**Box . “One Bank’s Liquidity Crisis: Continental Illinois”. 3: ‘One Bank’s Liquidity Cr is: Continental Illinois’**<sup>**1/**</sup> _Foreign depositors_ The episode of the crisis at the Ch: Foreign depos ts are u **i** cago-ba **s** ually Eurodollar deposits that are traded in the wholesale marke . These fundsed Continental Illinois bank in 1984 is noteworthy in analyzing **t** he causes and are sttrigge **r** s that can lead to one bank’s failure and thuctured as interest-bearing time instrum **e** nts--very liquid and shor te development of its liquidi **t** y c **r** m maturities--and are denominated in the isis. domestic currency rather than the currency of the foreign country. They are not insured by the FDIC. Foreign depositors’ **1. Analyzing the causes that trigger the liquidity crisis** behavior may differ from that of domestic depositors because of differences in their credit sensitivities and their perceptions of the bank’s financial stab lity. _Business strategy_ : aggress **i** ve growth strategy. Corporate finance literature<sup>**<u>2</u>**</sup> highlights that rapid growth is not always a positive factor unless management takes active steps to control it. The term ‘sustainable growth’ is used to express that a _Cash flows_ : Continental Illinois experienced a decrease in earnings which clearly deteriorated its liquidity position. company should not grow above its sustainable growth rate, which is its growth rate in equity. In applying this lesson to However, the management did not view this as a problem in its fundamentals but rather as a temporary shock. banking, the conclusion is that growth is not necessarily something that needs to be maximized--bank management should _No internal controls:_ understand that rapid grC **o** ntinental Illinois’ management failed to design internal controls to monitor liquidity and credit risk wth creates financial challenges that must be anticipated and managed. and a contingency funding plan was not put in place. Continental Illinois ́ strategy was to provide ‘cheap’ loans, especially to energy companies. During its growth period, the _External warnings_ bank’s management was praised by the industry and market for its aggressive strategy. The indicators that not only the  that showed the increasing liquidity risk: industry but also the management were looking at were profitability ratios: high returns on equity and high returns on - Economic conditions: Rising interest rates. average assets.

- Latin America debt crisis: Continental Illinois had significant exposure to these countries, so when the crisis

- _Balance sheet liquidity indicators_ : What management and observers failed to pay attention to were the bank’s liquidity emerged in this region it reinforced the worries about the bank’s stability.

- indicators which showed increased risks during its rapid growth:

- Stock prices declined almost 37 percent in 1982 due to the negative consequences of the continuing decline of the

- - Loans to assets increased dramatically, meaning, the greater the share of loans in the bank’s portfolio the greater the energy sector in Continental Illinois’ performance. default risk it was exposed to.

- CAMEL downgrade to 4.

|- The return on assets (ROA) was decreasing;<br>- The equity to assets ratio was falling;<br>Nfi l ii bt thi id htt bl<br> <br>- However there was no downgrade from any credit rating agency, Fitch maintained its rating, despite the increasing<br>volume of non-performing loans coming from the energy companies that Continental Illinois was exposed to.|
|---|
|- on-perormng oans were ncreasng u s was vewe as a sor-erm proem.<br>_Citi fdi r (libiliti)_: Continental Illinois had little retail bankin business and therefore a small share<br>**2. Analyzing the development of the crisis**|
|_omposon unng souces aes_g , ,<br>of core deposits and little franchise value. Its sources of funding were based on Fed funds, CDs and volatile short-term and<br>less expensive instruments rather than longer-term funds. This funding strategy exposed the bank to high and continuous<br>rollover risks and the need for searching new sources of funding.<br>_Penn Square Bank failure:_The Penn Square Bank failed due to speculative oil and gas exploration loans. Continental<br>Illinois had invested heavily in Penn Square, so the failure of the latter had a negative impact on Continental Illinois'<br>earnings and market confidence.|
|When the crisis started in the aftermath of the Penn Square failure, Continental Illinois was unable to fund itself from<br>domestic markets, so it turned to foreign money markets and significantly increased its foreign deposit levels.<br>_Increased CD rates:_The loss of confidence in the aftermath of the Penn Square failure meant that Continental Illinois had to<br>pay higher rates on its CDs.|
|_Assets Composition_: Continental Illinois followed an aggressive lending strategy based on aggressive loan pricing, focusing<br>on selected areas. Over time, Continental was originating loans with interest rates lower than those used earlier. Taking into<br>_Depositors run:_The rumors in the market about potential Continental Illinois bankruptcy led depositors to run away.<br>Overseas depositors and even domestic correspondent banks moved away.|
|account the increase in interest rates over that period, it implied the bank adopted a below market pricing strategy. However,<br>it did not use securitized products to reduce its illiquid assets.<br>_Fed discount window_: When the run started, Continental Illinois had to borrow from the Fed discount window; but this,<br>however, did not prevent the depositors from running away.|
|_Risk concentration_: Continental Illinois’ activities were highly concentrated in the energy sector, especially on gas and oil<br>companies. It was, therefore, highly exposed to the volatility of energy prices. However, this vulnerability was not viewed<br>by the management as a risk but rather only as a short-term problem. Thus, the drop in oil prices in 1981 that negatively<br>fftd th i t hih Ctitl Illii hd lt iiid b th t<br>_FDIC assistance package_: FDIC had to intervene as concerns were raised about the spillover effects that the bank crisis<br>could have on the entire banking system(“too big to fail”).Thus, FDIC provided guarantees of protection to all depositors<br>and creditors.|
|aece e energy companes o wc onnena nos a en was mnmze y e managemen.<br>_Type of creditors:_Small retail deposit funding which is viewed as being relatively stable, with less credit and interest rate<br>itiit th th fdi Th th id f kt fdifCtitl Illii ltd<br>_‘Nationalization’:_As outflows continued, FDIC tried to find a merger partner for Continental Illinois but it could not.<br>Finally, FDIC acquired 80 percent ownership of Continental Illinois|
|sensvy an oer unng sources. us, e ncrease use o mare unng sourcesromonnena nos resue<br>in a higher exposure to the price and credit sensitivities of major fund providers<br>**3. What are the lessons from Continental Illinois regarding liquidity management?**|
|Wholesale fund providers are very sensitive toperceived changes in a bank’s credit capacity as they are unsecured-- as<br>opposed to retail depositors. Specifically, Continental Illinois relied on Fed Funds, CDs and foreign deposits. CDs are<br>negotiable instruments, saleable to a secondary investor. While retail CDs generally allow for early redemptions with<br>- Rapid loan growth is not necessarily a good indicator of the performance of a bank. Aggressive asset growth requires that<br>liquidity needs and sources be planned for accordingly. Experience tells us that excessive bank credit growth quite often<br>ends in ‘tears’.|
|penalties, wholesale CDs generally do not. Fed funds are unsecured funds traded daily by banks using excess reserves. The<br>market is primarily overnight, therefore, these funds have very short maturity. They are not deposits, so they are not FDIC<br>insured, although, they are usually considered to have very low credit risk. But if a bank experiences financial difficulties, it<br>fid it bilit t b i thi kt hd liitd<br>- A small retail deposit funding base, with high dependence on wholesale funding, is risky. Wholesale funds providers are<br>more credit sensitive and less willing to provide funding during financial difficulties. It also exposes the bank to continued<br>rollover risk.|
|may n s ay o orrow n s mare ampere or emnae.<br>Moreover, wholesale funding needs to be rolled over regularly and, therefore, Continental Illinois was exposed to variations<br>i th liidit f fdi kt<br>- Concentration on one particular segment makes the bank very vulnerable to shocks in that segment, posing high liquidity<br>risk. Banks need to diversify funding sources to prevent a liquidity crisis.|
|n e quy o unng mares.<br>1/Federal Deposit Insurance Corporation (FDIC), Continental Illinois and ‘Too Big to Fail’,_History of the Eighties--Lessons_<br>_for the Future_, Volume I, Chapter 7, 1997<br>- Adequate liquidity risk management can prevent banks from going to the LOLR to be rescued. Robust liquidity<br>management is critical to identify liquidity risks and put in place actions contained in the bank’s contingency funding plan<br>to overcome liquidity crises.|
|2/Higgins, ‘Managing Growth’,_Analysis for Financial Management_, Chapter 4, 9thedition|