Continental Illionis Downfall

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The case of Continental Illinois Bank is an example of how internal credit portfolio problems can precipitate a funding liquidity crisis. In this case, these problems were exacerbated by weaknesses in the institution's funding strategy. Continental Illinois was once the largest bank in Chicago. Starting in the late 1970s, the bank began pursuing an aggressive growth strategy that saw its commercial and industrial lending jump from USD 5 billion to over USD 14 billion in the five years prior to 1981. During that time, the bank's total assets grew from USD 21.5 billion to USD 45 billion.

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The first sign of Continental's problems surfaced with the closing of Oklahoma-based Penn Square Bank. This smaller bank had issued loans to oil and natural gas companies in Oklahoma during the boom of the late 1970s. If a loan was too large for it to service, Penn Square would pass it on to a larger institution such as Continental Illinois. But as oil and natural gas prices decreased after 1981, some firms began to default on their debt. In 1982, Penn Square became insolvent and regulators stepped in to close the bank. By then, Continental held more than USD 1 billion in loans to Penn Square's oil and gas customers, and therefore suffered heavy losses as defaults rose.

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While many other banks also suffered credit losses during this period, Continental was unusual in that it had only a tiny retail banking operation and a relatively small amount of core deposits. Therefore, it relied primarily on federal funds and floating large issues of certificates of deposit (CDs) to fund its lending business.

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When Penn Square failed, Continental found itself increasingly unable to fund its operations from the U.S. markets. As a result,it began to raise money at much higher rates in foreign wholesale money markets (e.g., Japan). But when rumors about Continental's worsening financial condition spooked the international markets in May 1984, the bank's foreign investors quickly began to withdraw their deposited funds. Continental Illinois was confronted with a full-blown liquidity crisis as depositors withdrew USD 6 billion in only ten days. Regulatory authorities eventually stepped in to prevent a domino effect on other banks, which they feared might put the entire U.S. banking system at risk.

 

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