposits in
excess of$100,000. (Given Continental's sources
ofdeposits, itseems clear that the deregulation of
retaiI-typedeposits had Iittleifanythingtodowith
the bank's problems.)
Responding to the withdrawal ofdeposits at
Continental, the Federal Reserve began to lend to
the bank. Continental also was helped by a lineof
credit arranged with a numberofcommercial
banks. These measures did notquietthe concerns
ofthe depositors, and, on May17, thefederal bank
regulatory agencies made a joint announcement
concerningfinancial assistance for Continental.
To ease the liquidity pressures from depositwith-
drawals, the FDIC agreed to guarantee all deposi-
tors regardless ofdenomination. (Continental's line
ofcreditwith the commercial banks eventually
was raised to $5% billion.) The capital position ofFRBSF
Continental was helped by injectionsof $1 Y2
billion from the FDIC and $500 million from the
group ofcommercial banks.
The assistance given Continental stabilized the
situation for awhile, but by no means did itcom-
pletely reassure the financial markets. Despite the
FDIC's guarantee (which prompted some analysts
to suggest that a Continental CD was just another
u.s. Treasury security), the marketstill required an
interest rate premium on large-denomination CDs
issued by Continental. There were reportedly
doubts aboutthe CDs' liquidity in terms of resale
in the secondary market, as well as concernsthat
there would be a delay in the disbursement of
funds ifContinental failed.
Otherbanks
A primemotivation behind providing assistance to
Continental was toprevent its problemsfrom spill-
ing overto other banks and the economy more
generally. (For adiscussion ofthe arguments relat-
ingtothe economic consequencesofinstabiIityin
banking, see F. Furlong, Economic Review, FRBSF,
Spring 1984.) The market's evaluation ofbanks,
theequitymarketat least, didnotappeartochange
muchonbalancebetween theend of1983 and the
beginning ofMay 1984. Following the run on
Continental, however, there was a distinct market
reaction, at least as far as large banks were con-
cerned. From early Maythrough mid-june, stock
prices at the money center banks (excluding Con-
tinental) fell about 18 percent while the S&P 500
fell only 6 percent (see Chart 1). The fall in stock
price was more pronounced for some ofthe large
banks than for others.
The drop in the stock prices ofthe large bank
holdingcompanies, ofcourse, does notnecessarily
indicate spill-overeffects from Continental perse.
The marketcould very well have been reacting to
some exogenous factor(s) thatwas perceived to
affect large banks in general. One candidate for
such an exogenous shock would be a change in
themarket's perception ofthedebtproblemofless
developed countries (LDC). Itwould explain why
the stock prices for the largest bank holding com-
panies apparently reacted more than those ofother
bankholdingcompanies. Forexample, arandomly
selected sample ofsmaller bank holding compa-
nies (assets of $1 billion to $10 billion), which
generallywouId be expectedto have less (ifanyat
all) LDC debtexposure, experienced a smaller
decline in stock prices than even the market in
general between May4 and mid-june (not shown
in the chart).
Alongwith theequitymarket, the bankCD market
reacted apparently by raising risk premiums on
bank CDs. Chart 2 shows thatthe spread between
theyield on three-month bankCDs inthe second-
ary marketand the three-month Treasury bill rate
(bank discount basis) widened noticeably in mid-
May, afteredgingupsome in lateApril. The spread
narrowed by mid-August but remained somewhat
above the level observed at the end ofApril.
The higher.risk premiums apparently demanded
by the marketwould imply a greater amountof
uncertainty aboutthe safety of large-denomination
deposits. The movement in CD yields relative to
Treasury security yields suggests thatCD holders
did not have complete confidence that the FDIC's
guarantee to large depositors at Continental would
beextended to large-denomination depositholders
at other big banks. However, this does not mean
thatthe FDIC guarantee to Continental depositors
did nottend to lowerthe risk premiums below
what would otherwise have been dictated bythe
market.
Message to stockholders
After weeks offutiIe searching for a take-over
candidate forContinentallilinois, the FDICfinally
announced on july 26 that itwould committhe
resources needed to ensure the survival ofthat
bank. (The FDIC's plan still must be accepted by
the stockholders ofContinental.) A major part of
the proposed package is the purchase of loans
from Continental mentioned above. The plan also
would provide a $1 billioncash infusionthatwould
make the FDIC the major stockholderof
Continental.
Even before the announcementofthe assistance
package in july, the fate of large depositors, of
course, already had been determined. What was
in question between May and late julywas the
future oftheContinental Illinoisstockholders. This
period ofuncertainty forthe stockholders is indi-
cated by the shaded area in Chart 1, and is marked
by a 75 percent drop in the price ofContinental
stock. The bank's stock, however, did retain some
value, indicating the beliefthat there was some
chance the stockholders would notbe totally
wiped out in the final arrangements.CHART 1
WEEKLY STOCK PRICE INDEX
OCTOBER 28, 1983 - AUGUST 24, 1984
CHART 2
DIFFERENTIAL BETWEEN 3·MONTH CD
AND 3·MONTH T·BILL RATES
(weekly)
basis
points
200
180
160
140
120
100
80
60
40
20 L.J.....L...L.-'-'-.L...L.....L..J.-L...l~L.....I.-L.L..J..J....L-
JAN APR JUL OCT JAN APR JUL
1983 1984
7.06
1984
.......................\
"
."
CONTINENT
ILLINOIS
Index
120
110 ,,__ ,r~..<,,''''''''''''-''''..........\ ........
100 -., ..........-.J'_~
90
80
70
60
50
40
30
20
10 ll...-...L---"----"---'------L--'
11.04 1.06 3.02 5.04
1983
As itturned out, underthe FDIC's proposal, current
stockholders would not necessarily lose every-
thing, although they would remain at substantial
risk ofbearing heavy losses in the future. The
market reacted tothe plan bybiddingupthe price
ofContinental stock about 29 percent in the week
that the FDIC announced the permanent plan for
assisting the bank (the week ending July 27). This
suggests that the marketthoughtthe chances that
Continental stockholders would not be wiped out
had irnproved. Even so, the price ofContinental
common stockwas closeto 70 percentlowerthan
its leveJjustbefore thedepositrun..
Oneofthe major concerns with the assistance
package proposed bythe FDIC is that it sent a
message to stockholders ofother banks, particu-
larly large banks, that they too stood a better
chanceofbeing protected iftheir bank should get
into trouble. Some indication ofhowthe aid to
Continental affected the rnarket's viewofthe riski-
ness ofbankequity mightbe gleaned from the
reaction ofbank stock prices. An examination of
Chart 1 indicates that the stock price index forthe
12 money center bank holding companies rose
only slightly in the week endingJuly 27-a 2
percentincreasecompared with a1percentrise in
the S&P 500 index. In subsequentweeks, the index
for the stock priceofthe 12 money center bank
holding companies did rise more noticeably, a
move that mightbe taken to confirm the viewthat
the market reacted with some lag to an unexpect-
edlyfavorable treatment ofContinental stock-
holders. However, even this rise in the stock price
indexforthe largestbankholdingcompanies may
have had little or nothingto do with the decision
on Continental Illinois since the increase was
about in linewith the overall rise in marketprices
indicated bytheS&P 500. Moreover, the stock
prices ofother bank holdingcompanies-the
sample ofsmaller bank holdingcompanies men-
tioned above-did notreact much in the weekof
July 27, and in subsequent weeks the prices ofthe
stocks forthis sample rose even less than the mar-
ket as a whole.
Conclusion
Part ofthe initial assistance the FDIC provided
Continental Illinois was a guarantee to cover all
deposits at the bank. Contrary to speculation by
some, the marketdoes appear to have interpreted
this guarantee as foretelling blanket protection of
uninsured deposits at all large banks.
Following theJuly announcement by the FDIC on
the permanent assistance for Continental, the
movement in the bank's stock price suggests that
the proposed plan did improvethe prospects for
Continental stockholders compared to their situa-
tion justpriortothe announcement. Nevertheless,
Continental's stockholders have not been "letoff
the hook," as they have sustained heavy losses
and still face considerable uncertainty. The issue
ofwhether even minimal protection to stock-
holders iswarranted, ofcourse, will continuetobe
debated. On-the question ofwhether a new mes-
sage was senttostockholdersofother bankholding
companies, itis possiblethatthetreatmentofCon-
tinental didnotaltertoanygreatextentthe market's
viewofhowotherbankswouId be handled ifthey
were in the same situation.
Frederick T. Furlong
Opinionsexpressed in this newsletterdo not necessarily reflect the views ofthe managementofthe Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernors of the Federal Reserve System.
Editorial commentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....Freecopiesof Federal Reserve publications
can beobtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.'J!IP:> 'O:>SPUPJJ UPS
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
8/15/84
. Change
from
8/8/84
Change from 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments' 2 182,111 808 6,086 5.4
Loans and Leases1 6 163,063 801 7,708 7.8
Commercial and Industrial 48,689 - 316 2,726 9.3
Real estate 60,640 102 1,741 4.6
Loans to Individuals 29,227 186 2,576 15.2
Leases 5,024 - 6 - 39 - 1.2
U.s. Treasury and Agency Securities2 11,864 - 7 - 643 - 8.1
OtherSecurities2 7,183 13 - 980 - 18.9
Total Deposits 189,747 1,307 - 1,250 - 1.0
Demand Deposits 45,153 1,559 - 4,084 - 13.0
Demand Deposits Adjusted3 29,290 - 513 - 2,041 - 10.2
OtherTransaction Balances4 12,294 - 197 - 481 - 5.9
Total Non-Transaction Balances6 132,299 - 55 3,314 4.0
MoneyMarketDeposit
Accounts-Total 37,674 - 150 - 1,923 - 7.6
Time Deposits in Amountsof
$100,000ormore 40,812 - 41 2,647 10.9
Other Liabiiities for Borrowed MoneyS 19,877 966 - 3,130 - 21.4
Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+l/Deficiency(-).
Borrowings
Netfree reserves (+)/Net borrowed(- 1
Period ended
8/13/84
43
24
19
Period ended
7/30/84
61
111
50
, Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
s Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately

Market responses to Continental Illinois

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Market responses to Continental Illinois

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