United States General Accounting Office

GAO Staff Study

May 1997 FINANCIAL CRISIS

MANAGEMENT

Four Financial Crises

in the 1980s

GAO/GGD-97-96

Preface

The increasing interconnectedness of financial institutions and markets

has highlighted the need to ensure that diverse federal, state, international,

and private financial organizations work together to effectively contain

and resolve financial disruptions. The federal government’s ability to

manage financial crises effectively is important to the stability of the U.S.

financial system and economy as well as the worldwide financial system.

In seeking to expand its current knowledge of financial crisis

management, GAO studied federal actions that successfully contained four

major financial crises of the turbulent 1980s—the Mexican debt crisis of

1982; the near failure of the Continental Illinois National Bank in 1984; the

run on state-chartered, privately insured savings and loan institutions in

Ohio in 1985; and the stock market crash of 1987.

On the basis of a review of emergency response literature, GAO focused on

three phases of financial crisis management. The preparedness phase

included activities undertaken prior to the occurrence of a crisis. The

containment phase included activities undertaken in immediate response

to a financial crisis to mitigate the financial disruption and lessen ill effects

on the financial system. The resolution phase included activities

undertaken to reduce the likelihood of the recurrence of the crisis or

similar financial crises.

GAO observed that leadership was critical for effective management and

containment of each of the four financial crises. Treasury and the Federal

Reserve led crisis containment efforts because of their financial resources,

access, and expertise, although each agency had its own distinct and

complementary leadership role. As part of the executive branch, Treasury

was better positioned than the Federal Reserve to provide the political

leadership considered desirable in containing a financial crisis. At the

same time, the Federal Reserve had critical mechanisms and resources for

providing temporary liquidity in a crisis—currency swaps, discount

window lending, and open market operations. Treasury also provided

temporary liquidity during the Mexican crisis through the Exchange

Stabilization Fund.

GAO observed that successful crisis response in each case depended

greatly on swift and sometimes innovative action, which appeared to help

reduce in scope and intensity the effect the crisis had on the financial

system. In addition, the more effective the communication of the federal

response the more it appeared to help prevent a crisis from worsening,

because it provided clear and credible information that played a part in

calming financial markets.

Page 1 GAO/GGD-97-96 Financial Crises
Preface

Several officials told GAO that contingency planning, including interagency

planning, helped facilitate federal preparedness and response to a crisis.

They said that contingency planning helped federal financial regulators

identify resources to contain the crisis as well as potentially vulnerable

firms or markets. GAO encountered mixed views on the part of financial

crisis managers concerning whether or not contingency planning should

be documented. Some officials were reluctant to document their planning

efforts due to fears of triggering a panic or because circumstances of a

crisis are never identical to those in the plan.

GAO observed that coordination of crisis containment efforts among key

participants was important because rarely did one agency have the

necessary authority, jurisdiction, and resources to contain the crisis. The

decentralized structure of financial regulation often presented challenges

to effective coordination in a crisis. In addition to coordinating with each

other, federal regulatory officials said that they often needed to coordinate

with state governments, international organizations, foreign governments,

and Congress. Crisis containment also required coordination with the

private sector to determine whether the private sector could contain the

crisis without federal assistance, and to identify resources available for

crisis containment.

Reliable and timely information was important to federal efforts to provide

early warning of potential crises and to help regulators decide whether

and how to intervene. Federal financial agencies, including the financial

institution and market regulators, each collected crisis-relevant

information in their routine monitoring of financial activity. However,

several officials told GAO that the federal government’s ability to identify

incipient financial crises or to monitor a crisis once it had occurred was

sometimes limited by the dispersed nature of the government’s crisis

surveillance capability, along with limitations and gaps in the available

information.

Financial crises are complex events often involving multiple markets and

institutions. To fully explore all of the actions and viewpoints involved

would require a much lengthier discussion than this study provides.

Page 2 GAO/GGD-97-96 Financial Crises
Preface

However, because the information about each of the four crises GAO

reviewed has not been previously published in consolidated form, GAO is

publishing its results as a staff study to permit appropriate archiving and

retrieval of the information for future reference by GAO staff and others

who may have interest.

Jean G. Stromberg

Director, Financial Institutions and

 Markets Issues

Page 3 GAO/GGD-97-96 Financial Crises
Contents

Preface 1

Chapter 1 

Introduction

6

Financial System Environment Changed 6

Linkages of Financial Markets Affected Nature of Crises 9

Public Sector Often Has a Crisis Management Role 11

Objectives, Scope, and Methodology 15

Chapter 2 

The Mexico Debt

Crisis of 1982

19

Summary of Chronology 19

Preparedness: Interagency Contingency Planning Helped Contain

Crisis

20

Containment: Swift and Collaborative Action Taken to Avoid

Immediate Default

26

Resolution: Executive and Legislative Initiatives 32

Chapter 3 

The Continental

Illinois Bank Crisis

35

Summary of Chronology 35

Preparedness: Surveillance and Planning Prepared Regulators 35

Containment: Joint Discussions Led to Containment Strategy 39

Resolution: FDIC Strengthened Oversight of Nationally Chartered

Banks

44

Chapter 4 

The Ohio Savings and

Loan Crisis

47

Summary of Chronology 47

Preparedness: Limited Information and Authority Made Planning

Difficult

50

Containment: Ohio Governor and Federal Reserve Led Crisis

Containment Efforts

51

Resolution: Legislation Enacted to Address Government

Securities Fraud and Improve Disclosure

59

Chapter 5 

The Stock Market

Crisis of 1987

60

Summary of Chronology 60

Preparedness: Routine Market Monitoring and Existing Networks

Helped Prepare Regulators

61

Containment: Leadership, Swift Action, and Collaborative Efforts

Helped Contain Crisis

63

Resolution: Crisis Studies Accompanied by Regulatory and

Legislative Initiatives

67

Page 4 GAO/GGD-97-96 Financial Crises
Contents

Appendix Appendix I: Major Contributors to This Report 70

Bibliography 71

Table Table 1.1: U.S. Federal Financial Organizations Involved in

Responding to Four Financial Crises in the 1980s

11

Figures Figure 2.1: Selected Events in the Mexico Debt Crisis of 1982 22

Figure 2.2: Selected Events in the Mexico Debt Crisis of 1982 26

Figure 2.3: Selected Events in the Mexico Debt Crisis of 1982 31

Figure 3.1: Selected Events in the Continental Bank Crisis 37

Figure 3.2: Selected Events in the Continental Bank Crisis 44

Figure 4.1: Selected Events in Ohio Savings and Loan Crisis of

1985

48

Abbreviations

BIS Bank for International Settlements

CBOE Chicago Board Options Exchange

CFTC Commodity Futures Trading Commission

CME Chicago Mercantile Exchange

DJIA Dow Jones Industrial Average

ESF Exchange Stabilization Fund

FDIC Federal Deposit Insurance Corporation

FDICIA Federal Deposit Insurance Corporation Improvement Act

FHLBB Federal Home Loan Bank Board

FHLBC Federal Home Loan Bank of Cincinnati

FIRREA Financial Institutions Reform, Recovery, and Enforcement

Act

FRS Federal Reserve System

FSLIC Federal Savings and Loan Insurance Corporation

IMF International Monetary Fund

NASD National Association of Securities Dealers

NYSE New York Stock Exchange

OCC Office of the Comptroller of the Currency

SEC Securities and Exchange Commission

SPR Strategic Petroleum Reserve

SRO self-regulatory organization

Page 5 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

The federal government has faced many challenges in responding to

financial disruptions that threaten the stability of the U.S. financial system.1

 In the 1930s, the United States experienced one of its most devastating

financial crises. Loss of public confidence in banks caused disruptions in

the financial system and, along with other factors, ultimately led to the

Great Depression. In the 1980s, the federal government was challenged by

a series of financial disruptions of considerable magnitude.2

 Some

disruptions became full-scale financial crises that cost taxpayers, firms,

and individuals collectively billions of dollars. Others became crises that

had the potential to cause widespread damage but were successfully

contained. The possibility of other such financial crises can not be

dismissed.

This report presents our review of four financial crises of the 1980s: the

Mexican debt crisis of 1982, the near failure and rescue of the Continental

Illinois National Bank in 1984, the Ohio savings and loan crisis of 1985, and

the 1987 stock market crash. These crises, which varied in magnitude,

were ultimately successfully contained and resolved through joint efforts

of federal agencies and others. By documenting these crises and the

efforts to contain them, this report seeks to expand current knowledge of

financial crisis management.

Financial System

Environment Changed

The financial crises of the 1980s were preceded by the abandonment of the

Bretton Woods system of fixed currency exchange rates, oil price shocks,

higher than normal annual rates of inflation, and record-setting interest

rates. For almost two and a half decades after World War II, western

countries maintained a system linking the prices of foreign currencies to

U.S. dollars and to gold. This arrangement, which the United States carried

out with its allies, was known as the Bretton Woods international

monetary system. External imbalances, inflation, and other economic

problems forced the abandonment of the Bretton Woods system, which

ended in August 1971 when the United States ceased to make dollars

convertible into gold. In March 1973, a system of generalized floating

exchange rates was adopted for the major international currencies. This

1

Our nation’s financial system is the collection of markets, individuals, institutions, laws, regulations,

and techniques through which bonds, stocks, and other financial instruments are traded, financial

services produced and delivered, and interest rates determined. The financial system enables funds to

be channeled from savers to borrowers, payments to be made for goods and services, and risks to be

transferred from those less able or willing to manage them to those who are more able or willing to do

so.

2

Financial history offers many examples of financial crises. See Charles P. Kindleberger, Manias,

Panics and Crashes: A History of Financial Crises (New York: Basic Books, 1989).

Page 6 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

followed an 18-month period during which an attempt was made to

maintain a regime of fixed exchange rates.

The 1970s and early 1980s were characterized by protracted inflation,

record-setting interest rates, and higher than normal rates of market

volatility. By early 1979 the annual rate of inflation in the United States

reached double digits. The rise of oil prices in 1973 to 1974 and 1979 to

1980 helped generate an increase in the overall inflation rate. Commodity

and real estate prices also soared in the 1970s. To combat inflation, the

Federal Reserve launched a strong anti-inflationary monetary policy in the

period 1979 to 1982, eventually raising nominal and real interest rates to

unprecedented levels for the postwar period. The anti-inflation policy

ultimately succeeded in controlling inflation; however, it produced a

massive interest rate shock and was a prime factor in precipitating the

collapse of the savings and loan industry.3

 In the early 1980s, the United

States experienced its severest recession since the 1930s.

Crises Affected Many

Sectors of Financial

Services Industry

Throughout the 1970s, banks attempted to increase income by aggressive

lending. Rising oil prices enriched oil exporting countries. These oil

exporting countries were depositing their foreign exchange holdings with

large North American, European, and Japanese banks with international

experience. With insufficient demand for loans in the United States and

encouragement from U.S. government officials, large U.S. banks began to

lend to newly industrializing countries as an outlet for these funds. Banks

made substantial investments in these countries and other specific sectors,

some of which had prospered from high commodity prices during the

inflationary period of the 1970s. The sectors included commercial real

estate, energy, and farming.

One of the first shocks to banks in the early 1980s came when the

Comptroller of the Currency closed Penn Square Bank of Oklahoma in

July 1982, a bank with easy lending policies and a large portfolio of loans

to oil firms.4

 It had deposits of $470 million. Many oil and gas explorers

and producers were unable to repay their loans due to failure to find oil

and gas and declining oil prices. OCC officials told us that Penn Square’s

failure was mainly due to management problems and criminal activity. The

failure of Penn Square had rippling effects on the economy. Banks

3

See National Commission on Financial Institution Reform, Recovery, and Enforcement, Origins and

Causes of the S&L Debacle: A Blueprint for Reform (Washington, D.C.: July 1993).

4

FDIC provided deposit insurance to Penn Square and served as receiver for its assets by settling

claims against the bank by creditors—including the claims of insured depositors.

Page 7 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

experiencing losses included Chase Manhattan, Continental Illinois

National Bank, Michigan National Bank, Northern Trust Company, and

Seattle First National Bank. Continental had purchased loans worth

$1 billion from Penn Square. After Penn Square’s closure, Continental

Illinois experienced a run on its deposits and received assistance from the

Federal Reserve and FDIC.

Another shock to the banking industry was the debt crisis of Mexico, a

major U.S. trading partner, which spread to other newly industrializing

nations. In August 1982, Mexico experienced a financial collapse and was

forced to suspend debt repayments to U.S. and foreign banks. By the end

of the 1970s and early 1980s, when oil that Mexico exported commanded

high prices, Mexico had about $100 million in foreign debt. However, when

the price of oil slid, so did Mexico’s foreign exchange earnings. Higher

dollar interest rates meant larger borrowing costs on Mexico’s sizable

external debt. Following the Mexican debt crisis in August 1982, other

developing countries—including Argentina, Brazil, Chile, Peru, Venezuela,

the Philippines, and Yugoslavia—also had debt servicing problems.

The savings and loan industry was also hard-hit by high interest rates, the

maturity mismatch5

 of savings and loan balance sheets, and deregulation.

During the inflationary 1970s, many savings and loans became insolvent as

home loan portfolio earnings were exceeded by high interest costs needed

to keep and attract new deposits. By the latter 1970s and the early 1980s,

the industry’s net worth was virtually wiped out by record-setting interest

rates and the maturity mismatch of savings and loan balance sheets.

Deregulation in 1982 permitted savings and loans to enter new lines of

business and led to increasingly risky asset choices. Many in the industry

speculated aggressively with high-risk loans that eventually defaulted, and

the tide of insolvencies continued. Institutions in the Southwest,

California, and Florida were hardest hit.6

Commercial bank failures also increased in the 1980s. When oil prices fell

sharply in 1986, many major banks in Texas failed, and others were sold or

merged with other banks. Declining real estate prices also contributed to

bank failures. Losses on loans to less-developed countries eroded bank

capital. High-quality corporate borrowers began to raise funds in capital

5

Matched maturities in bank asset-liability management is the funding of loans with deposits of about

equal duration and is intended to minimize interest rate risk.

6

See Thrift Failures: Costly Failures Resulted From Regulatory Violations and Unsafe Practices

(GAO/AFMD-89-62, June 16, 1989); and Troubled Financial Institutions: Solutions to the Thrift Industry

Problem (GAO/GGD-89-47 Feb. 21, 1989).

Page 8 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

markets through bonds and commercial paper—driving banks to do more

real estate lending. Banks lost low-cost sources of funds in savings and

checking accounts as investors sought investments paying higher rates of

return.7

The 1980s crises affected many U.S. financial markets, including equity,

options, and futures markets. The most significant event in this sector was

the market crash of 1987. Although the stock market declined during the

recessionary period of 1981 through 1982, stock prices rose to a then

post-World War II high between 1983 and 1987 as institutional and foreign

investors poured money into the stock market. Some observers believed

that concern about rising interest rates at home and abroad and large

budget and trade deficits led to the crash of 1987. Other observers

attributed the crash to proposed legislation that would have limited the

merger and acquisition activity that had contributed to a large part of the

increase in stock values during the 1980s. Nearly all stocks suffered a

massive sell-off in the 1987 crash, which led to mechanical and liquidity

problems in trading and financial systems at exchanges and clearing

organizations.

Linkages of Financial

Markets Affected

Nature of Crises

Increasing financial linkages among domestic and global financial

markets—a product of new financial products, foreign investment in

capital markets, and advances in communications technology—affected

the nature of financial crises during the 1980s. These linkages also

introduced a new dimension to systemic risk8

 in the financial system.

During the 1980s, foreign investments in U.S. capital markets increased

dramatically as did U.S. investment in foreign markets, especially equities.

For example, foreign purchases and sales of U.S. securities grew from

about $198 billion in 1980 to almost $4.2 trillion in 1990. During the same

period, U.S. purchases and sales of foreign stocks and bonds grew from

about $53 billion to about $904 billion. Financial linkages increased for

many reasons, including the increased use of exchange-traded and

7

See Martin Feldstein, The Risk of Economic Crisis, Chicago: University of Chicago Press, 1991.

8

Systemic risk is the possibility that failure of one or more financial organizations or countries will

trigger a chain reaction and cause the collapse of other financial organizations or countries. A chain

reaction of failures could take place because of linkages between and among markets and due to

participation by the same institutions in several markets. Systemic risk is the risk that a disturbance

could severely impair the workings of the financial system and, at the extreme, cause a complete

breakdown. A breakdown in capital markets could disrupt the process of savings and investment,

undermine the long-term confidence of private investors, and cause turmoil in the normal course of

economic transactions.

Page 9 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

over-the-counter derivative products.9 Derivative products, among other

purposes, provide needed protection against risks associated with

fluctuations in currency exchange rates, interest rates, and other prices

and indexes. Beginning in the 1970s, private corporations—large

commercial banks, securities firms, and institutional investors—began

using derivative financial instruments on a wide scale, which helped foster

linkages among equities, debt, and futures markets.

Advances in telecommunications and information technology had

furthered linkages among financial industries and markets and also

increased certain risks. Advances in communications and computer

technology enhanced market participants’ ability to quickly learn of

foreign market conditions and do business worldwide. Cited as a

contributing factor to the 1987 market crash were complex,

technology-aided trading strategies. Moreover, the volume of trading

during the crash challenged automated systems and created problems for

systems that cleared and settled transactions.10

Many disruptions in the 1980s—beginning with the silver crisis of 198011

—heightened awareness that shocks could spread across markets,

institutions, and borders, thus enlarging the scope of crises. All the major

foreign securities exchanges experienced substantial increases in prices

before the 1987 crash—and during the crash, sharp drops in value. The

disruption to the U.S. financial system could have been great if the 1987

stock market crash had not ended when it did. In 4 trading days in

October 1987, the Dow Jones Industrial Average lost about one-third of its

total value—almost $1 trillion. Had the precipitous decline continued for

another day, massive disruptions to the U.S. financial system and the

financial systems of other countries might have occurred.12

9

Derivative products are instruments that derive their value from a reference rate, index, or the value

of an underlying asset. See Financial Derivatives: Actions Needed to Protect the Financial System

(GAO/GGD-94-133, May 18, 1994).

10See Clearance and Settlement Reform: The Stock, Options, and Futures Markets Are Still at Risk

(GAO/GGD-90-33, Apr. 11, 1990).

11In March 1980, declining silver futures prices generated calls for hundreds of millions of dollars more

margin from Hunt family members and related entities as well as calls for additional deposits to

maintain required collateralization for loans. To fulfill these cash needs, the Hunts borrowed heavily

from broker-dealers, banks, and others. A concern existed that the Hunt default might lead to the

failure of one or more large broker-dealers and possibly jeopardize futures clearing houses,

broker-dealers, and banks.

12See Financial Markets: Preliminary Observations on the October 1987 Crash (GAO/GGD-88-38,

Jan. 26, 1988).

Page 10 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

Public Sector Often

Has a Crisis

Management Role

In the 1980s, as today, federal financial agencies had congressionally

determined roles in financial crisis management. Table 1.1 highlights the

major responsibilities of the federal agencies. The Federal Reserve and the

Department of the Treasury, the nation’s finance ministry, had broad

responsibilities for the health of the financial system. Three agencies—the

Federal Reserve, Office of the Comptroller of the Currency (OCC), and

Federal Deposit Insurance Corporation (FDIC)—were responsible for

ensuring the safety and soundness of federally chartered banks and

state-chartered banks that were federally insured. The same responsibility

for federally insured savings associations was assigned to the Federal

Home Loan Bank Board (FHLBB).13 The National Credit Union

Administration supervises insured credit unions. Since Congress permitted

banks and savings and loans to operate under a state or national charter,

responsibility for supervisory oversight of those institutions often involved

federal and state regulators. With many self-regulatory organizations

(SRO),14 the Securities and Exchange Commission (SEC) and Commodity

Futures Trading Commission (CFTC) were responsible for market integrity

and investor protection in the securities and futures markets, respectively.

State regulators were responsible for oversight of insurance companies.

Table 1.1: U.S. Federal Financial

Organizations Involved in Responding

to Four Financial Crises in the 1980s

Federal agency Responsibility

CFTC Regulates the commodity futures and options markets

and seeks to ensure fairness and integrity in the

marketplace. Responsible for ensuring the economic

utility of futures markets—price discovery and offsetting

price risk—by encouraging their integrity and protecting

market participants against manipulation, abusive trading

practices, and fraud. Oversight includes exchanges,

some off-exchange instruments, and market participants.

FDIC Promotes and preserves public confidence in banks and

protects the money supply by providing deposit

insurance to commercial banks, savings banks, and

savings and loan associations. FDIC’s mission is to

maintain stability in the national financial system by

insuring bank depositors and reducing the economic

disruptions caused by bank failures.

(continued)

13By authority of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA),

the Office of Thrift Supervision replaced the Federal Home Loan Bank Board as primary regulator of

state and federally chartered savings institutions. The Federal Home Loan Bank Board was abolished.

14SROs include such organizations as the Chicago Board Options Exchange (CBOE), the Chicago

Mercantile Exchange (CME), the National Association of Securities Dealers (NASD), the New York

Stock Exchange (NYSE), and the Options Clearing Corporation (Options CC).

Page 11 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

Federal agency Responsibility

FHLBB Supervised the Federal Home Loan Bank System and the

Federal Savings and Loan Corporation (FSLIC) and

regulated federally chartered savings and loan

associations and federally chartered savings banks,

supervised savings and loan holding companies, and

shared with the states the supervision of FSLIC-insured

state-chartered savings and loan associations.

Federal 

Reserve

System

As U.S. central bank, makes and administers policy for

the nation’s credit and monetary systems. Through

discount window operations and supervisory and

regulatory banking functions, helps to maintain the

banking industry in sound condition, capable of

responding to the nation’s domestic and international

financial needs and objectives. Regulates and supervises

bank holding companies and state-chartered banks that

are Federal Reserve members.

OCC Part of the Department of the Treasury that regulates

about 2,700 national banks. Approves organizational

charters, promulgates rules and regulations, and

supervises the operations of national banks through

examinations. Examinations assess the financial condition

of banks, the soundness of their operations, the quality of

their management, and their compliance with laws, rules,

and regulations.

SEC Administers federal securities laws that seek to provide

protection for investors; ensures that securities markets

are fair and honest; and, when necessary, provides the

means to enforce securities laws through sanctions.

Treasury A major policy advisor to the president that formulates

and recommends domestic and international economic,

financial, tax, and fiscal policies; serves as financial agent

for the U.S. government; and manufactures coins and

currency.

Source: GAO.

An international financial crisis may also involve foreign countries and

international organizations. Three key international organizations are the

International Monetary Fund (IMF), the International Bank for

Reconstruction and Development (World Bank), and the Bank for

International Settlements (BIS). Both IMF and the World Bank were

established following World War II and funded by subscriptions or quota

shares from the United States and other members. IMF, which was involved

in one of the four crises we discuss, was established to promote

international monetary cooperation and exchange rate stability and

provide short-term lending to members experiencing balance-of-payments

difficulties. Originally, IMF was to make medium-term loans of 3 to 5 years’

Page 12 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

duration for balance-of-payments support. Its lending was to be based on a

country’s fiscal and monetary policies, exchange rates, and other

macroeconomic factors. The World Bank, on the other hand, was to

provide developing countries long-term loans for development when

private financing was unavailable. Over the past several decades, however,

both IMF and the World Bank have provided longer term financial

assistance to countries involved in economic adjustments. BIS, a central

bank for central banks, is both a wholesale money market bank accepting

deposits from central banks and a forum promoting cooperation among

central banks. Established in 1930, BIS performs a variety of trustee and

other banking functions, mainly for central banks and international

organizations. With encouragement and guarantees from leading central

banks, BIS has helped provide bridge financing15 to a number of central

banks in Latin America and Eastern Europe pending disbursement of IMF

and World Bank credits.

Policy Tools Available to

Contain Crises

In a series of laws passed during this century, Congress gave federal

financial organizations responsible for the health of the financial system a

variety of policy tools to provide liquidity to help prevent or contain a

financial crisis.16 These include open market operations, access to the

Federal Reserve’s discount window, the Exchange Stabilization Fund, and

deposit insurance.

Before the Federal Reserve was established in 1913, periodic financial

panics led to many bank failures, associated business bankruptcies, and

general economic contractions. In establishing the Federal Reserve,

Congress gave it three important tools to carry out responsibilities as

lender of last resort and regulator of the supply of money: open market

operations, foreign currency operations, and discount window lending.

Open market operations enable the central bank to buy and sell

government securities, influencing the quantity and growth of legal

reserves and thereby enhancing or diminishing liquidity to the overall

banking system. The Federal Reserve can undertake foreign currency

transactions to counter disorderly conditions in exchange markets.

Discount window lending is a line of credit facility provided by the Federal

Reserve primarily to depository institutions and occasionally to other

institutions whose financial distress might harm the economy. The line of

15In the context of international finance, bridge financing is short-term credit extended to countries in

anticipation of longer term financing.

16See the Federal Reserve Act of 1913, the Banking Act of 1933, and the Gold Reserve Act of 1934.

Page 13 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

credit must be secured by adequate collateral, which is determined by the

Federal Reserve.

Another policy tool available for containing financial crises is the Treasury

Department’s Exchange Stabilization Fund (ESF).17 This fund provides the

Treasury Secretary a means to (1) conduct international monetary

transactions for the purpose of stabilizing the exchange value of the dollar,

(2) counter disorderly market conditions, or (3) extend short-term credit

to foreign governments when such credits are backed by assured sources

of repayment. Congress has provided the Treasury Department wide

latitude in its operation of ESF. The Secretary’s decisions regarding the use

of ESF resources are subject to approval by the President but remain final

and unreviewable by any other government official.

In the Banking Act of 1933, Congress created the federal deposit insurance

fund to better protect depositor savings and reduce the number of runs on

bank deposits. At the time of the Continental bank and Ohio savings and

loan crises, federal deposit insurance was administered by two separate

entities, the Federal Deposit Insurance Corporation (FDIC) and the Federal

Savings and Loan Insurance Corporation (FSLIC). FDIC and FSLIC provided

deposit insurance for the nation’s banks and savings and loans,

respectively. The insurance funds of these entities were funded primarily

through assessments on members. Both funds enjoyed the full faith and

credit of the U.S. government. In exchange, federally insured depository

institutions would be subject to strict regulatory supervision and

examination and limited in the types of activities they could pursue.18

U.S. Government: Ultimate

Lender of Last Resort

Financial crises of the 1980s strained the basic regulatory framework for

protecting the nation’s financial system. Despite their deposit insurance

mechanisms, the savings and loan industry turned to the federal

government in the 1980s for assistance. The nation’s experience with

financial crises has increased public awareness that the federal

government, and therefore the American taxpayer, is the ultimate lender of

last resort. This means providing liquid funds to those financial institutions

in need, especially when alternative sources of funding have dried up. That

is, the federal government is the entity the international financial

community and financial markets regard as a major source of funds to

17See 31 U.S.C. §5302.

18FSLIC was dissolved in 1989 by FIRREA. A new fund, the Savings Association Insurance Fund, was

created and FDIC was designated as its administrator.

Page 14 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

provide liquidity in a crisis. Ultimately, the U.S. government bore the costs

of several crises.

The experience of banks and savings and loans in the 1980s provided

ample evidence of the seriousness of the risks involved in concentrations

of certain types of financial exposure—particularly when insufficient

capital is held to protect against risk exposures. The failure of

policymakers and regulators to effectively contain the savings and loan

crisis proved costly to American taxpayers. Through FIRREA, Congress

created a new agency—the Resolution Trust Corporation—to resolve

failed savings and loans, liquidate their assets, and pay off insured

depositors. The collapse of the savings and loan industry resulted in

taxpayers incurring a large expense estimated, as of 1996, to be about

$132 billion.19

Objectives, Scope,

and Methodology

The objective of this study is to describe how federal financial agencies

with responsibilities for financial institutions and markets recognized,

contained, and eventually resolved four financial crises that occurred in

the 1980s.

Scope During the survey phase of our work, we sought to identify all financial

disruptions in the 1970s and 1980s that had the potential, if not quickly

contained, to cause wide-ranging damage to the financial system. We

decided that information on some events that occurred during the

1970s—such as the Penn Central20 commercial paper crisis and the failure

19See Financial Audit: Resolution Trust Corporation’s 1995 and 1994 Financial Statements

(GAO/GGD-96-123, July 2, 1996).

20In June 1970, Penn Central—the largest railroad in the United States and the sixth largest business

enterprise in the country—declared bankruptcy and threatened the commercial paper market. Penn

Central had about $200 million in outstanding commercial paper and after reporting losses, it was no

longer able to sell commercial paper nor roll over maturing issues. Corporations that relied heavily on

commercial paper had to seek alternative sources of funding. Actions by the Federal

Reserve—encouragement of money center banks to lend to customers who were unable to roll over

commercial paper and discount window lending—provided liquidity, enabling the commercial paper

market to continue functioning. This prevented the crisis from developing into a full-scale panic.

Page 15 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

of Franklin National Bank21 and Bank I.D. Herstatt22—as well as official

recollections of those events, were too dated to enable us to reconstruct

an accurate chronology and understanding of the crises. These financial

crises also were too dated for us to determine the interactions among the

various agencies and officials involved in containing and resolving them.

We then considered the following financial disruptions that occurred in

the 1980s:

• silver crisis of March 1980,

• Drysdale Government Securities failure of May 1982,

• Mexico debt crisis of August 1982,

• Continental Illinois Bank crisis of May 1984,

• Ohio savings and loan crisis of March 1985,

• market crash of October 1987, and

• Drexel Burnham Lambert failure of February 1990.23

We selected the Mexico debt crisis, the Continental Illinois Bank crisis, the

Ohio savings and loan crisis, and the 1987 market crash for further review

and in-depth analysis on the basis of the following criteria:

• Decisions and actions had to be quickly made and implemented.

• Diverse federal and nonfederal financial organizations were involved.

• The disruption was significant, occurred quickly, and involved an abrupt

and widespread reversal of expectations of market participants about the

stability of particular institutions or markets that, if left unchecked, could

have caused significant damage not only to affected markets or

institutions but to other parts of the financial system and the economy.

21In October 1974, the Franklin National Bank of New York—the 20th largest bank in the United

States—was declared insolvent by OCC. At the time, it was the largest bank failure in U.S. history.

Nine months before the collapse Franklin had $3.7 billion in deposits. Franklin had borrowed heavily

in the Eurodollar interbank market and had speculated unsuccessfully in foreign exchange and

municipal securities markets. When Franklin was closed, it had borrowed $1,723 million from the

Federal Reserve discount window. This lending by the Federal Reserve avoided instability in domestic

and foreign financial markets. Losses from Franklin’s failure totaled $59 million.

22In June 1974, German banking authorities (Das Bundesaufsichtsamt fur das Kreditwesen) closed

Bankhaus I.D. Herstatt in Cologne and ordered its liquidation. Herstatt was a large bank with

international operations and a reliance on profits from foreign exchange and gold speculation. It had

assets of more than 2 billion German marks. Hundreds of large and small companies and public

authorities feared for their deposits. Several U.S. banks received no foreign exchange settlement

payments. The total loss was $467 million.

23Drexel’s holding company declared bankruptcy in February 1990. In 1989, it had settled felony insider

trading charges, suffered decreased revenues as issuers in the high-yield bond market (upon which

Drexel relied for a substantial portion of its revenues) began to default on payment obligations, and

had severe short-term funding problems when its commercial paper rating was lowered. See pp. 44-46

of Securities Firms: Assessing the Need to Regulate Additional Financial Activities (GAO/GGD-92-70,

Apr. 21, 1992).

Page 16 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

• Federal agencies could rely on their existing statutory and regulatory

authorities and resources to deal with the problem. Congressional action

was not needed before federal agencies could respond to the crisis.

• Senior officials were available to be interviewed.

Taken as a whole, the crises we selected for our review sample reflected

diversity in (1) the nature of the problem, (2) the financial institutions or

markets affected, and (3) the types of players involved. We believe that the

four cases selected cover a wide-ranging set of experiences involving

different markets and participating decisionmakers from many sectors of

government. Throughout, our primary interest was how federal

organizations exercised their existing authority to cope with sudden

financial distress.

Methodology In conducting our study, we first undertook an extensive literature search

of congressional testimony, books, journals, and newspaper articles

pertaining to financial crises. This review enabled us to chronologically

describe the four events and identify the participants involved in

containing and resolving them and the actions the participants took.

We also reviewed the social science research literature in this area, which

deals with responses to natural and technological disasters, for

information relevant to our work on financial disruptions. Emergency

situations have been the subject of social science research for decades.24

Although a comprehensive review of all such research was not feasible,

we reviewed the studies that disaster analysts suggested were the most

significant and relevant to financial crises. Our review of disaster literature

led us to conceptualize financial crisis management in terms of three

primary phases, which we have defined as follows:

• Preparedness is the pre-crisis or pre-impact phase and includes the earliest

sign of possible danger and any activities undertaken to prepare for

managing a potential financial crisis before the crisis occurs.

• Containment is the period when the crisis actually occurs and includes

immediate activities undertaken in response to a financial crisis to

mitigate the financial disruption and to prevent or lessen ill effects that

could result due to financial linkages.

24See Emergency Management: Principles and Practices for Local Government, Thomas Drabek and

Gerald Hoetmer (Editors), International City Management Association (Washington, D.C., 1990);

Emergency Management: Strategies for Maintaining Organizational Integrity, Thomas Drabek,

Springer-Verlag (New York, 1990); Normal Accidents: Living With High Risk Technologies, Charles

Perrow (New York, 1984).

Page 17 GAO/GGD-97-96 Financial Crises
Chapter 1 

Introduction

• Resolution is the period of attempting to mitigate any long-term effects

and includes activities undertaken to restore institutions and markets to

normalcy and to reduce the likelihood that the crisis or similar crises will

recur.

We interviewed more than 70 federal, private sector, and state and local

officials involved in the four financial crises to determine the nature of

their involvement, interactions they had with other participating officials,

and the rationale for their actions. Generally, we asked the officials to

draw on their experience in these events and discuss the important

lessons from that experience—observations they would share with others

who might go through a similar experience in the future. In addition to the

interviews, we reviewed books, journal articles, congressional testimony,

speeches, and newspaper articles. We also reviewed agency records,

including letters, transcripts of meetings, memoranda, notes, special

studies, and other documents relating to each organization’s involvement

in the four crises. Such records were not available for all crises.

We received technical comments on this report from the Commodities

Futures Trading Commission, Federal Deposit Insurance Corporation,

Federal Reserve, Office of the Comptroller of the Currency, Securities and

Exchange Commission, and other officials involved in these crises. We

incorporated the comments where appropriate.

Page 18 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

During the early 1980s, Mexico, a major U.S. trading partner, experienced

a financial collapse precipitated in part by sharp declines in oil prices,

which reduced Mexico’s foreign exchange holdings from the sale of its oil.

The crisis began formally on August 12, 1982, when Mexico’s Secretary of

Finance informed the Federal Reserve Chairman, the Secretary of the

Treasury, and the IMF Managing Director that Mexico would be unable to

meet its August 16 obligation to service $80 billion in mainly

dollar-denominated debt obligations to U.S. and foreign banks. The

Mexico debt crisis illustrated that growing ties between domestic and

global capital markets could trigger a domestic financial crisis.

Summary of

Chronology

By the time that Mexico was unable to meet debt obligations to U.S. and

foreign banks, the Federal Reserve and Treasury had jointly developed a

strategy for U.S. assistance to prevent a financial crisis. The strategy was

to condition the granting to Mexico of substantial extended credit on a

commitment to an IMF economic reform or stabilization program; at the

same time, the United States would provide short-term emergency credit

and currency swaps1

 as necessary. When the crisis came in August 1982,

the United States took the lead in a multinational response and played a

key role in implementing the strategy. Mexican governmental entities,

European and Japanese central banks and finance ministries, IMF, and

commercial banks in the United States and abroad were also involved in

crisis containment efforts. The Federal Reserve played a key role in

organizing the responses of (1) U.S. and foreign commercial banks, which

were asked to accept a moratorium on principal payments, provide $5

billion in new loans, and restructure existing debt; and (2) central banks in

Europe and Japan, which were asked to provide $925 million in liquidity

support. The Federal Reserve lent Mexico a total of $1.05 billion. The

Department of the Treasury took the lead in putting together the more

immediate executive branch responses, which involved a $1 billion ESF

swap, a Department of Energy and Department of Defense Strategic

Petroleum Reserve prepayment of $1 billion for oil that the U.S. purchased

from Mexico, and a Department of Agriculture $1 billion Commodity

Credit Corporation loan guarantee to Mexico to facilitate the import of

grains and fundamental foods. Treasury also provided a $600 million

longer term swap in conjunction with the Federal Reserve and BIS. IMF led

economic reform negotiations with Mexico and led an effort to obtain

$5 billion in new commercial bank loans for Mexico, and provided close to

$4 billion in medium-term credits.

1

Foreign exchange swaps are bilateral agreements to exchange two currencies at one date and to

reverse the transaction at some future date. When a foreign central bank initiates the swap drawing, it

uses the dollars to finance sales of dollars to support its own currency.

Page 19 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

Preparedness:

Interagency

Contingency Planning

Helped Contain Crisis

The Mexican debt crisis began on Thursday, August 12, 1982, when

Mexico’s Secretary of Finance informed the Federal Reserve Chairman,

the Secretary of the Treasury, and the IMF Managing Director that Mexico

would be unable to meet its August 16 obligation to service about

$80 billion in mainly dollar-denominated debt obligations to U.S. and

foreign banks.2

 Mexico owed $25 billion of this debt to U.S. banks.3 The

situation had the potential for upsetting the financial stability of the

industrialized world. Because the private sector was initially unwilling to

lend additional money to Mexico, the United States, IMF, and central banks

of developed countries had to step in and fill the vacuum.

According to various U.S. government officials, the Mexico debt crisis,

which developed visibly over several months, was not a surprise. The

question, starting in March 1982, was not whether Mexico was

approaching crisis but what to do about it. For months before the start of

the crisis, Federal Reserve and Treasury officials had been watching

changes in Mexico’s foreign exchange reserves, borrowing patterns,

balance of trade, and domestic economic and political situations. Crisis

management leadership was an issue, but it was resolved before the crisis

began. Generally, leadership in preparedness was shared by the Federal

Reserve and Treasury, with Treasury focusing on political aspects and the

Federal Reserve on the economic aspects of containment and resolution

of the crisis. Three meetings between financial officials of the Mexican

Ministry of Finance, the Bank of Mexico, the Federal Reserve, and

Treasury concerning the deteriorating situation had already occurred

before the August 12 start of the crisis. U.S. officials said they had a

general understanding of a range of potential problems that Mexico’s

inability to repay its debts would precipitate. Federal Reserve and

Treasury officials said they had discussed and generally decided on their

respective agencies’ responses to Mexico’s expected requests for

assistance, but a single written interagency contingency plan was not

developed. U.S. officials said that, generally, the Federal Reserve,

Treasury, and other organizations were sharing available information and

communications were well coordinated.

2

There were about 25 different kinds of Mexican debt. Debtors included the national oil company, the

development bank, the telephone company, and other government corporations. A quarter of the debt

was accumulated by the Mexican state oil company.

3

At the time Mexico was the largest international borrower from U.S. commercial banks.

Page 20 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

Agencies Shared

Information, Planned

Response, and Resolved

Leadership Issues Before

the Crisis Began

Fearful of a foreign currency crisis, Federal Reserve, Treasury, and the

Department of State (State) officials said they were monitoring Mexico’s

borrowing, balance of trade, foreign exchange trends, and domestic

economic and political situations for months before the start of the crisis.

Senior officials at the Federal Reserve and Treasury said they met to

discuss Mexico’s likely request for assistance and develop a U.S. strategy.

These were more “when/how” than “what if” discussions—that is, when

Mexico asks for help, how shall we respond? The Federal Reserve and

Treasury officials identified the first opportunities to meet with Mexico’s

newly appointed top financial officials at various multinational finance

meetings as well as during visits by these officials to Washington, D.C.

Federal Reserve officials had information about the exposure to Mexican

debt of most U.S. banks. They had determined, on the basis of country

lending data that the bank supervisory agencies—in particular,

OCC—maintained routinely,4 that Mexican debt accounted for 44 percent of

the capital of the 9 largest U.S. banks and 35 percent of the capital of the

15 biggest U.S. regional banks.5

 Officials also knew that if payments

ceased, bank capital positions would rapidly deteriorate and threaten the

banking system. They also understood that Mexico’s debt servicing

problems were likely to spread to other developing countries.

Preparedness planning took place before the crisis began. On January 7,

1982—7 months before the crisis broke—State officials asked for an

interagency meeting on the Mexico debt situation. Reports from the

Treasury attache in the U.S. Embassy in Mexico City expressed concern

about Mexico’s ability to finance its debt and access to U.S. financial

markets. Federal Reserve and Treasury officials said they viewed State’s

requests as inappropriate because they saw the potential crisis as one best

addressed as an economic rather than as a political problem. They said

they were concerned that State might insist that terms of U.S. assistance

be softened for foreign policy or diplomatic reasons. That is, Treasury

officials were concerned that State would urge assistance even if the

country was not taking economic adjustment and reform measures. The

Federal Reserve and Treasury initially resisted State’s call for a meeting.

When the meeting did occur on March 23, more than 2 months after the

State Department’s request, Treasury officials said they asserted

4

This information is maintained by the Interagency Country Exposure Review Committee. OCC

develops and analyzes information on and assesses risk in international lending, including the

evaluation of transfer risk associated with exposures to countries experiencing difficulties servicing

their external debt.

5

Banks are ranked according to size based on the amount of their assets.

Page 21 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

themselves as leaders of the meeting. Once State Department officials

understood that the Federal Reserve and Treasury officials were alert to

Mexico’s debt problem, they stepped back.

The initiative of top Mexican financial leaders played an important role in

U.S. preparedness efforts. Soon after their appointments, Mexico’s

Secretary of Finance and Director General of the Bank of Mexico

requested separate meetings with the Federal Reserve, the Department of

the Treasury, and IMF—the three key organizations whose support Mexico

would need if a financial crisis developed. (See fig. 2.1.)

Figure 2.1: Selected Events in the Mexico Debt Crisis of 1982 (May, June, July)

3 23

31

Bank of America has diffculty syndicating $2.5

billion loan for Mexican governmental entities.

Second visit of Mexican financial officials to 

the Federal Reserve, Treasury, and IMF.

The Federal Reserve agrees to an overnight

currency swap of $700 million under existing

reciprocal currency arrangement.

Federal Reserve Open Market Committee agrees

to allow Bank of Mexico to draw down its full

$700 million currency swap on an extended

basis if certain conditions are met. Bank of

Mexico draws $200 million overnight. Open

Market Committee lets stand its conditional

approval for the extended swap. The Open

Market Committee wants the swap contingent

on Mexico agreeing to an IMF program.

May

First visit of top Mexican finance officials and key

staff to the Federal Reserve, Treasury, and IMF.

Bank of Mexico approaches the Federal

Reserve about an overnight currency swap of

pesos for dollars under existing reciprocal

currency arrangements. The Federal Reserve 

agrees to the swap.

1

11

30

Third visit of Mexican finance officials to the 

Federal Reserve, Treasury, and IMF.

Bank of Mexico swaps pesos for $700 million

overnight with the Federal Reserve under

existing reciprocal currency arrangements.

June July

30

29

Date: Date: Date:

Source: GAO analysis.

Agencies Shared

Information and Views

Before Crisis Broke

Mexican officials met with U.S. officials on three separate occasions

before the crisis emerged in August. Treasury and State officials said they

prepared for these meetings by developing and agreeing on the positions

they would take. Treasury staff briefed the Treasury Secretary on Mexico’s

situation, requests Mexico might make, and proposed U.S. responses. The

Treasury Secretary met with the Federal Reserve Chairman to discuss

requests and responses before meetings with the Mexican officials. As of

early August, Mexico had liquid reserves of less than $200 million, and the

Page 22 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

country was losing dollars at the rate of $100 million a day.6 Mexican

capital was being moved out of the country for a safe haven in the United

States and elsewhere. Mexico appeared unable to generate export

surpluses and maintain confidence in its economy, which were essential

for Mexico to find the hard currency needed to service its loans.

Treasury and the Federal Reserve had $1 billion in currency swap

arrangements with Mexico: $300 million from Treasury’s Exchange

Stabilization Fund and $700 million from the Federal Reserve’s swap line.7

Overnight drawings on the Federal Reserve’s swap arrangement were used

to bolster month-end figures for dollar reserves.8

 Treasury and Federal

Reserve officials both told their Mexican counterparts that before any

substantial credit was granted to Mexico on other than an overnight or

short-term basis, Mexico should have a convincing economic stabilization

program to restore confidence in the peso and the Mexican economy. That

is, Mexico should have an IMF-approved economic adjustment or reform

program.9 IMF requires that borrowing countries commit to reforms that

improve the country’s economy and balance of payments. Federal Reserve

and Treasury officials said they knew, however, that Mexico’s current

president—who would soon be replaced by a successor—was unwilling to

adopt the policy measures that would be required for an IMF program.

According to these officials, the president was in the last year of a 6-year

term and did not want to admit to having made any economic policy

errors.

Before Crisis, Officials

Coordinated to Agree on

Strategy

Federal Reserve and Treasury officials said they agreed on a two-part

strategy for dealing with Mexico: (1) refuse to grant Mexico any

substantial credit unless Mexico committed to seeking an IMF adjustment

program; but (2) continue to support Mexico with advice and overnight

currency swaps until the December 1, 1982, installation of Mexico’s next

6

See Joseph Kraft. The Mexican Rescue. New York: Group of Thirty, 1984.

7

A major feature of foreign currency operations of the Federal Reserve is the swap network, which

consists of reciprocal short-term credit arrangements with 13 foreign monetary authorities and with

the Bank for International Settlements. These arrangements enable the Federal Reserve to borrow the

foreign currencies it needs for intervention operations to support the dollar. They also enable the

partner foreign central banks to borrow the dollars needed to support their currencies. See The

Federal Reserve System: Purposes and Functions, Board of Governors of the Federal Reserve,

Washington, D.C.: 1984.

8

See Paul A. Volcker and Toyoo Gyohten. Changing Fortunes: The World’s Money And The Threat To

American Leadership. New York: Times Books, 1992.

9

IMF seeks to maintain stability in the world economic and financial system. See Paul R. Masson and

Michael Mussa, The Role of IMF: Financing and Its Interactions with Adjustment and Surveillance,

Washington, D.C.: 1995.

Page 23 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

president, who was expected to seek IMF help. Any longer term credits

would have to be repaid from IMF medium-term loans. According to

Federal Reserve officials, at the end of May, Mexican officials asked the

Federal Reserve to swap pesos for dollars overnight so Mexico could meet

its requirements for a certain level of foreign reserves as backing for its

currency. The Federal Reserve agreed to the overnight currency swap.

Agencies Jointly

Developed Contingency

Plans

Over the next several months, U.S. officials said this strategy was

challenged as Mexico’s need for assistance escalated. Mexican officials

asked the United States for an extended swap as a bridge loan to a $2 to

$3 billion jumbo loan they planned to arrange. The bridge loan was later

obtained not through an extended swap, but through a loan from U.S.

commercial banks. U.S. officials said they explored contingency plans to

address the possibility that Mexico’s President would not seek IMF help,

but no such plans were put into writing. The outgoing President of Mexico

had entered office in 1976 while a tough and unpopular IMF program was in

progress. Treasury, Federal Reserve, and State officials said they

discussed a variety of strategies and worked through their sometimes

differing assessments of those plans. Among other ideas, they said they

discussed alternatives to IMF credits to assure repayment of swaps if a

crisis developed, including supplying dollars as prepayment for oil. The

Federal Reserve could not approve an extended swap without an assured

means of repayment. To have this means of repayment, Federal Reserve

staff drafted a letter from the Secretary of the Treasury to the Chairman of

the Federal Reserve in which Treasury agreed to provide backing for the

swaps by assuring repayment of any drawings by Mexico.

At the end of April, Mexico requested a $600 million overnight currency

swap with the Federal Reserve to satisfy international reserve reporting

requirements. At the end of June, the Bank of Mexico requested a swap on

an extended basis, which the Federal Reserve’s Federal Open Market

Committee approved. The Federal Reserve officials said they wanted such

a swap contingent on Mexico agreeing to an IMF stabilization program to

repay the swaps. When the request from the Bank of Mexico was changed

at the last minute to an overnight swap for $200 million, the Federal

Reserve Chairman asked the Federal Open Market Committee to let its

approval stand, enabling him to make the swap available if needed to avert

a liquidity crisis and provided conditions were satisfied. According to

Federal Reserve officials, the Federal Reserve deposited $200 million in

dollars in Mexico’s account at the Federal Reserve Bank of New York, and

the Bank of Mexico gave the Federal Reserve an equivalent quantity of

Page 24 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

pesos at the going exchange rate, with a promise to reexchange them

when the swap expired. U.S. officials agreed that swaps were temporary

remedies and not the solution to the much larger debt repayment problem.

On July 23, Mexican finance officials again visited Treasury, the Federal

Reserve, and IMF in Washington, D.C. Participants in the meetings said that

Mexico’s situation was discussed at length, particularly whether or not

Mexico had the foreign currency reserves needed to get through August.10

U.S. officials said they again stressed that dollars would not be provided

on an extended basis to Mexico without that country’s commitment to an

IMF stabilization or reform program. Mexico’s President reportedly would

not seek IMF help even though borrowing was increasingly difficult. U.S.

officials said they believed that the President of Mexico would not be

interested in an IMF program until Mexico had run out of foreign reserves.

The situation then sharply deteriorated. Mexico officially asked for the full

$700 million Federal Reserve swap at the end of July. Planning efforts

ensured that everything was in place. According to Federal Reserve

officials, the Federal Open Market Committee had given its approval the

prior month, and officials were able to use the instrument that had been

drafted to limit the length of time that Federal Reserve swap funds were in

use. The swap drawing was provided August 4 and was supposed to last

while Mexico began discussions with IMF. The funds were quickly

depleted, setting the stage for the full-blown Mexican debt crisis. (See fig.

2.2.)

10Foreign currency reserves are the stock of official assets denominated in foreign currencies that can

be used to meet external payment obligations. In most cases, reserves are managed by the central

bank and are part of its balance sheet.

Page 25 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

Figure 2.2: Selected Events in the Mexico Debt Crisis of 1982 (August)

4

5

12

Bank of Mexico swaps pesos for $700 million in

an extended swap. Mexican officials agree to

seek an IMF adjustment program if necessary

for repayment. The funds are quickly depleted.

Mexico announces a two tier exchange rate for

the peso. The higher exchange rate is for Mexican 

government payments and key imports.

Mexico's Secretary of Finance telephones the 

Federal Reserve Chairman, the Secretary

of the Treasury, and the IMF Managing

Director to inform them Mexico can not

meet its August 16 debt obligations to 

banks and that he and the Director General of

the Bank of Mexico will come to Washington,

D.C., to discuss the situation.

Mexico announces foreign exchange markets

will not open on August 13.

Mexican finance officials meet with officials of 

the Federal Reserve, Treasury, and IMF. 

Officials from Mexico's Ministry of FInance,

Bank of Mexico, the Federal Reserve, Treasury,

Office of Management and Budget, Energy, and 

State work out provisions of a $1 billion currency

swap, the purchase of Mexican oil, and

agricultural credits. Federal Reserve Chairman 

contacts heads of European, Canadian, and 

Japanese central banks and gets indication of 

support in principle for lending to Mexico. 

Meeting to take place the coming week in Basle,

Switzerland, under the auspices of the Bank for 

International Settlements.

18

13

14

19

August

Mexico's Secretary of Finance contacts heads

of major creditor banks, alerts them to

Mexico's problems, and invites them to a

meeting of Mexico's bankers during the

next week.

Treasury's Exchange Stabilization Fund 

lends $1 billion to the Bank of Mexico

for about a week.

Mexico's Secretary of Finance announces

assistance package. 

Representatives of central banks meet in

Basle, Switzerland, under the sponsorship

of the Bank for International Settlements, 

and agree in principle to a loan of $750

million as a bridge to an IMF program if

their central bank governors agree. 

Spain adds $175 million. The United

States agrees to match the total provided

and provides $925 million.

Mexico's foreign exchange markets reopen.

Mexico's Secretary of Finance meets with 

officials of U.S. banks.

The President of the Federal Reserve Bank of

New York hosts a dinner at the Federal 

Reserve Bank of New York at which he, 

Mexico's Secretary of Finance, the Director 

General of Bank of Mexico, the Chairman 

of the Federal Reserve Board, and the 

Deputy Secretary of the Treasury, together

with key staff, discuss strategy for the 

August 20 bankers meeting.

Mexican officials meet with representatives of

creditor banks at the Federal Reserve Bank

of New York. Representatives of over 100

banks attend. Mexico's Secretary of Finance

discusses Mexico's condition and liquidity

problem, U.S. and other central bank support,

and plans for an IMF program. Mexico's Secretary

of Finance then asks for a 90-day moratorium

on principal payments.

Representatives of 14 banks form a

bank advisory group to start work on

moratorium and other issues. The advisory

group works to identify all creditor banks. The

advisory group asks all identified banks

for a 90 day payment moratorium starting

August 23. 

Mexico repays $1 billion to Exchange

Stabilization Fund and receives $1 billion as

advance payment for oil purchased

for the strategic petroleum reserve. 

The Bank for International Settlements

announces $1.85 billion loan, $925 million

of which comes from the United States.

Funds are to be made available in three

stages depending on progress toward

agreement on an IMF economic adjustment 

program.

21

24

26

15 20

16

17

Date: Date: Date:

15

Source: GAO analysis.

Containment: Swift

and Collaborative

Action Taken to Avoid

Immediate Default

The crisis formally began on Thursday, August 12, 1982, when Mexico’s

Finance Secretary informed the Treasury Secretary and the Federal

Reserve Chairman that Mexico had almost run out of foreign exchange

reserves and would not be able to meet its obligations to foreign banks on

August 16. Money that was supposed to last a month or two drained out of

Mexico’s foreign exchange reserves in a flight of money abroad. Federal

Reserve and Treasury officials said they knew immediately that the crisis

Page 26 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

had come. They said that outright default would have ruined Mexico’s

credit rating and shut off the further lending that was essential to the

operation of its economy. Creditor banks would suffer losses, and the

solvency of some banks could be threatened. U.S. and foreign officials said

that they were concerned because the world’s largest commercial banks

had heavy exposure to Mexico as well as other developing countries. The

potential for worldwide financial system instability could not be

discounted.

The next day, Mexican financial officials flew to the United States to meet

with Treasury, Federal Reserve, and IMF officials to discuss a plan of

action. U.S. officials said they encouraged accelerated negotiations with

IMF for a reform program. According to U.S. officials, Mexican officials

agreed, but they also said the country would need additional help until the

IMF financing could become available.

Agencies Used

Contingency Plans to

Avoid Immediate Default

According to U.S. officials, the most urgent problem facing the

government was to avoid Mexico’s default on August 16, which could

threaten the capital positions of the world’s largest commercial banks. The

Treasury Secretary assigned the Deputy Secretary of the Treasury the task

of organizing the assistance effort. Treasury agreed that Monday morning

it would provide Mexico with a $1 billion swap from its Exchange

Stabilization Fund (ESF) for 1 week.11 However, the swap would have to be

secured, and Mexico had little undedicated cash flow. Various federal

officials said they turned to one of the possibilities they had discussed

during preparedness planning—namely, supplying dollars as prepayment

for a U.S. purchase of oil from Mexico. Mexico’s 1981 contract to supply

oil to the Department of Defense’s Strategic Petroleum Reserve provided a

precedent for this possibility.

U.S. officials told us that arranging a U.S. government oil purchase from

the Mexican government, with the proceeds of the sale to secure the loan,

was difficult and required considerable effort by the Treasury Deputy

Secretary and cooperation from the Departments of Defense and Energy,

the Office of Management and Budget, and other U.S. government

11ESF was originally established to provide the Secretary of the Treasury with funds to conduct

international monetary transactions to stabilize the dollar’s exchange value. The Secretary of the

Treasury may use ESF consistent with U.S. obligations in IMF regarding orderly exchange

arrangements and a stable system of exchange rates. Financing is considered on a case-by-case basis

on the basis of a demonstrated need for liquidity, evidence of an appropriate economic adjustment

program in cooperation with IMF, and an assured source of repayment. For a more detailed discussion

of ESF see pp. 114-117 and 148-152 of Mexico’s Financial Crisis: Origins, Awareness, Assistance, and

Initial Efforts to Recover (GAO-GGD-96-56, February 23, 1996).

Page 27 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

agencies. Negotiations with the Mexican government were challenging, as

both the United States and Mexico were concerned about the domestic

political implications of the price for the oil. The difficulty was essentially

avoided by obscuring the price. The United States would pay Mexico $1

billion from ESF for oil for the Strategic Petroleum Reserve valued at $1.2

billion. The oil would be delivered over the course of 15 months, and

Mexico would pay a $50 million negotiating fee for the advance from the

Treasury ESF.

12 The Commodity Credit Corporation would also provide

Mexico with a $1 billion credit for the purchase of U.S. agricultural

products by October 1. Some U.S. officials thought the price paid for the

oil was too high, but they said that the Secretary of the Treasury overruled

their objections. The agreement enabled Treasury to activate the $1 billion

swap on August 16, 1982. According to U.S. officials, $1 billion dollars was

credited to the Bank of Mexico account at the Federal Reserve Bank of

New York. The Bank of Mexico subsequently used the funds from the

Strategic Petroleum arrangement with the Energy Department to repay

Treasury’s $1 billion ESF swap.

Federal Reserve Chairman

Sought Help From Central

Bankers

As Treasury Department officials worked to avoid an immediate default,

the Federal Reserve Chairman said he focused on providing somewhat

longer term funding for Mexico. The Federal Reserve Chairman

telephoned central bankers in other countries to discuss Mexico’s

financial difficulties. Mexico’s Secretary of Finance made similar calls to

other central bankers and finance ministries. At the Federal Reserve

Chairman’s request, the Bank for International Settlements (BIS) in Basle,

Switzerland, called a meeting of central bankers for August 18 to discuss

Mexico’s situation.13

According to U.S. officials, the central bankers agreed that the central

banks of industrialized countries would loan Mexico $1.5 billion as a credit

bridge to IMF assistance, contingent on assurance of repayment if an IMF

12Treasury advanced payment to the Bank of Mexico for $1 billion. The Department of Defense, which

actually received the oil, then paid Treasury $1 billion.

13BIS is the principal forum for consultation, cooperation, and information exchange among central

bankers. In recent years it has mobilized supplementary resources for IMF and arranged bridge

financing for heavily indebted developing countries. BIS was established in 1930—and is the oldest

functioning international financial organization—to manage Germany’s World War I reparations

payments. After World War II, BIS evolved into a clearinghouse for the main European central banks.

See “The Bank for International Settlements and the Federal Reserve,” Charles Siegman, Federal

Reserve Bulletin October 1994.

Page 28 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

agreement was not reached.14 The United States would advance half and

the rest would be split among central banks in Europe and Canada and the

Bank of Japan. Spain and the United States added an additional

$350 million at the last moment, bringing the total to $1.85 billion. The

funds were made contingent upon Mexico showing it could put up

adequate collateral if IMF negotiations for a long-term economic

stabilization program fell through. The U.S. share of the $1.85 billion was

$925 million and consisted of a new Treasury ESF $600 million swap with

the Bank of Mexico and a new Federal Reserve swap line of $325 million.

According to U.S. officials, these funds were to provide Mexico with

adequate financing until a larger package could be arranged.

Federal Reserve Facilitated

Principal Payment

Moratorium Agreement

U.S. officials said that to provide time for IMF to negotiate a program with

Mexico, Mexico sought an agreement with U.S. commercial banks that

would provide for a 90-day postponement of principal payments on

Mexico’s debt. The heads of about 100 leading commercial banks attended

a meeting on August 20 in New York at the Federal Reserve Bank of New

York to discuss the Mexican debt situation.15 According to Federal

Reserve officials, on August 21, Mexico’s Finance Secretary met with an

advisory group of U.S. commercial bank representatives.16

Emphasizing at the August 20 meeting that any agreements reached were

between Mexico’s Ministry of Finance and the banks, according to meeting

participants, the president of the Federal Reserve Bank of New York

described the funding provided by the U.S. government to Mexico as well

as multilateral negotiations for the $1.5 billion, later raised to $1.85 billion.

The Finance Secretary of Mexico told the bankers that Mexico would seek

an IMF program, and he asked the banks to accept postponement of

Mexico’s principal payments for 90 days. With the support of this bank

advisory group, headed by three Co-Chairmen, the Mexican government

identified all the banks with loans outstanding and requested that they

postpone payments due for the 90 days. No bank specifically objected to

the request for a standstill on payments, and central bank and Mexican

officials interpreted this to mean that commercial banks agreed to the

14The countries participating in this agreement were Belgium, Canada, France, Germany, Italy, Japan,

the Netherlands, Sweden, the United Kingdom, and the United States. Spain and Switzerland

cooperated with the agreement.

15Because the large banks had sought participation of other smaller banks in foreign loans, estimates

of the number of banks that actively participated in loans to Mexico ranged from 500 to over 1,000.

16The advisory group banks were Citicorp, Chase, Chemical, Morgan Guaranty, Bank of America,

Bankers Trust, Manufacturers Hanover, Bank of Tokyo, Lloyds, Societé Générale of Belgium, Bank of

Montreal, Swiss Bank, Deutsche Bank, and Banamex.

Page 29 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

terms proposed by Mexico’s Finance Secretary. The advisory group also

developed information on maturing debts.

Containment Was Slowed

by Unexpected Actions of

Mexican President

On September 1, unexpected actions by the President of Mexico slowed

negotiations related to the IMF austerity program. In his last annual

address, the President nationalized all Mexican banks because, he said,

they had provoked and aided the capital flight. The President also imposed

foreign exchange controls and denounced wage and spending restraints.

These actions caused confusion about the Mexican government’s

willingness to reform its economy.

According to Federal Reserve officials, the announcement resulted in a

surge of requests for repayments of dollar deposits in the foreign offices of

Mexican banks, which brought the international foreign exchange clearing

system to the edge of breakdown. Mexican banks could not honor demand

for dollar deposits, and it was feared that all the foreign currency

assistance provided might be used up in honoring these claims. A bank

advisory group pressured banks with claims to roll over debts. On

September 7, 1982, the Federal Reserve Bank of New York deposited

$70 million from money advanced to Mexico by BIS in the Bank of Mexico’s

account. According to Federal Reserve officials, a standstill was arranged

so that the foreign branches of Mexican banks received reduced requests

to honor demands for repayment.

According to Federal Reserve officials, in September IMF provided

Mexico’s Finance Secretary with a carefully worded memo setting forth

conditions for negotiations. The Finance Secretary informed IMF that the

negotiations could continue. When Mexico requested access to the second

part of the BIS and U.S. swap lines, however, the central banks were

reluctant to provide access because Mexico’s progress toward an IMF

agreement seemed slow. (See fig. 2.3.)

Page 30 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

Figure 2.3: Selected Events in the Mexico Debt Crisis of 1982 (September, November, December)

Mexico nationalizes banks and establishes

foreign currency exchange controls. 

Director General of the Bank of Mexico

resigns.

Federal Reserve Bank of New York deposits

$70 million in Bank of Mexico's account at the

Federal Reserve Bank of New York. These funds

were provided by Mexican authorities to U. S. 

offices of Mexican banks to help ease demand 

on dollar deposits.

1 10

16

23

September December

Mexico's Ministry of Finance sends IMF an official

letter of intent to enter into an economic 

adjustment program.

IMF Managing Director advises representatives

of major banks that Mexico's creditor banks must

agree in writing to provide $5 billion in new loans

before he will recommend that the IMF Executive

Board approve the economic adjustment program

for Mexico.

Mexico's new President takes office.

IMF Managing Director announces that $4.3 billion

in new loans has been pledged and that he will 

recommend approval of the Mexican adjustment

program.

IMF Executive Board approves the agreement

with Mexico. 

November

1

7

Date: Date: Date:

Source: GAO analysis.

Federal Reserve Chairman

Encouraged Solution

The Mexican government agreed to the terms of an IMF program on

October 23. The Federal Reserve Chairman acted quickly to encourage the

containment of the crisis. Two days later, on the 25th, he informed BIS that

the United States was prepared to permit limited drawdowns of its portion

of the funds to Mexico, on the basis of the progress of the Mexico-IMF

agreement.

The Finance Secretary of Mexico announced the agreement’s terms on

November 10. The announcement stated that Mexico would cut its budget

deficit from 16.5 percent of gross national product to 8.5 percent to

encourage private investment, reduce its foreign borrowings in 1983 to

$5 billion from $20 billion in 1981, cut back the growth of the money

supply to deal with inflation, hold inflation to 55 percent in 1983, reduce

subsidies, limit wage increases, and increase exports. Taxes were to be

raised. The details of the agreement were laid out in an attached

memorandum on economic policies.

With this agreement in hand, the Managing Director of IMF informed the

U.S. and foreign banks they would have to provide written commitments

for an additional $5 billion in loans to Mexico by December 15 before the

IMF assistance plan could be implemented; Mexico needed the additional

loans to repay BIS and Federal Reserve loans and to build reserves. Unless

the banks came up with the money, the Managing Director of IMF

reportedly said that he would not recommend that the Executive Directors

of IMF accept the Mexican program.

Page 31 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

Once again, the Federal Reserve Chairman encouraged action on the

resolution. He quickly announced his support for the new loans. He also

indicated that new loans U.S. banks made to Mexico as part of a resolution

package to service that country’s international debt in an orderly manner

should not be subject to supervisory criticism as imprudent. With this

reassurance, the banks agreed to extend more loans to Mexico and began

to negotiate terms and reschedule the $20 billion in loans coming due in

1983 and 1984. The banks also accepted a second 90-day moratorium. The

banks launched lengthy negotiations among themselves about fairly

sharing the new loans to Mexico.

Pace of Containment

Quickened Under New

President of Mexico

Once Mexico’s new President took office on December 1, 1982, the pace of

containment quickened. Steps in the restructuring program—eased

exchange controls and increased fuel prices and interest rates—were

announced within a week by Mexican government officials, and Mexican

finance officials and the bankers agreed to terms on December 8. On

December 22, with a commitment of $4.3 billion in new lending from the

banks, the IMF Managing Director announced that a critical mass of new

lending had enabled the IMF program to move forward. Throughout this

period and in the weeks following, U.S. officials said that the United States

and foreign central banks encouraged regional and smaller banks to give

full consideration to making loans to Mexico sufficient to reach the

previously announced goal of $5 billion. In the end, 526 banks participated

in the lending to Mexico.

By the end of 1983, the containment effort could be called a success.

According to U.S. officials, Mexico had repaid the interest arrears on its

loans as well as emergency loans and currency swaps, established

economic reforms, and restructured its debt through 1984. Mexico had not

defaulted. Large U.S. and foreign banks had not failed, and financial

system collapse had been avoided.

Resolution: Executive

and Legislative

Initiatives

To encourage more critical assessments of the risk of lending to foreign

countries and more prudent U.S. bank international lending, Congress

passed the International Lending Supervision Act of 1983.17 Generally, the

act sought to balance the interest of debtor countries in maintaining

access to private credit markets against the need for maintaining a safe

and sound banking system. The act required OCC, FDIC, FHLBB, and the

17Pub. L. No. 98-181, Title IX, as amended, 12 U.S.C. §§ 3901-3912.

Page 32 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

Federal Reserve to establish uniform systems of supervision and ensure

that, among other things,

• agency assessments of the adequacy of bank capital include country risk,

• banks achieve and maintain special reserves for foreign loans as required

by the agencies,18

• banks provide quarterly data on international banking activities to the

agencies,

• banks publicly disclose information about their exposure in foreign

countries that is material to bank assets and capital, and

• banks amortize fees from loans over the life of loans.

The act significantly increased the oversight responsibilities of the Federal

Reserve and other banking agencies with respect to foreign lending. The

act directed federal banking agencies to consult with supervisory

authorities of other countries to reach understandings aimed at achieving

effective and consistent supervisory policies and practices with respect to

international lending. The act also required federal banking agencies to

establish regulations for accounting for fees on international loans.

The Baker and Brady Plans As the decade of the 1980s proceeded, other less-developed

countries—principally Latin American countries—went through debt

crises. The approach used to contain the Mexican debt crisis in 1982 was

used with these other countries. Two successive U.S. government

initiatives were undertaken to readdress developing country debt. Since

each initiative was launched by the Secretary of the Treasury, the plans

bore the Secretary’s last name. In 1985 the Baker plan tried to revive

economic growth in developing countries by insisting that the heavily

indebted middle income developing countries undertake economic reform

programs designed to promote growth with the support of private banks

and multilateral development banks. But the Baker plan did not succeed in

restoring growth in these countries, and concerns grew about the

monetary burden of the debt. In 1989, the Brady plan recognized that some

18The act provides for the maintenance of special reserves when the appropriate federal regulator

determines that the quality of an institution’s assets has been impaired by an inability of public or

private borrowers in a foreign country to make payments on their external indebtedness for reasons

that include a failure by the country to, for example, move toward implementing sound economic

policies that can restore growth and enhance creditworthiness. Such reserves are not required for

countries that are maintaining debt service and are working with international institutions to develop

and implement sound economic policies. The act was amended in 1989 to provide for additional

agency review of risk exposures, and appropriate additions to general reserves, of institutions with

medium- and long-term loans outstanding to any highly indebted country. A highly indebted country is

any country designated as such in the World Bank’s annual world debt tables. See Foreign Debt

Reserving Act of 1989, Pub. L. No. 101-240, § 402.

Page 33 GAO/GGD-97-96 Financial Crises
Chapter 2 

The Mexico Debt Crisis of 1982

of the troubled debtors might not be able to fully service their debts and

restore growth at the same time. The Brady plan sought permanent

reductions in the debtors’ existing debt-servicing obligations in countries

with commitments to economic reform plans. Mexico reduced its

debt-servicing burden under the Brady plan in 1990 by reducing its stock

of debt, lengthening maturity, and lowering interest payments.

Page 34 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

The Continental Bank crisis began on May 8, 1984, when Continental

Illinois National Bank, then a major money center bank ranked the

sixth-largest U.S. bank in terms of assets, experienced the beginning of a

sudden run on its deposits. Beset by rumors about its difficulties,

Continental faced a liquidity crisis of major proportions. Federal agencies

agreed that Continental’s failure would threaten the immediate health of

many smaller banks whose deposits it held. This crisis illustrated that a

financial crisis could develop as a result of a major financial institution

having a high loan concentration in a few business sectors, such as oil or

real estate.

Summary of

Chronology

On May 8, 1984, the Continental Illinois National Bank (Continental),

which held a large amount of nonperforming loans,1

 experienced the

beginning of a sudden run on its deposits. Initially, the Federal Reserve

encouraged bank lending and provided massive amounts of liquidity

support. Federal banking agencies crafted a multipart strategy to (1) stop

the run and (2) sell or arrange to recapitalize the bank. They announced

that FDIC would place a temporary $2 billion subordinated note in the

bank, that the ultimate resolution of Continental’s problems would not

subject depositors or general creditors to loss, and that the Federal

Reserve would continue to provide liquidity support through the discount

window. Other money center banks participated by taking $500 million of

the subordinated note. This successfully slowed the run. Unable to sell the

bank, FDIC permanently resolved Continental’s problems several months

later with a capital infusion of $1 billion into Continental’s holding

company and the purchase of $5.1 billion of its poor-quality loans.

Treasury resolved a disagreement among the bank agencies about the

treatment of shareholders. In consultation with the Department of Justice,

Treasury settled disagreements regarding the treatment of bondholders.

Preparedness:

Surveillance and

Planning Prepared

Regulators

On May 8, 1984, when the crisis began, Continental was a major money

center bank. In 1981 it was ranked as the sixth-largest U.S. bank in terms

of assets. Continental was also the nation’s leading commercial and

industrial lender and was considered a preeminent money center

wholesale bank.2

 Continental had hundreds of correspondent banks and

1

Nonperforming loans are those not paying principal and interest according to the original terms of the

loan agreement. When the principal and interest payments on a loan are past due by 90 days or more,

the loan is considered in default.

2

Continental had 57 offices in 14 states and 29 foreign countries with $34 billion in assets, about 12,000

employees, and about 21,000 shareholders.

Page 35 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

over $30 billion in deposits, 90 percent of which were uninsured foreign

deposits or large certificates substantially exceeding the $100,000 deposit

insurance limit. Continental was the largest provider of correspondent

banking services in the country. At the time of the crisis, according to U.S.

government documents, Continental held a large amount of

nonperforming energy and real estate loans that resulted from inadequate

management controls. Due to these nonperforming loans, Continental’s

credit rating was downgraded in July of 1982. As a result of the

downgraded credit rating, the federal funds and certificate of deposit

markets began to dry up as the bank lost the confidence of domestic

money markets. Continental turned to foreign money markets for funding.

Throughout 1982, 1983, and the first part of 1984, Continental regularly

required $8 billion in overnight funds. In the first months of 1984 the

Vice-Chairman, President, and Chief Financial Officer resigned from

Continental. As rumors spread about the bank’s ill health, maturities on

Continental notes began to shorten, and the bank had to offer higher rates

of interest to attract lenders. Continental was relying heavily on volatile

European funding sources. In response to rumors about the bank’s

financial difficulties, large uninsured depositors—particularly foreign

banks—were removing funds to avoid losses in case the bank failed.3

 The

bank lost about $9 billion in funding, and the prospect was for the total to

reach the $15 to $20 billion range of lost funding. (See fig. 3.1.)

3

Continental lost about $15 billion in funding in the 10-day period prior to May 17, 1984.

Page 36 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

Figure 3.1: Selected Events in the Continental Bank Crisis (May)

Commodity News Service reports that

Continental might be bought and has received

special attention from regulators.

Depositors begin to withdraw funds from

Continental.

Board of Trade Clearing Corporation leads

trading community move out of Continental.

Depositor withdrawals continue.

Continental borrows $850 million from the

Federal Reserve.

OCC news release states that OCC is not

aware of any significant changes in the 

bank's operations, as reflected in its

published financial statements, that would

serve as the basis for rumors that OCC

solicited aid for Continental from Japanese

banks.

Continental President contacts 200 banks

to deny rumors.

Depositor withdrawals continue.

8

9

10

11

13

12

May

16

17

14

Heads of Federal Reserve, Comptroller of the 15

Currency, and FDIC meet to discuss placing 

$2 billion subordinated debt in Continental.

Continental borrows $3.6 billion from Federal

Reserve Bank of Chicago.

Continental approaches Morgan Guaranty

officials for help in arranging a credit line from

major commercial banks.

Continental President and the President of the 

Federal Reserve bank of Chicago talk with

leaders of 15 of the nation's largest banks. 

Continental sends messages informing

overseas banks of safety net. 

Continental announces that 16 of the nation's

largest banks have extended it $4.5 billion in

credit for 30 days. 

Chairmen of Federal Reserve, Comptroller of the

Currency, and FDIC decide to put $2 billion into

Continental and meet with Treasury Secretary. 

Treasury Secretary agrees to assistance package

and suggests commercial banks participate.

First National proposes merger with Continental.

Chairmen of Federal Reserve, Comptroller of the

Currency and FDIC meet with heads of major 

banks to discuss their participation in the

assistance package.

FDIC chairman announces that "FDIC would

ensure...all deposits at Continental, no matter

how large." 

Regulators announce a temporary assistance

program of a $2 billion subordinated debt note, 

that Continental resolution will protect

depositors and general creditors, and that the

Federal Reserve will support Continental at the

discount window. Continental President

announces Continental availability for merger or

takeover. Continental's line of credit is raised

to $5.5 billion with 28 participating banks.

Source: GAO analysis.

As uncertainty about the bank’s health continued in May 1984, the bank

was unable to meet its funding requirements. Beset by rumors about its

difficulties, Continental faced a liquidity crisis of major proportions.

According to FDIC documents, federal agencies agreed that Continental’s

failure would threaten the immediate health of many smaller banks whose

deposits it held and would have severe consequences for the entire

economy. It would also, they agreed, generate flights to quality throughout

the financial markets—that is, investors and depositors in money center

banks would seek more profitable investments and safer places for their

funds, respectively—and create severe funding problems for other large,

highly leveraged money center banks suspected of weakness because of

poor-quality loans in their portfolios. The FDIC Chairman said that

something had to be done quickly to stabilize the situation. By May 11,

1984, when other funding sources were unavailable, the Federal Reserve

loaned Continental $2.8 billion at the discount window.

Page 37 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

According to an FDIC official, the timing of the run on Continental was the

only aspect of the crisis that surprised regulatory officials. According to

the Comptroller of the Currency, through its routine monitoring and

surveillance of Continental’s financial condition, OCC was aware of

Continental’s problems, which had developed over several years. In the 2

years before the run, OCC had provided nearly constant supervision with

bank examiners located on-site in the bank. After a 1982 bank

examination, OCC sought corrective measures and took enforcement

action.

Regulatory officials said they had not met to jointly develop contingency

plans to address a possible run on the bank. However, OCC, Federal

Reserve, and FDIC officials said they had informal relationships and had

taken steps individually that prepared them to manage the crisis. In

addition, federal officials involved in managing this crisis had previously

worked together. For example, staff of the Federal Reserve, FDIC, OCC, and

Treasury had communicated and coordinated on the resolution of the

Penn Square Bank in 1982.

Agencies Were Aware of

Continental’s Condition

Through Routinely

Collected Information

Continental’s funding difficulties began in July 1982, when the failure of

Penn Square—one of its correspondent banks—revealed that Continental

had more than $1 billion in problem energy loans.4

 Problems in

Continental’s loan portfolio grew in the years following the Penn Square

failure. Continental owned nearly $1 billion in shipping loans of

questionable quality and also had loan exposure to the Mexican and

Argentine debt crises. Continental’s lenders were increasingly concerned

about the bank’s creditworthiness.

Although regulatory agency officials said they were aware of Continental’s

problems, they said that no interagency meetings were held to discuss

Continental’s financial condition or federal responses to a possible run on

the bank. Before the run in May 1984, OCC was monitoring the development

of the bank’s funding problems and reporting to the Federal Reserve Bank

of Chicago and FDIC. In fact, for months before the run, OCC and Federal

Reserve Bank of Chicago officials told us that they had tried to contain

Continental’s problems by urging the bank to improve the quality of its

loan portfolio, retain earnings to rebuild capital, and investigate ways of

writing off bad loans.

4

Penn Square was a small bank in Oklahoma City that made energy exploration loans to many

companies who failed to find oil and gas and faced sharp drops in energy prices. Penn Square sold

these loans to other banks for a fee. Continental purchased $1.1 billion of these loans. Penn Square had

more than 24,000 accounts with $250 million in insured deposits.

Page 38 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

OCC routinely collected considerable documentary information about

Continental’s condition, including the quality of Continental’s loan

portfolio and the stability of its funding.5

 This information, and the

agencies’ attention to it, increased federal agency preparedness for the

crisis that later occurred. Once the run was under way, regulators said

they made a special effort to collect information on correspondent bank

exposures to Continental for a detailed determination of the systemic risk

associated with a Continental failure. However, the Federal Reserve, FDIC,

OCC, and Treasury officials said they understood the general magnitude of

the crisis without having details on correspondent bank exposures.

Federal Reserve and FDIC

Were Strategically

Prepared in Some Ways

The Federal Reserve and FDIC had already taken steps that prepared them

for the crisis. The Federal Reserve Bank of Chicago had developed

documents describing its response to a run on a “major” money center

bank—with the unwritten understanding that the unnamed bank was

Continental. The Federal Reserve Bank of Chicago had planned to arrange

extraordinary levels of collateral to secure discount window lending and,

if needed, quick possession of more collateral.6

 Although FDIC had not

developed a specific response to a run on Continental, the agency had

prepared legal documentation for the placement of subordinated debt in a

large bank. FDIC had originally developed this documentation to respond to

another possible crisis, but it was adaptable for use in responding to the

Continental crisis.

Containment: Joint

Discussions Led to

Containment Strategy

Generally, federal agencies shared the leadership in containing the

Continental crisis as each agency exercised its statutory authority. Agency

officials said they agreed readily on some containment and resolution

strategies and less readily on others. If the federal agencies had met to

make contingency plans before the crisis occurred, as was done in the

case of the Mexican debt crisis, they might have avoided having to resolve

their differing views in a crisis setting.

5

On April 2, 1984, OCC determined that Continental had no significant additional domestic liquidity

available, excluding the Federal Reserve discount window, and that major sources of international

funding were drying up. Even so, OCC did not declare Continental insolvent.

6

The discount window is a line of credit facility maintained by the Federal Reserve for direct loans to a

financial institution. All institutions that hold required reserves with the Federal Reserve are eligible to

borrow at the discount window.

Page 39 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

Officials Agreed on

Intervention and

Containment Strategy

Top officials of OCC, FDIC, and the Federal Reserve had the first of many

joint discussions about the Continental crisis on the morning of May 11,

1984, at Federal Reserve headquarters in Washington, D.C.7

 They

immediately agreed that the government should intervene to prevent the

bank’s failure. They believed Continental’s failure would seriously threaten

the banking system. They also agreed that FDIC would not pay off

depositors by liquidating the bank and meeting its obligations from the

proceeds. Regulators thought that a pay-off would be disruptive to the

financial system and FDIC, could cause a run on other money center banks,

and could disrupt relations between U.S. banks and foreign creditors. At

this time federal banking regulatory agencies generally wanted the

management and shareholders of Continental to be accountable for

mistakes they made, and OCC communicated this to Continental officials.

An interim financial assistance program was to ensure that Continental

would have the capital resources, liquidity, and the time it needed to end

the crisis of confidence and resolve problems in an orderly and permanent

manner. Agency officials also agreed that FDIC should purchase $2 billion

in subordinated debt from Continental, and the Federal Reserve should

provide loans to Continental through its discount window as long as FDIC

was involved in providing capital to Continental.8 The subordinated debt

note was viewed as a short-term funding solution—that is, a mechanism to

stabilize Continental’s funding sources.9

Other elements of the strategy emerged in discussions among Treasury

and the other money center banks. On Monday, May 14, the Secretary of

the Treasury said he suggested, and bank regulators agreed, that other

banks should participate in the FDIC-subordinated note to demonstrate the

banking system’s confidence in Continental. After discussions revealed

that the other banks had concerns about the riskiness of this participation,

the FDIC Chairman suggested that FDIC assure the banks and all depositors

and lenders that the resolution of the bank would not result in any losses

in dealings with Continental. After some discussion, the other regulators

agreed to this, and the banks participated by taking $500 million of the

note.

7

See Irvine H. Sprague. Bailout: An Insider’s Account of Bank Failures and Rescues. New York: Basic

Books, 1986.

8

Federal Reserve discount window borrowing reached a daily high of $7.6 billion in August 1984.

9

The note was conditioned on Continental’s accepting certain restrictions related to hiring,

promotions, and other factors. FDIC could replace senior management; remove members of the Board

of Directors; and, in principle, control the bank.

Page 40 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

The discount window loans to Continental—which quickly exceeded any

previous bank loan from any Federal Reserve Bank—gave Continental the

funding it needed to pay off maturing notes. However, this Federal

Reserve assistance did not mitigate the market’s distrust of Continental’s

financial strength, and normal funding was impossible.

Joint Agency

Announcement of Rescue

Package Slows Run

With the hope of ending the run and restoring confidence in Continental,

FDIC, OCC, and the Federal Reserve jointly announced on May 17th the

placement by FDIC of the $2 billion subordinated debt note. As

subordinated debt, the note would be the last debt repaid in the event of a

failure. Therefore, all current creditors would be repaid before FDIC. This

was by far the largest commercial bank bailout in FDIC history. FDIC

provided $1.5 billion of the subordinated debt, and a group of seven major

U.S. banks provided the balance. In addition, a consortium of 28 banks

provided Continental with a $5.3 billion funded line of credit, which was

later replaced by a $4.5 billion standby line of credit. The agencies also

announced that the resolution of the bank would not impose losses on

anyone. This meant that FDIC would not pay off depositors by liquidating

the bank and meeting its obligations from the proceeds—which could fall

short and would take a considerable period of time. Instead, FDIC would

support a takeover, find a merger partner, or recapitalize the bank; in any

event, all Continental obligations would be honored. The Federal Reserve

would continue to meet the bank’s liquidity requirements.

This announcement did not completely end the run. Withdrawals from

Continental slowed considerably after the announcement, but they

continued. However, the announced intervention bought regulators some

limited time to explore alternatives.

Secretary of the Treasury

Mediates Agencies’

Disagreement Over Rescue

Methods

In keeping with its statutory authority, FDIC officials said it developed the

solution to Continental’s problem in consultation with the other regulatory

agencies. FDIC first allowed the bank to look for a merger partner or a

buyer. When Chemical, Citicorp, and First Chicago banks reviewed

Continental’s loan files, they decided that Continental was in worse shape

than they expected and declined to participate in a merger or purchase.

Regulators said they were concerned that Continental could worsen the

financial condition of an acquiring institution. The regulators said they

believed that any merger or purchase would likely require massive FDIC

assistance. FDIC developed a plan to place capital in the bank and resolve

the difficulties through open bank assistance. The continuing withdrawals

Page 41 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

from the bank limited the amount of time available for the resolution

effort.

Regulatory officials said they resolved several disputes in the development

of the resolution. Concerned that the bank’s shareholders would not

support a package that left them entirely at risk, FDIC proposed that the

resolution leave the shareholders with 15 percent of the bank’s stock free

and clear so that the shareholders would not be at risk to absorb further

losses. FDIC would hold 85 percent of the stock. OCC and the Federal

Reserve said they objected strongly, arguing that the government should

not bail out stockholders of the bank or its holding company, who should

risk a complete loss on their investment. The agencies brought the dispute

to the Secretary of the Treasury, who agreed with OCC and Federal Reserve

officials that stockholders should be at risk. FDIC agreed that the final

package would leave the stockholders at risk of losing their entire

investments.

A similar dispute arose over the treatment of the bank holding company’s

bondholders.10 All agencies agreed that the holding company bondholders

should be at risk—but their bonds had indenture covenants11 preventing

infusions of capital into the bank from outside the holding company by

sales to others of bank securities without the approval of debt holders.

Placing capital directly into the bank without waivers from bondholders,

which would not help the holding company, could provoke a lawsuit.

Placing the capital in the holding company to be downstreamed into the

bank avoided legal complications but left the holding company solvent and

the bondholders whole.

Treasury officials said they believed that the holding company

bondholders should not be bailed out and the assistance should be placed

directly in the bank. As the primary regulator of bank holding companies,

Federal Reserve officials said they argued that the holding company

should be bailed out to avoid major financial and confidence problems in

other bank holding companies. FDIC officials said they argued that

Continental could not afford the legal battles involved with a direct

placement of capital in the bank; they also said that placing subordinated

debt that does not count as capital—and that does not have legal

10Continental’s parent holding company was Continental Illinois Corporation.

11Indenture covenants are formal agreements between bond issuers and bondholders specifying the

terms and conditions of bonds. The indenture covenants may include such considerations as, for

example, amount of issue, interest to be paid, maturity date, repayment schedule, call provisions,

collateral pledged, appointment of a trustee, and other items.

Page 42 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

complications—would not adequately reassure the public that the bank

was properly capitalized. Treasury officials said they continued to insist on

the placement of subordinated debt. The head of FDIC eventually took the

issue to the Secretary of the Treasury, who indicated that FDIC should use

its legal authority to press ahead with its plan to downstream assistance

from the holding company to the bank. FDIC’s version of the assistance

package was supported by a legal opinion from the Department of Justice.

The final rescue package was announced at a joint OCC, FDIC, and Federal

Reserve news conference by the FDIC Chairman on July 26, 1984. The

permanent assistance program was designed to prevent the failure of

Continental and enable the bank to restore its position as a viable

self-financing entity. FDIC placed $1 billion in the holding company in

exchange for holding company stock. This $1 billion was immediately

downstreamed to the bank as equity capital. FDIC also purchased troubled

loans with a face value of $5.1 billion for $3.5 billion. FDIC paid for the

troubled loans by assuming Continental’s debt to the Federal Reserve

Bank of Chicago. Final accounting of cost to FDIC was $1.6 billion.

Key management changes were also announced. FDIC had the right to

convert up to 80 percent of the preferred stock. Stockholders were left

with a 20-percent stake in the bank, but losses on the bad loan portfolio

were charged against that stake and eventually wiped it out. FDIC sold its

remaining interest in Continental in June 1991. Continental continued to

operate, but as a much different institution. (See fig. 3.2.)

Page 43 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

Figure 3.2: Selected Events in the Continental Bank Crisis (July, September)

16

18

19

21

July September

FDIC assumes Treasury will drop objection to

plan and prepares congressional briefing.

Treasury still objects and the briefing is 

cancelled.

Question of FDIC's legal authority referred to

Justice Department. Justice says that if FDIC

has a basis to conclude this approach was

necessary then transaction is legal. 

Treasury Secretary criticizes plan as bad public

policy in memo to Chairmen of FDIC, Federal

Reserve, and Comptroller of the Currency. FDIC

Chairman supports the plan, and the Federal 

Reserve approves protection of holding 

company bondholders. 

At joint news conference with Federal Reserve,

FDIC, and OCC, Continental announces

permanent assistance package. $1 billion is

placed in holding company and downstreamed

to Continental. FDIC purchases troubled loans

with a face value of $5.1 billion for $3.5 billion

and assumes Continental debt to the Federal

Reserve Bank of Chicago.

Borrowings from Federal Reserve, FDIC, and 

safety net banks reach $12.6 billion.

22

23

25

26

Federal Reserve Bank of Chicago tells FDIC it

will file public lien on all Continental assets. 

Federal Reserve Bank of Chicago thinks

Continental does not have enough collateral.

Federal Reserve Chairman persuades Federal

Reserve Bank of Chicago President to wait

on lien.

Final assistance package approved by

Continental stockholders.

Interagency regulator group begins work on 25

agreement with Continental.

FDIC plans to take two-thirds of the holding

company and loan losses are to be charged

against the shareholders' remaining third. 

Treasury disagrees with decision to provide aid

through the holding company and believes the

plan needs Treasury approval. 

Borrowings from the Federal Reserve, FDIC,

and safety net banks are $8.2 billion.

FDIC Chairman proposes taking 85% of stock

and giving stockholders the remaining 15%

without liability. Comptroller of the Currency 

objects strongly. FDIC board meets with 

Treasury Secretary and Federal Reserve

Chairman. Treasury Secretary decides 

shareholders must be liable for loan

losses. Deal returns to old format with an 80/20 

split. Stock options included in package. 

Meeting also includes discussion of legality 

of assistance to holding company. 

Negotiators draw up plan. 

Treasury and Federal Reserve discuss format

of rescue. 

Source: GAO analysis.

Resolution: FDIC

Strengthened

Oversight of

Nationally Chartered

Banks

FDIC officials told us that the Continental failure led to some changes in

procedures at FDIC. For example, before the Continental failure, FDIC

examined only state-chartered banks that were not members of the

Federal Reserve System. After Continental, FDIC conducted examinations

of state-chartered banks that were members of the Federal Reserve

System as well as nationally chartered banks like Continental. Also, FDIC

officials said they began to meet weekly with senior officials of other

federal bank supervisory agencies to exchange information about

emerging bank problems.

Hearings on the failure of Continental were held in September and

October 1984 by the House Committee on Banking, Finance, and Urban

Page 44 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

Affairs. Senate hearings were not held. The failure of Continental raised

questions for the Committee about

• whether regulators had created a two-tier system for large and small

banks, with large banks being considered “too big to fail”;

• whether Congress should have a voice in rescue plans created by bank

regulators;

• whether the decades-old system of deposit insurance needed to be

reformed; and

• whether Congress should further deregulate banks.

Legislative Initiatives to

Limit “Too Big to Fail”

Policy

Although Congress considered several banking bills in 1984 through 1986

that contemplated a wide variety of banking topics, bank reform

legislation did not pass during this period. In 1987, Congress passed the

Competitive Equality Banking Act of 1987 (P.L. 100-86). Among other

things, the act gave FDIC bridge bank authority to facilitate FDIC’s

disposition of failed banks. The bridge bank is to assume the assets and

liabilities and carry on the business of the failed bank for a limited time

until the bank is acquired or merged. Bridge bank authority essentially

buys FDIC time to arrange an orderly merger or acquisition and enables the

agency to delay resolution of holding company issues until other issues are

resolved.

The Federal Deposit Insurance Improvement Act of 1991 (FDICIA)12

established cost constraints for regulators resolving financial difficulties of

banks. Before the passage of FDICIA, FDIC could fully protect all bank

depositors and creditors, regardless of cost, if the bank was deemed

essential to its community. The new act narrowed the circumstances

under which FDIC could act in this way. The least-cost provision of the act

sought to limit the circumstances under which uninsured deposits are fully

protected by preventing FDIC from incurring a loss when it protects them.13

Only when a large bank failure is determined to pose a systemic risk to the

nation’s financial system may FDIC protect all deposits and nondeposit

liabilities in a failing depository institution and sustain a loss. FDICIA also

required that such action be approved in advance by FDIC’s Board of

Directors, the Board of Governors of the Federal Reserve, and the

Secretary of the Treasury in consultation with the president. Absent such

approval, FDIC must resolve the problems of a failing institution using the

12P.L. 102-242.

131992 Thrift Resolutions: RTC Policies and Practices Did Not Fully Comply With Least-Cost Provisions

(GAO/GGD-94-110, June 17, 1994).

Page 45 GAO/GGD-97-96 Financial Crises
Chapter 3 

The Continental Illinois Bank Crisis

resolution method that is least costly to the insurance fund—which can be

a liquidation in which only insured deposits are protected. Other legal

changes would also influence how FDIC would handle a failure like

Continental’s today. Also, the Resolution Trust Corporation Completion

Act of 198814 prohibited the use of federal deposit insurance funds to

benefit shareholders in connection with a resolution.

14P.L. 103-204.

Page 46 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

The Ohio savings and loan crisis began on March 5, 1985, when the most

widespread run on depository institutions since the Great Depression

began. The run was set off by the collapse in March of Home State Savings

Bank, the largest of Ohio’s 71 privately insured savings and loan

institutions. About $4 billion in deposits of a half-million depositors were

threatened at 71 institutions. This crisis showed that a financial crisis

occurring in a financial institution that is not federally insured could

involve the federal government in a financial rescue. This case also

illustrated the linkage that had developed between securities markets and

financial institutions. Factors that helped contain the Ohio savings and

loan crisis included the joint leadership of the Ohio Governor’s Office and

the Federal Reserve, provision of liquidity by the Federal Reserve

Cleveland Bank, innovative action by the state of Ohio and federal

regulators, and collaboration between federal and state regulators.

Summary of

Chronology

The 1985 Ohio savings and loan crisis was the most widespread run on

depository institutions since the Great Depression. The run was set off by

the collapse in March of Home State Savings Bank, the largest of Ohio’s 71

privately insured savings and loan institutions. A concern of the Federal

Reserve was that the run could spread to other states with private

insurance funds and ultimately to federally insured savings and loans.

Because the 71 thrifts were not federally regulated, federal agency officials

said they lacked immediate access to important crisis-related information.

At the Ohio Governor’s request, the Federal Reserve provided liquidity

support to qualified thrifts experiencing heavy withdrawals. Federal

Reserve officials and staff also worked closely with the Ohio Governor,

sometimes engaging in nonroutine activities. Federal Reserve officials

helped the state monitor the run, collect information, respond to questions

from the public, and find a permanent solution to the instability.

Ultimately, the run was contained through a state-declared bank holiday,

temporary limits on withdrawals, and state-mandated conversion of most

of Ohio’s privately insured thrifts to federally insured status. The Federal

Home Loan Bank of Cincinnati provided the thrifts with federal deposit

insurance. By the middle of June 1985, most thrifts had reopened with

federal insurance, and confidence had been restored in nearly all of the

institutions.

Figure 4.1 lists a chronology of events in the Ohio savings and loan crisis.

Page 47 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

Figure 4.1: Selected Events in Ohio

Savings and Loan Crisis of 1985

(March)

3 4 5

ESM Government Securities

is closed by regulators.

Home State asks Federal

Reserve Bank of Cleveland

about borrowing

documents.

Depositors stage run on

Home State.

Federal Reserve Bank of

Cleveland asks Federal

Home Loan Bank of

Cincinnati for information

about Home State and 

Guarantee Fund.

Federal Reserve Bank of

Cleveland staff monitor

activities from positions

at Guarantee Fund thrifts.

Deposit outflow is $6 million.

Governor of Ohio

announces closure of

Home State and appoints

conservator to wind up its

affairs.

Federal Reserve Bank of

Cleveland announces 

Guarantee Fund thrifts

eligible to borrow

at discount window.

Governor of Ohio appoints 

conservator to wind up Home

State affairs.

Guarantee Fund institutions

have $13.4 million outflow.

After meeting with thrift

executives, Governor of

Ohio decides to extend the

bank holiday 2 more days.

Federal Home Loan Bank

Chairman meets with Federal

Reserve Chairman in

Washington, D.C., to discuss

Ohio thrift situation.

Governor of Ohio orders

48-hour extension of bank

holiday.

Federal Home Loan Bank

officials call Ohio thrifts and

ask whether they intend to

seek federal insurance.

Governor of Ohio meets

separately with Federal

Reserve Chairman and 

Federal Home Loan Bank

Board Chairman in 

Washington, D.C.

Federal deposit insurance

exams are to begin

at Guarantee Fund 

institutions.

12

18 19

11

17

10

24 25 26

Sunday Monday Tuesday

Federal deposit insurance

examinations continue.

Deposit outflows are $7.7 

million.

Eighteen institutions are now 

open on a full-service basis.

Deposit outflows are $3.9

million.

Page 48 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

Home State announces

Saturday closure.

State of Ohio gives Federal

Reserve Bank of Cleveland

data on Guarantee Fund 

thrifts.

Home State signs note to

borrow at the discount 

window.

Federal Reserve Bank of

Cleveland starts monitoring

and analyzing data on 

Guarantee Fund thrifts.

Home State conservator is

named.

Ohio Superintendent of

Savings and Loan has 

meeting to discuss Home 

State options.

Governor of Ohio declares

3-day bank holiday.

Federal Reserve Bank of

Cleveland President 

indicates liquidity help will be

available when thrifts reopen.

Governor of Ohio and

Federal Reserve Bank of

Cleveland meet with Ohio

financial institutions to

ask their help.

State of Ohio asks

Federal Reserve Bank of

Cleveland to discuss sale of

Home State and other thrifts

with out-of-state financial

institutions.

Ohio Superintendent of

Banks asks federal bank

regulatory agencies to help 

examine Guarantee Fund

thrifts.

A task force is set up by

State of Ohio to coordinate

Superintendent of

Savings and Loans, Federal

Reserve Bank of Cleveland,

and Federal Home Loan

Bank actions.

Federal deposit insurance

examinations continue.

Guarantee Fund thrifts

reopen for limited service.

Guarantee Fund thrifts have 

$5.4 million in runs.

ESM Government Securities

audit report withdrawn.

1 2

8 9

15 16

22 23

29 30

Wednesday

6 7

Federal Reserve Bank of

Cleveland ships cash to 

Home State.

Federal Reserve Bank of

Cleveland and Federal

Home Loan Bank do not

have data on Home

State.

Federal Reserve Bank of

Cleveland sends examiners

to Home State to review

collateral.

Governor of Ohio calls

Federal Reserve Bank of

Cleveland President to

discuss Home State and ask

for assistance.

Ohio Superintendent of 

Savings and Loans, Guarantee

Fund, and Home State meet to

discuss discount window

borrowing.

Ohio legislature lends

$50 million to new state

deposit insurance fund.

Guarantee Fund runs total

$23 million.

Federal Home Loan Bank

takes preliminary look at

Guarantee Fund thrifts.

Federal Home Loan Bank

Chairman tells Ohio

delegation that insurance

applications will be handled

expeditiously.

Guarantee Fund runs total

$64 million.

Thrift executives tell

Governor of Ohio they may

not make it through next

day.

State of Ohio requires all

Guarantee Fund thrifts to get

federal deposit insurance.

Guarantee Fund thrifts are 

opened with partial 

withdrawals allowed.

Federal Reserve Chairman

reiterates Ohio thrift

eligibility for liquidity

assistance.

One Guarantee Fund thrift

gets federal deposit

insurance.

Deposit outflows of $2.9

million.

20 21

13 14

27 28

Thursday Friday Saturday

Deposit outflows of $4.4

million.

Twenty-six thrifts are now 

open for full service.

Deposit outflows of $1.3

million.

Guarantee Fund officials

discuss ESM and Home State

situation with Ohio 

Superintendent of the

Division of Savings and Loan.

Source: GAO analysis.

Page 49 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

Preparedness: Limited

Information and

Authority Made

Planning Difficult

In 1985, savings and loan institutions in Ohio experienced the most

widespread run on depository institutions since the Great Depression.

About $4.3 billion in deposits of a half-million depositors were threatened

at 71 institutions. The run, which began on March 5, resulted from

publicized losses of $150 million from Home State Savings Bank (Home

State), Ohio’s largest privately insured savings and loan institution.1

 The

run continued despite efforts by Ohio and Ohio Deposit Guarantee Fund

officials to reassure the public. State officials said that depositor funds

were safe, and officials of the private Guarantee Fund said that depositors

would not lose their money. The Ohio Deposit Guarantee Fund was a

private, state-chartered insurance system that guaranteed 100 percent of

all deposits. After questions were raised on a radio talk show about the

ability of the Guarantee Fund to meet the needs of Home State depositors,

withdrawals began at other thrift institutions.

Home State’s losses were due to the failure on March 4, 1985, of a largely

unregulated government securities dealer, ESM Government Securities,

following a massive fraud involving false audit reports. ESM was missing

about $300 million in customer funds. Home State was heavily exposed to

this failed securities dealer through repurchase agreement transactions.2

Lax supervision had allowed Home State to borrow almost 50 percent of

its funds through ESM. As the result of ESM’s failure, Home State and

American Savings and Loan Association in Florida, which were

part-owned by the same person, sustained substantial losses. Home State

estimated losses at $150 million or more.

Home State’s deposits, like those of the other state-chartered and privately

insured Ohio thrifts, were insured by the Ohio Deposit Guarantee Fund.

Immediately before the run on Home State, the Guarantee Fund had total

assets of $130 million to guarantee about $4.3 billion in deposits for about

500,000 depositors. According to Federal Reserve officials, the thrifts had

chosen private deposit insurance because such insurance was less

expensive and burdensome compared to federal deposit insurance. The

Guarantee Fund had no legal power to ensure compliance by its members

and had no cease and desist power. According to a Guarantee Fund

official, the privately insured Ohio thrifts were regulated by the Ohio

Department of Commerce’s Division of Savings and Loan Associations.

1

On March 6, 1985, the Cincinnati Enquirer reported that Home State might suffer large losses in

connection with the failure of ESM.

2

Repurchase agreements are contracts to sell and subsequently repurchase securities at a specified

date and price.

Page 50 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

Federal Agencies Had

Limited Information About

Home State

When the run on privately insured thrifts began, federal agencies had little

information about the Guarantee Fund or thrifts it insured. The Federal

Reserve Bank of Cleveland had been concerned for some time about the

condition of the fund and its insured thrifts. However, the fund had not

honored the Reserve Bank’s 1982 requests for information.3 FHLBB, which

had failed in its attempts to bring the privately insured institutions under

Federal Savings and Loan Insurance Corporation (FSLIC) coverage, also

lacked information about the condition of the thrifts.4

 The Guarantee Fund

had collected information on the financial condition of the thrifts it

insured, but it did not share this information with the Federal Reserve.

Although Ohio state banking regulators and officials of the guarantee fund

were aware of the exposure of Home State to ESM Government Securities,

they said they had not initiated any interagency meetings with federal

officials to prepare for a possible crisis resulting from the failure of Home

State. Ohio state regulators had initiated interagency meetings, but those

meetings had not involved federal officials. About 5 months before the

run—in October 1984—the Ohio Superintendent of Savings and Loans met

with officials of ESM Government Securities, Home State, and the

Guarantee Fund to caution them on Home State’s exposure to ESM.

However, according to a state official, state banking officials were

reluctant to issue cease and desist orders because state judges would not

support them. In addition, the Guarantee Fund had no authority to issue or

enforce a cease and desist order.

Containment: Ohio

Governor and Federal

Reserve Led Crisis

Containment Efforts

A lack of information about the scope of the crisis and the financial

condition of the 71 Ohio thrifts complicated and slowed federal and state

responses to the crisis, which took about 3 months to resolve. State and

federal officials said the State of Ohio and the Federal Reserve intervened

after it was clear that Home State and many of the other Ohio thrifts were

in poor financial shape and unable to stop the runs on their deposits, and

the private Guarantee Fund was insufficient to cover depositor

withdrawals.

3

The Federal Reserve Bank of Cleveland was aware of financial problems at at least one privately

insured thrift as a result of its discount window transactions.

4

FSLIC was established by Congress in 1934 to insure deposits in savings and loan institutions and

savings banks. The Financial Institutions Reform, Recovery, and Enforcement (FIRREA) Act of 1989

transferred the assets and liabilities of the Corporation to a new deposit insurance fund called the

Savings Association Insurance Fund. This fund is operated by the Federal Deposit Insurance

Corporation.

Page 51 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

Among other things, the containment and resolution efforts involved

discount window borrowing to satisfy deposit withdrawals, intensive

information gathering to monitor the run, carefully managed

communications with the public, the declaration of a bank holiday for the

thrifts, emergency state legislation, and an intensive effort to bring

Guarantee Fund-insured thrifts under federal deposit insurance.

According to Federal Reserve and Federal Home Loan Bank officials,

leadership during the Ohio savings and loan crisis came primarily from the

Governor of Ohio and officials of the Federal Reserve. The legal authority

necessary to contain and resolve the crisis rested with the Governor of

Ohio. Federal Reserve officials—including the president and staff of the

Federal Reserve Bank of Cleveland and the Federal Reserve Board

Chairman—facilitated decisions and actions of the Ohio Governor.

According to the Governor of Ohio, the Federal Reserve also provided

liquidity support to the privately insured thrifts, supplied bank examiners

to monitor the run and conduct federal deposit insurance examinations,

and assisted in other ways.

Federal Agencies Did Not

Agree on Necessity of

Involvement

Federal financial officials said they disagreed about the necessity to

become involved in the Ohio savings and loan situation. The top FHLBB

official told us that he was responsible for regulation and oversight of

federally chartered thrifts and the operation of FSLIC and was not inclined

to involve FHLBB in crisis management efforts, since the thrifts had elected

private rather than federal deposit insurance. A Federal Reserve official

told us that the Federal Reserve Board Chairman was instrumental in

encouraging Federal Home Loan Bank officials to provide federal deposit

insurance for qualified Ohio thrifts. According to Federal Reserve and

Ohio officials, FDIC officials were also reluctant to be involved; they

considered the crisis a state problem.

Federal Reserve Opened

Discount Window as Run

Continued

On March 4—the same day that ESM failed—the Federal Reserve Bank of

Cleveland received a request from Home State for information about

discount window borrowing. After reviewing Home State’s application, the

Federal Reserve Bank of Cleveland judged Home State’s collateral

acceptable and began discount window lending.5

 During the week of

March 5 through 9, the Federal Reserve Bank of Cleveland followed

routine procedures to make cash shipments to various Home State offices.

5

The Depository Institutions Deregulation and Monetary Control Act of 1980 (P.L. No. 96-221) gave

nonmember depository institutions, including the state-chartered thrifts in Ohio, eligibility for discount

window borrowing.

Page 52 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

Federal Reserve officials told us they were increasingly concerned that

Home State’s problems could spread to other privately insured Ohio

savings and loans.

By the end of the first week of the run, Home State depositors had

withdrawn an estimated $155 million, and the Guarantee Fund had

advanced $45 million to satisfy deposit demands, according to a Guarantee

Fund official. On March 10, 1985, the Federal Reserve emphasized in a

public statement that privately insured, state-chartered depository

institutions could be eligible for discount window assistance.

Federal Reserve Believed

Risk of Contagion Made

Containment Efforts

Necessary

During the week of March 4 through 9, the Federal Reserve Bank of

Cleveland officials said they worked to determine Home State’s financial

condition and the likelihood that the run would threaten other institutions

in Ohio and other parts of the country.6

 They were also concerned about

the payment system, since Guarantee Fund thrifts had correspondent

clearing relationships with commercial banks. In addition, the Federal

Reserve Bank of Cleveland helped educate some members of the Ohio

Governor’s staff about banking issues, including possible approaches to

solving the Home State problem. On March 6, a senior Federal Reserve

examiner who had reviewed Home State’s books told the president of the

Federal Reserve Bank of Cleveland that the financial condition of Home

State was as bad as any he had seen.

Federal Reserve Bank of Cleveland officials said they conferred with other

Federal Reserve officials in Washington, D.C., and New York about

possible effects of the run on other thrifts and banks. Federal Reserve

officials decided that the Federal Reserve was compelled to act to contain

the crisis because of the possibility of contagion and possible effects on

the dollar in international foreign exchange markets. The decision was

difficult because of the lack of reliable information on the financial

condition of the privately insured institutions.

Federal Reserve Led

Efforts to Obtain Reliable

Information

Federal Reserve officials said the lack of information on the financial

condition of Guarantee Fund thrifts delayed decisive action by the state of

Ohio and the Federal Reserve and prompted debates about the existence

of risk to the financial system. When Home State’s problems were first

disclosed, little information was available to state and federal agencies.

6

Georgia, Maryland, North Carolina, Pennsylvania, Rhode Island, and Utah also had privately insured

savings and loans.

Page 53 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

The Federal Home Loan Bank of Cincinnati had quarterly and annual

reports of the Guarantee Fund insured thrifts, but these were considered

of little value because they had not been verified by on-site federal

examinations and did not provide information about financial linkages,

such as creditor relationships.

With assistance from Ohio thrift regulators, the Federal Home Loan Bank

of Cincinnati, the Office of the Comptroller of the Currency, and FDIC, the

Federal Reserve said it initiated a large effort to quickly determine the

financial condition of the privately insured Ohio thrifts and how many

would qualify for liquidity assistance through the discount window.7

 On

March 6, 1985, several senior members of the Federal Reserve Bank of

Cleveland’s Division of Bank Supervision and Regulation reviewed records

at Home State. On March 8, 1985, the Federal Reserve received the

available examination reports from the state on thrifts with deposits

insured by the Guarantee Fund. Next, about 200 examiners—most of them

Federal Reserve examiners—were deployed throughout the state on

March 11 to collect operational and financial information on those thrifts.

The Federal Reserve Bank of Cleveland and the Federal Home Loan Bank

of Cincinnati began assessing the condition of Guarantee Fund thrifts. On

this basis, the Federal Reserve Bank of Cleveland decided which thrifts

could survive with liquidity assistance from the discount window until a

permanent solution could be devised.

Ohio Governor Developed

Basic Strategy

The then-Governor of Ohio told us that on March 6, 1985, he received a

telephone call from the owner of Home State, who told him that the failure

of ESM Government Securities had caused his thrift problems. The

Governor asked his chief of staff to define the problems, ascertain the

causes of the problems, and determine whether other thrifts were

threatened. The Governor received assurances from his staff that there

were no problems. Federal Reserve officials initially had difficulty

convincing the Governor of Ohio that the situation could prove serious.

The Governor also discussed the Home State situation with state

legislative leaders. He and they agreed that Ohio had to act to protect

depositors and thrifts; they also agreed, however, that the state would not

put money into Home State, although it should do something to protect

other institutions. One of the Governor’s objectives was to quickly find a

buyer for Home State.

7

The discount window loans would be made by the Federal Reserve Bank of Cleveland and secured by

government and agency securities, commercial loans, and residential mortgages.

Page 54 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

State and Federal Officials

Discuss Objectives and

Strategies

The weekend of March 9 and 10, the Governor met with advisors to

discuss options; he also formally requested help from the president of the

Federal Reserve Bank of Cleveland. Federal Reserve officials and the

Governor’s staff discussed the possibility of bringing the privately insured

thrifts under federal deposit insurance. The president of the Federal

Reserve Bank of Cleveland told us that on March 10, 1985, the Federal

Reserve invited several large Ohio bank holding companies to discuss

purchasing Home State. Similar meetings with out-of-state institutions

concerning Home State and other privately insured thrifts that would not

qualify for federal insurance took place on March 16 and 17. The potential

buyers, which were unable to determine the financial condition of Home

State, wanted the state to provide indemnification or compensation for

losses. The Governor said he believed this would be unacceptable to the

legislature and voters.

Federal Reserve and Ohio state officials said they worked closely together,

despite the differences in their primary goals. Federal Reserve officials

were most concerned about stopping the run and preventing it from

spreading to other states. State officials were most concerned about

limiting the financial exposure of the state of Ohio and minimizing losses

to individual depositors. Officials of the Federal Reserve Bank of

Cleveland and the Ohio Governor’s Office had not worked together before,

and neither group fully understood at first the other’s responsibilities,

concerns, and resources, according to officials we interviewed. Officials

said that educational efforts required considerable time.

During the weekend of March 9 and 10, Federal Reserve officials said they

discussed the objectives of the Federal Reserve’s involvement; possible

future events; and operational and logistical actions, including ways to

improve operations for monitoring the run. Federal Reserve officials

focused on promoting cooperative efforts among the various parties

involved in managing the crisis.

To Enhance Coordination

and Communication,

Federal Reserve Engaged

in Nonroutine Activities

Federal Reserve officials anticipated problems communicating and

coordinating with their examiners in the field who were monitoring the

run. The Federal Reserve Bank of Cleveland said it set up a situation room

to facilitate communication and coordination during crisis containment

efforts. The room, which was near the offices of senior officials, was

equipped with 20 telephones, maps, televisions, and radios to monitor the

crisis, including media reports. Examiners were briefed about events,

provided with the latest financial information on thrifts insured by the

Page 55 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

Guarantee Fund and packages of documents necessary for discount

window borrowing for the thrifts, and equipped with cellular telephones or

pagers.

Federal Reserve officials said, and Federal Reserve documents

demonstrate, that they engaged in other nonroutine activities to facilitate

crisis containment efforts. On March 11, 1985, Federal Reserve examiners

were positioned throughout Ohio near Guarantee Fund thrifts to

unobtrusively survey levels of depositor traffic in thrift lobbies and

parking lots. Examiners were to report activity back to the situation room.

The examiners were instructed to avoid doing anything that would alarm

thrift employees or their customers. Examiners were also to deliver

documents for borrowing at the discount window and establish secure

warehouses for collateral. Situation room personnel began to contact the

thrifts to advise them of the availability of the discount window, inquire

about withdrawals, and offer to send an examiner to deliver borrowing

documents and secure collateral.

Federal Reserve

Communicated Carefully

With the Public and Media

Communications with the public were carefully managed by the Federal

Reserve Bank of Cleveland. Officials of the Ohio Superintendent of

Savings and Loans, the conservator of Home State, and the Guarantee

Fund were not answering questions from the public. According to Federal

Reserve documentation, the Public Information Department at the Federal

Reserve Bank of Cleveland took calls from depositors, bank officers and

directors, municipal officials, congressional offices, and the print and

broadcast media. Questions concerned when deposits would be available,

deposit insurance, why thrifts had been closed, and how depositors were

supposed to pay their bills. The most difficult task was explaining that the

thrift crisis was the responsibility of the state of Ohio and not the federal

government and that the Federal Reserve was acting as a facilitator.

To ensure consistency and minimize confusion in communications with

the media, two officials were assigned the task of communicating with

media representatives. The Federal Reserve publicly restated its policy

that state-chartered institutions were eligible for liquidity assistance

through the discount window under normal terms and conditions.

As Runs Spread, Ohio

Governor Closed Home

State and Legislature Acted

The runs on deposits intensified, spreading to other institutions insured by

the Guarantee Fund, despite continued assurances from officials of the

State of Ohio and the Guarantee Fund that depositor money was safe.

Page 56 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

About $23.4 million in withdrawals occurred on March 13 and $63.9 million

on March 14. According to Federal Reserve documentation, six Guarantee

Fund-insured thrifts were particularly hard-hit. At the drive-in windows of

some Cincinnati institutions, examiners observed some lines as long as

100 cars.

The Governor of Ohio and the state legislature took several actions to

reduce the widening depositor withdrawals. The Governor told us that he

announced that Home State would not reopen for business; he also

appointed a conservator to wind up the thrift’s affairs. At the time of its

failure, Home State had $1.4 billion in assets and 92,000 accounts at 33

offices. Home State’s problems would clearly exhaust the $130 million

Guarantee Fund.

On March 13, 1985, the Ohio legislature passed a bill that appropriated

$50 million for a new fund to back the remaining Guarantee Fund

thrifts—excluding Home State—and provided for thrift contributions of

$40 million. On March 14, the Chairman of the Federal Home Loan Bank

Board met with members of Ohio’s congressional delegation in

Washington, D.C. The Chairman of the Federal Home Loan Bank told us

that the subject of the meeting was expedited approval of federal deposit

insurance for the thrifts insured by the Guarantee Fund. Also on March 13,

1985, Federal Home Loan Bank officials began examining state reports on

thrifts to estimate the number eligible for federal deposit insurance.

Governor Declared Bank

Holiday and Established

Public Communications

Center

The then-Governor of Ohio told us that on March 14, 1985, officials of

some of the privately insured thrifts told him that they were unable to stay

open through the end of the next day and lacked adequate collateral for

discount window borrowing to meet depositor demands. The Governor

considered several options: doing nothing, imposing limits on withdrawals,

or closing the thrifts. He decided to close the privately insured thrifts for

72 hours to stop the runs and buy time to devise a permanent solution to

the problem.

The then-Governor of Ohio said that on March 15, 1985, he and the

president of the Federal Reserve Bank of Cleveland held a news

conference announcing a Guarantee Fund thrift holiday for the remaining

70 thrifts.8

 The president of the Federal Reserve Bank of Cleveland also

announced that liquidity help would be available when thrifts reopened.

That same day, the state of Ohio opened a telephone bank staffed by 300

8

Executive Order 85-7.

Page 57 GAO/GGD-97-96 Financial Crises
Chapter 4 

The Ohio Savings and Loan Crisis

people to handle inquiries from the public concerning the state’s actions

and the safety of deposits. The day before the closed thrifts were due to

reopen, on March 17, the Governor met with over 100 thrift executives,

who told him they were concerned about additional runs on deposits.

After the discussion, the Governor decided to extend the bank holiday by 2

days.9

Governor and Federal

Officials Pushed for

Federal Insurance

The Governor’s strategy was to restore depositor confidence by

(1) completing emergency legislation requiring federal deposit insurance

for the Guarantee Fund-insured thrifts, (2) pursuing expedited approval of

federal deposit insurance from the federal government for those thrifts by

March 19, and (3) reopening those thrifts by March 19. According to

Federal Reserve documents, on March 19 and 20 Federal Reserve

examiners examined closed thrifts to determine which would be eligible

for federal deposit insurance. Some thrifts were well managed, in sound

financial condition, and would qualify for federal insurance; others were

not likely to qualify. On March 18 and 19, the Federal Home Loan Bank of

Cincinnati telephoned the privately insured thrifts to determine their plans

to seek federal deposit insurance. Over 200 examiners were sent to

expedite the application process for thrifts that indicated they would apply

for federal deposit insurance.

State Legislature Limited

Withdrawals, Required

Federal Deposit Insurance

The then-Governor of Ohio told us that on March 20, the Ohio state

legislature enacted a law that provided for the reopening of the closed

thrifts—on a limited basis in some cases and on a full-service basis in

others. The law limited thrifts to no more than $750 in withdrawals per

month per customer and required thrifts to have federal deposit insurance

before opening on a full-service basis. On March 29, 1985, 26 of the former

71 Guarantee Fund institutions had reopened with a full range of banking

activities—most with federal insurance. By the 24th of April, 51 of the 71

thrifts had opened, 31 with federal deposit insurance and 19 without, as

approved by the Ohio Superintendent of Savings and Loans. As of June 14,

1985, all but 8 of the original 71 privately insured thrifts had opened on a

full-service basis.

Home State, acquired by Hunter Savings and Loan of Cincinnati, reopened

on June 14, 1985. The state of Ohio had contributed a total of $129 million,

in addition to the resources provided by the Guarantee Fund, to reopen

Home State. The state of Ohio received $134 million from lawsuits.

9

Executive order 85-8.

Page 58 GAO/GGD-97-96 Financial Crises
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The Ohio Savings and Loan Crisis

Resolution:

Legislation Enacted to

Address Government

Securities Fraud and

Improve Disclosure

Following the containment of the Ohio savings and loan crisis, two federal

laws were enacted to address problems that surfaced during the

crisis—fraudulent sales activities of government securities and disclosure

to depositors about their depository institution’s insurance coverage. The

Government Securities Act of 1986 (P.L. 99-571) created tighter regulation

of government securities brokers and dealers like ESM Government

Securities. The act focused on secondary brokers and dealers that sell

government securities by requiring the dealers to register with SEC. It also

required new regulations designed to prevent fraudulent and manipulative

practices and protect the integrity, liquidity, and efficiency of the market

for government securities. Previously, such government securities brokers

and dealers were not regulated. The act required government securities

brokers and dealers to file independently audited balance sheets and

income statements at least once a year. Dealers were to meet regulatory

standards showing they had adequate cash reserves and properly managed

customer accounts and securities. Newly regulated members were

required to join a stock exchange, which made them subject to exchange

regulation.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (P.L.

102-242) required all state-chartered banks, thrifts, and credit unions

without federal deposit insurance to conspicuously disclose that fact to

existing and prospective customers. These institutions were also required

to disclose that depositors are not guaranteed return of their money if the

institution fails. The provision also applied to any other institution, as

determined by the Federal Trade Commission, that might be mistaken for

a bank.

Page 59 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

The stock market crisis began on October 19, 1987, when a large and rapid

sell-off of equity securities led to mechanical and liquidity problems in

trading and financial systems at stock, options, and futures exchanges and

associated clearing organizations. Credit relationships between financial

firms and banks were also strained. The market break was extraordinary

in terms of the speed and extent of falling prices and skyrocketing trading

volume. This crisis showed that the size and potential impact of increased

linkages between the equities markets and futures markets could change

the character of a financial crisis. Factors that contributed to containing

the crisis included the complementary leadership of the financial

exchanges, the Treasury Department, and the Federal Reserve; the early

offer of liquidity by the Federal Reserve to keep the markets functioning;

swift and innovative action by federal financial regulators; and the

collaboration of the private and public sectors.

Summary of

Chronology

On October 19th, 1987, an accelerated and massive sell-off of equity

securities and futures and options contracts led to automation and

liquidity problems in U.S. financial markets and institutions. Difficulties

also occurred in the clearance and settlement system and in bank

extensions of credit to securities firms. European and Pacific rim financial

centers experienced similar declines. Federal officials were most

concerned that the U.S. system for allocating credit would be halted. To

keep markets open and functioning as they should, federal officials and

agencies took various actions in accordance with their individual

authorities and responsibilities. For example, the White House and

Treasury collaborated in making public announcements to foster

confidence in the markets. Treasury discussed with finance ministries in

London and Tokyo and other financial centers the importance of providing

liquidity support to their markets. The Federal Reserve also discussed with

other central banks the importance of providing liquidity support. The

Federal Reserve provided prompt and sizable liquidity through open

market operations. Around noon on October 20th, the market was

plummeting and uncertainty existed about whether NYSE could remain

open. However, buying activity in one stock index futures contract around

noon signalled the turnaround of the markets. By the end of the week,

markets were calmer, but some officials involved in trying to manage the

crisis believed that luck played a major role in the recovery.

Page 60 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

Preparedness:

Routine Market

Monitoring and

Existing Networks

Helped Prepare

Regulators

On October 19 and 20, 1987, a large and rapid sell-off of equity securities

led to automation and liquidity problems in trading and financial systems

at stock, options, and futures exchanges and associated clearing

organizations. Credit relationships between financial firms and banks were

also strained. The crash was extraordinary in terms of the speed and

extent of falling prices and skyrocketing trading volume. From the close of

trading Tuesday, October 13, to the close of trading Monday, October 19,

the Dow Jones Industrial Average (DJIA) declined by almost one-third,

representing about a $1 trillion loss in value of all outstanding U.S. stocks.1

 On October 19, the DJIA plunged 508 points (23 percent).2 NYSE volume was

604 million shares, more than twice the average daily volume for the year.

The individual markets experienced a variety of difficulties on the 19th

and 20th of October. NYSE specialists faced large order imbalances

throughout both days. NYSE’s automated order entry system was

overloaded because of insufficient capacity. Due to reduced

over-the-counter market-maker3

 participation, investors had difficulty

getting timely price information, and NASD transaction reports were

delayed. A proliferation of option transactions within the same underlying

securities at CBOE in response to rapid price changes slowed trading. CBOE

stopped offering some options on individual stocks that were not trading

and did not trade one stock index option contract for over 1 hour. CME’s

clearing department received late payments4

 and delayed some of its

payments, and CME suspended trading in the S&P 500 index futures

contract for about an hour on October 20, 1987. Derivatives option and

futures markets became disconnected from equity markets. Some

securities firms said that their banks were refusing to lend them additional

funds. Many firms were overwhelmed with customer orders, and some

firms were pressuring NYSE and NASD to stop trading so that they could

catch up with customer order flows.

At mid-day on October 20, the securities markets and the financial system

approached breakdown. The ability of stock, options, and futures markets

1

The DJIA, a price-weighted index of 30 stocks listed on NYSE, is the most widely followed indicator of

U.S. stock market movements.

2

Since the 1920s, only the drop of 12.8 in the DJIA on October 28, 1929, and the fall of 11.7 percent the

following day, which together constituted the Crash of 1929, have approached the October 19 decline

in magnitude.

3

Market makers are professional securities dealers who have an obligation to buy when there is an

excess of sell orders and to sell when there is an excess of buy orders.

4

These late payments were not rule violations, and CME took no action to declare the firm making the

late payments in default.

Page 61 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

to price equities was in question, and those markets were described as

disconnected. Many individual stocks ceased to trade because few buyers

were in the market, and trading in many individual options was halted.

Stock index futures were selling at a large discount, and investors were

questioning the value of equity assets. Rumors circulated that several

major market participants, including a clearinghouse, were about to fail.

The financial system was close to gridlock, and a widespread credit

breakdown seemed possible. The primary concern of federal officials was

that the U.S. system for allocating credit would be halted, and the financial

system would stop functioning.

Agencies Depended

Largely Upon Information

and Existing

Communication Networks

Although the Federal Reserve had developed a written plan that outlined

potential responses to a range of financial crises, no interagency meetings

had been held before October 1987 to prepare for a market crash like the

one that occurred. However, an SEC official told us that a joint SEC-CFTC

effort in 1986 to monitor expiration day effects—so-called triple-witching

days—helped prepare them to handle the market crash.5

 The readiness of

federal officials and agencies to manage the market crash largely

depended upon the availability of information that federal agencies had

routinely collected, the existing communication networks among the

agencies, and the ability of the agencies to influence the behavior of

market participants and their creditors.

At the time of the crash, federal regulators, exchanges, and clearing

organizations routinely collected information on the financial health of

firms, the trading of financial instruments, and payments. Federal

regulators received quarterly detailed reports of firm capital levels. These

reports provided information on the likely resilience of firms to market

volatility. Exchanges and some federal regulators collected information on

the trading of financial instruments, such as customer identity, the number

of shares or contracts, price, and other trading information. CFTC collected

trading data through its large trader reporting system. Exchanges and the

over-the-counter securities market also collected information about the

performance of their specialists or market makers. CME’s clearing

department had a system that provided information about payments in the

futures clearance and settlement system.

Many of the federal agencies involved in responding to the market crash

had established interagency communication networks before the market

5

The term “triple-witching days” refers to the third Friday of March, June, September, and December,

when options and futures on stock indices expire concurrently and trading on index futures, index

options, and underlying stocks has been characterized by increased volume and price volatility.

Page 62 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

crash occurred. SEC, CFTC, and the exchanges had jointly developed a

telephone list of public and private sector market officials that included

both office and home phone numbers. Also, CFTC had routinely invited SEC

officials to market surveillance meetings focusing on volatility in stock or

options futures contracts, including a special surveillance meeting called

for the afternoon of Monday, October 19, on the basis of the previous

Friday’s 120-point drop. Many officials at SEC and CFTC had worked with

exchange and firm officials and understood their responsibilities,

concerns, and organizational resources. However, Federal Reserve and

Treasury officials had limited working experience with SEC and CFTC

officials.6 Also, the SEC Chairman, who was new to his position, had little

working experience with other senior federal financial officials.

Containment:

Leadership, Swift

Action, and

Collaborative Efforts

Helped Contain Crisis

Generally, federal officials and agencies acted within their respective

authorities in responding to the market crash. Officials and agencies

shared information willingly, although some information was simply

unavailable. Interagency and public communications were occasionally

problematic. The most significant policy decisions, especially the decision

on whether or not to close NYSE, were made collaboratively. The NYSE

Chairman consulted on this matter with officials at other exchanges,

federal regulatory agencies, Treasury, the Federal Reserve, and the White

House.

Federal Officials Acted

Within Their Agencies’

Authority

Federal officials and agencies responded to the market crash in

accordance with their respective authorities and responsibilities.

Treasury’s objective was to keep markets open and encourage investor

confidence in the markets. To this end, according to the Secretary of the

Treasury, Treasury officials (1) consulted with and encouraged the

Federal Reserve to provide liquidity with open market operations;

(2) prepared a message for the president to encourage investor confidence

in the financial markets, including a call for a budget summit agreement to

reassure credit markets about the direction of long-term interest rates; and

(3) discussed with finance ministries in London, Germany, and Tokyo the

importance of providing liquidity support to their markets.

SEC and CFTC objectives were to preserve the integrity and economic utility

of securities and futures markets. To do this, SEC expedited various rule

reviews, and both SEC and CFTC consulted with exchanges and clearing

6

After the silver market crisis of 1979-1980, CFTC established quarterly interagency financial futures

surveillance meetings involving staff from CFTC, the Federal Reserve, and Treasury. SEC was invited

to participate after initiation of stock futures trading in 1982.

Page 63 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

organizations to ensure that these organizations were fulfilling their

responsibilities. One expedited rule review allowed additional issuer stock

buy-back programs so that companies could purchase their own securities

as long as they did not engage in manipulative activities.7 SEC and CFTC also

collected and disseminated information to federal officials on the financial

condition of member firms. The exchanges and NASD were directly

responsible for keeping their markets liquid and their trading systems

open and for monitoring firm capital. The NYSE Chairman consulted with

other officials—especially those at SEC and the White House—concerning

conditions at NYSE and the implications of closing it. Clearing organizations

were to keep payments flowing by ensuring timely payments.

The Federal Reserve’s primary objective was to provide financial system

liquidity, mainly through system repurchase agreements in open market

operations. To that end, and to reassure the markets, the Federal Reserve

issued a public statement of its readiness to serve as a source of liquidity

to support the economic and financial system. The Federal Reserve also

maintained a highly visible presence through open market operations in

arranging system repurchase agreements. One Federal Reserve official

was concerned that the liquidity put into the financial system would not be

working liquidity, i.e., would not be used for its intended purpose. Finally,

Federal Reserve officials discussed with officials of major banks the

importance of meeting unusually large customer financing needs.

Many Activities of Federal

Agencies Were Routine

In responding to the market crash, federal agencies performed many

well-defined, routine tasks. Exchanges and clearinghouses generally used

existing operational procedures to ensure that individual financial

instruments were trading and that payments were timely. NYSE operations

procedures followed existing rules that allowed specialists additional time

to open securities and to halt trading. SEC and CFTC monitored volatility

through procedures already developed to oversee expiration day effects.

SEC followed a drill to monitor the capital of the 25 largest firms. CFTC used

the large trader reporting system to analyze trading for the effects of

portfolio insurance and index arbitrage. The Federal Reserve’s

arrangements of system repurchase agreements were also a matter of

routine.

7

SEC regulations include a rule designed to prevent an issuer from dominating the market for its

securities; the rule pertains to volume, timing, price, and the manner of purchases. See 17 C.F.R. Sec.

240.10b-18.

Page 64 GAO/GGD-97-96 Financial Crises
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The Stock Market Crisis of 1987

Agencies Shared

Information but Some

Information Was Not

Available

In the market crash case, agencies effectively shared crisis-relevant

information—data related to the financial health of firms, the functioning

of trading systems, and payments in clearance and settlement systems.

Generally, such information went quickly and directly to senior

decisionmakers both inside and outside the federal government. However,

federal regulators and some exchanges did not have all the information

they wanted.

Some of the desired information was available with some difficulty or after

some delay. For example, derivatives markets had difficulty pricing

options and futures because of an inability to get price data from NYSE.

CBOE had to request information from NYSE on which stocks were trading.

SEC and CFTC had to request additional information from firms on trading

strategies. The Federal Reserve and SEC had to collect information about

credit relationships between firms and banks.

Other information was simply unavailable. According to a Federal Reserve

official we interviewed, no one knew whether capital calculations were

correct because equity prices were changing so rapidly. This complicated

the task of reassuring banks of the solidity of a firm’s capital. The largest

unknown during the crisis, of course, was the market sentiment of

participants and when and how much they would buy and sell.

Communications Were

Sometimes Problematic

The federal response to the market crash included some significant

communications problems. A message regarding the possible closure of

NYSE that the NYSE Chairman intended to give differed from the message

some heard. The NYSE Chairman said he told others that NYSE was having

problems, and if the decline continued there would be further problems.

Federal regulators and exchanges said that they were told that NYSE was

about to close. The NYSE Chairman called SEC and, according to SEC

officials, told them that NYSE was about to close. SEC called CFTC, NASD,

CBOE, and other exchanges and told them that NYSE was about to close.

According to an SEC official, the NYSE Chairman called SEC back about 10

minutes later and said that buyers were coming into the market and that

NYSE would stay open.

Miscommunication on this point also occurred between the SEC Chairman

and the print media. On the morning of October 19, 1987, at about 11:15

a.m., the SEC Chairman told reporters that he had discussed market

conditions with the NYSE Chairman and that a trading halt had been among

the items covered. He stressed that if the market fell too rapidly a trading

Page 65 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

halt was an option. The wire services reported that SEC was considering a

trading halt, and SEC officials said that the SEC Chairman was misquoted.

About 1 p.m., SEC announced that no such trading halt was under

consideration. The NYSE Chairman announced that NYSE did not intend to

close unless required to do so by the President. CFTC told reporters that no

halt in trading of index futures was under consideration. According to a

NYSE official, although the comments attributed to the SEC Chairman

appeared to some to have spooked the markets and led to further price

declines, the sell-off of equity securities actually had nothing to do with

what the SEC chairman said.

Agencies Decided Some

Multijurisdictional Issues

Collaboratively

In the market crash case, the heads of federal financial organizations and

exchanges and their senior staff collaboratively decided multijurisdictional

issues. One example of this was the decision to keep NYSE open even

though specialists were overwhelmed and automated systems were

malfunctioning. Because this decision had implications beyond equities

markets, the NYSE Chairman consulted on this matter with officials at other

exchanges, federal regulatory agencies, Treasury, the Federal Reserve, and

the White House.

Another example of collective leadership was in the case of the near

failure of First Options of Chicago Inc. (First Options). Federal Reserve,

the Comptroller of the Currency, CBOE, and Options CC officials decided

how to keep First Options solvent, although this action was not well

coordinated according to OCC officials. First Options, the options clearing

firm with the largest number of option market makers, had severe liquidity

problems and required an infusion of $312 million from its holding

company, Continental Illinois Corporation. Continental bank, the parent

company, initially infused cash into First Options but took back the

advance at the instructions of OCC officials. These actions violated OCC

restrictions on the amount of money a bank can advance to an operational

subsidiary. Instead, First Options was made a subsidiary of the holding

company and received a cash infusion from the holding company.

Treasury and Federal

Reserve Led Efforts to

Calm Markets

In the market crash case, the Federal Reserve and Treasury played

significant leadership roles in helping to restore confidence in the markets.

Actions of the Federal Reserve that helped restore confidence in the

market included the agency’s statement of readiness to provide liquidity,

its support of keeping NYSE open and First Options solvent, and its

encouragement of extensions of credit during the market crash.

Page 66 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

Treasury’s successful effort to reassure institutional and individual

investors through statements from the President was especially important.

One exchange official we interviewed pointed out that in times of financial

panic, the most effective reassurance is likely to come from the White

House, especially because elected officials can be held accountable for

their words and actions.

Resolution: Crisis

Studies Accompanied

by Regulatory and

Legislative Initiatives

Immediately after the market crash, various studies sought to describe and

explain the market crash and recommend actions to prevent such a crash

from occurring again.

One study commissioned by the President said that the precipitous market

decline of mid-October was triggered by (1) an unexpectedly high

merchandise trade deficit that pushed interest rates to new high levels and

(2) proposed tax legislation that led to the collapse of the stocks of a

number of takeover candidates. According to this study, the initial decline

ignited mechanical selling by a number of institutions employing portfolio

insurance strategies and mutual fund groups reacting to requests from

investors to exit the fund and receive cash.8

 This study concluded the

following:

• One agency should coordinate regulatory issues that have an impact

across related market segments and throughout the financial system.

• Clearing systems should be unified across marketplaces to reduce

financial risk.

• Margins should be made consistent across marketplaces to control

speculation and financial leverage.

• Circuit breaker mechanisms should be formulated and implemented to

protect the market system.

• Information systems should be established to monitor transactions and

conditions in related markets.

SEC, CFTC, GAO, and exchanges also conducted studies that identified

various issues and set forth recommendations.9

 Our study found two areas

needing immediate attention to help restore confidence in the markets and

alleviate concerns that the markets could crash again. Specifically, we

8

Presidential Task Force on Market Mechanisms, Report, Washington, D.C.: January 8, 1988.

9

See Commodity Futures Trading Commission, Division of Economic Analysis. Division of Trading and

Markets, Final Report On Stock Index Futures And Cash Market Activity During October 1987,

Washington, D.C.: Jan. 1988; and Securities and Exchange Commission, Division of Market Regulation,

The October 1987 Market Break, Washington, D.C.: Feb. 1988.

Page 67 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

found that (1) problems with the New York Stock Exchange’s systems

adversely affected trade executions and pricing information both in New

York and in other markets, and (2) decisions of federal and self-regulators

were made without benefit of any formal intermarket contingency

planning.10

In March 1988, a Working Group on Financial Markets was appointed by

the President to consider the major issues raised by numerous studies and

their recommendations.11 The members of the Working Group were the

senior officials of Treasury, the Federal Reserve, SEC, and CFTC, with the

Under Secretary for Finance of the Treasury serving as Chairman. The

Working Group made conclusions and recommendations in the areas of

circuit breakers,12 clearance and settlement, margin payments,

contingency planning, capital adequacy, and trade processing systems.13

The Working Group has continued to provide a forum for high-level

discussion of interagency financial regulatory issues.

The Market Reform Act of 1990 included provisions responsive to the

market crash experience.14 These provisions granted SEC additional

authority to suspend trading on a temporary basis in any nonexempt

security and at securities exchanges, subject to a presidential disapproval.

The act also gives SEC emergency authority to take steps to restore order

to securities markets, which can be accomplished through altering rules

on hours of trading, position limits, and clearance and settlement.

SEC, CFTC, and securities and futures exchanges implemented coordinated

circuit breaker mechanisms that provide for a 30-minute trading halt of all

securities and all derivative instruments after a 350-point DJIA decline in a

day and a 1-hour halt after a 550-point DJIA decline. Stock, options, and

futures markets also implemented a teleconferencing system linking

financial markets and regulators. Computer capacity has been increased at

exchanges and at broker-dealers. A 3-business-day settlement period has

also become standard for securities markets, which eliminates 2 days of

potential participant default.

10See Financial Markets: Preliminary Observations on the October 1987 Crash (GAO/GGD-88-38,

Jan. 26, 1988).

11Executive Order 12631.

12Circuit breakers are intended to deal with large and rapid market declines. When a particular price

has fallen by a specified amount over a specific time period, exchanges temporarily halt trading.

13Working Group on Financial Markets, Interim Report, Washington, D.C.: May 16, 1988.

14Public Law 101-432.

Page 68 GAO/GGD-97-96 Financial Crises
Chapter 5 

The Stock Market Crisis of 1987

The Federal Deposit Insurance Corporation Improvement Act of 1991

clarified that in extraordinary circumstances, the Federal Reserve could

lend from its discount window to anyone without legal constraints on the

use to which the credit was being put. As before, however, all borrowers

were required to show that they needed the Federal Reserve’s cash to

remain in business, could not borrow elsewhere, and had secure collateral

to back up the loans.

Page 69 GAO/GGD-97-96 Financial Crises
Appendix I 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Thomas J. McCool, Associate Director, Financial Institutions and

Markets Issues

Craig A. Simmons, Director (Retired)

Alison Kern, Assistant Director (Retired)

Patrick S. Dynes, Project Manager

Gordon Agress, Evaluator

Desiree W. Whipple, Reports Analyst

Office of the Chief

Economist,

Washington, D.C.

James L. Bothwell, Chief Economist

Office of

Congressional

Relations,

Washington, D.C.

Helen H. Hsing, Director

Page 70 GAO/GGD-97-96 Financial Crises
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