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U . S . C o n g r e s s . H o u s e . C o m m i t t e e on B a n k i n g ,
F i n a n c e & U r b a n A f f a i r s . S u b . on F i n a n c i a l
I n s t i t u t i o n s S u p e r v i s i o n , R e g u l a t i o n and
Insurance.
C O N T I N E N T A L I L L I N O I S N A T I O N A L B A N K : R E P O R T OF
AN I N Q U I R Y INTO ITS F E D E R A L S U P E R V I S I O N A N D
ASSISTANCE




HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN
FERNAND J ST
HENRY B GONZALEZ. Tesus
FRANK A N N U N Z I O , Illinois
PARREN J MITCHELL. Maryland
WALTER E F A U N T R O Y , District of
(x>lumbia

AFFAIRS

SRMAIN, Rhode Island. Chairmon
CHALMERS P WYLIE, Ohio
STEWART B McKINNEY. Connecticut
JIM LEACH, Iowa
NORMAN I) SHUMWAY. California
STAN PARRIS, Virginia
BILL McCOLLUM, Florida
GEORGE C WORTLEY. New York
MARGE ROUKEMA, Now Jeraey
DOUG BEREUTER, Nebrusku
DAVID DRLIER, Californiu
JOHN HILER. Indiana
THOMAS J RIIX;E. Pennsylvania
STEVE BARTLEIT. Tesua
TOBY ROTH, Wisconsin
ROD CHANDLER, Washington
AL MrCANDLESS, California
JOHN E OROMERG, Illinois
JIM KOLBE, Arizona
J ALEX MCMILLAN. North Carolina

STEPHEN I, NEAL, North Carolina
CARROLL HUBBARD, J * . Kentucky
JOHN J LAKAICE, New York
STAN LUNDINE. New York
M A R Y HOSE O A K A R . Ohio
BRUCE F VENTO, Minnesota
DOUG BARNARD. J*.. Geor|<ja
ROBERT GARCIA, New York
CHARLES E SCHUMER. New York
BARNEY F R A N K . MmwachusetU
BUDDY ROEMER, Louisiana
RICHARD II LEHMAN. California
BRUCE A MORRISON. Connecticut
JIM COOPER, TenneiHMru
MARCY KAPTUR, Ohio
BEN ERDREICH. Alubuma
SANDER M LEVIN. Michigan
T H O M A S R CARPER. Delaware
ESTEBAN E TORRES. California
GERALD D KLECZKA. Wisconsin
BILL NELSON. Florida
P A U L E KANJORSKI. Pennsylvania
BART GORDON. Tennessee
THOMAS J MANTON, New York
JAIME B FUSTER. Puerto Rico

S U B C O M M I T T E E ON F I N A N C I A L INSTITUTIONS SUPERVISION, REGULATION A N D
INSURANCE
FERNAND J ST GERMAIN. Rhode Island. Chairman
FRANK A N N U N Z I O . Illinois
CARROLL HUBBARD. JH , Kentucky
DOUG BARNARD. JM . GeorK««
JOHN J LAFAIVCE. New York
MARY ROSE O A K A R . Ohio
BRUCE F VENTO. Minnesota
ROBERT GARCIA. New York
CHARLES E SCHUMER, New York
BARNEY FRANK. Massachusetts
RICHARD II LEHMAN. California
JIM COOPER, Tenni^ee
BUDDY ROEMER, Louisiana
MARCY KAPTUR, Ohio
BILL NEI^SON, Florida
P A U L E KANJORSKI. Pennsylvania
BART GORIX)N, Tennessee
THOMAS J MANTON. New York




RICH A HO L. STII

CHALMERS P WYLIE. Ohio
JIM LEACH, Iowa
STEWART B Mt K I N N E Y . Connecticut
NORMAN D S H U M W A Y , California
BILL Mi.<;OLLUM, Florida
GEORGE C WORTLEY. New York
DAVID DREIER, California
STAN PARRIS. Virginia
MARGE ROUKEMA. New Jersey
DOUG BEREIJTER, Nebraska
S I E V E IIAirTLETT, Teaas
TOBY ROTH, Wisconsin

SutH~ofHfnitt*'r Staff

(ID

Director

CONTINENTAL ILLINOIS NATIONAL

BANKI

R E P O R T O F A N I N Q U I R Y I N T O ITS F E D E R A L SUPERVISION A N D

ASSISTANCE

STAFF REPORT
TO THE
SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION,
REGULATION AND INSURANCE
COMMITTEE ON BANKING, FINANCE AND URBAN




AFFAIRS

C O N T I N E N T A L ILLINOIS N A T I O N A L NANKi
R E P O R T O F A N I N Q U I R Y I N T O ITS F E D E R A L SUPERVISION A N D A S S I S T A N C E

CONTENTS

Chapter

Page

t.

Introduction and Summary

1-3

II.

Inquiry Findings and Recommendations

<1-13

III.

Policy C o m m e n t s

U-23

IV.

Management

2<»-5<i

A . Strategic Planning

2<»-25

B. Internal C o n t r o l s

26-39

C . P e r f o r m a n c e R e l a t i v e to Peers

k0-k9

D . Nonbank Subsidiaries
Supervision

35-109

A . Federal Supervisory Framework

53-68

B. Comptroller and Federal Reserve Examiner Findings

V.

50-5<»

69-86

1.

Overview

69-72

2.

Loan Management and R e v i e w

73-83

3.

Capital

83-86

C . Federal Supervision Weaknesses

87-96

D. Federal R e s e r v e Approvals o l Continental Illinois
C o r p o r a t i o n Expansions

97-109

VI.

Market Evaluation o l Continental

II0-13<*

VII.

Penn Square Energy Lending and Penn Square National Bank

135-162

VIII.

F e d e r a l Assistance

163-189

Appendicies
1.
2.

Financial Statements
Federal R e s e r v e Inspection Report Transmittal L e t t e r s




(IV)

CHAPTER I
INTRODUCTION

SI* months before the failure of an Oklahoma City shopping center bank revealed
profound deficiencies In the credit • management

system of

the Continental Illinois

National Bank, the federal regulatory agency responsible for examining and supervising
the bank rated Its overall condition "good" and Its management "excellent".
months later Continental was fighting for its life.

Twenty-four

Its credit management problems had

become Insurmountable, and private sector confidence in the bank had evaporated.

By

early May 19S<I, financial market rumors about Continental's deteriorating condition were
resulting In weekly deposit outflows totalling billions of dollars. Without massive external
aid, Continental could not survive.

As a first step In assisting Continental, the FDIC, the Federal Reserve and the
Comptroller of the Currency, on May

17, announced an interim assistance program

consisting of private bank funds and agency credit and attempted to assure the depositors
and general creditors of Continental that they would incur no loss when a final assistance
package was put In place.

This action coincided with the FDIC curtailing its experiment

in requiring uninsured depositors to incur a partial loss in a bank failure even If the bank
were merged with another. As dramatic and sweeping as the federal agency assurance to
Continental

depositors

and creditors

was, withdrawals

from

Continental

continued

virtually unabated.

Through the rest of May, June, and most of July, round-the-clock negotiations
among agency officials, attorneys representing various interests, investment bankers, and
other banks were pursued in a search for a purchaser of Continental and failing that to
construct a permanant assistance program.

A purchaser could not be found, and on July

26, the FDIC announced a permanent assistance package consisting of installation of a
new management team, removal of $4.) billion In problem loons, Infusion of $1 billion In
new capital, and maintenance of credit lines from major banks and the Federal Reserve.

On the same day, House Banking Committee Chairman Fernand J. St Germain
annowced hearings Into the circumstances that led to the need for assistance and the




(U

2

structuring of the assistance program Itself.

In his statement, Chairman St Germain

explained!
The rescue ol Continental dwarfs the combined guarantees and outlays of the
Federal Government in the Lockheed, Chrysler and New York City bailouts which
originated in this Committee.
More Important is the fact that the Federal
Government provided assistance to these entitles only after the fullest debate, great
gnashing of teeth, the Imposition of tough conditions, and ultimately, a majority
vote ol the House and the Senate and the signature of the President of the United
States.
(Statement from the Floor of the House of Representatives, July 26, 19S<#>
The inquiry Into Continental's need for assistance and the assistance package was
carried out by the Subcommittee on Financial Institutions Supervision, Regulation and
Insurance and utilized a staff team consisting ol Full Committee, Subcommittee, and
several General Accounting Office auditors assigned to this Subcommittee.

The Inquiry

team conducted an extensive review of examination, supervision, and assistance plan
documentation In the possession of the Office of the Comptroller of the Currency, the
Federal Reserve, and the Federal Deposit Insurance Corporation.
interviewed agency

The Inquiry team also

and Continental Bank officials responsible lor the examination,

supervision, management and audit ol Continental, and individuals who participated In the
development of the assistance plan.

Hearings began on September IS, I9I<» with the testimony of the three Individuals
responsible lor examining Continental Bank from the mid-1970s to th« present, and a
Continental
September

Bank

loan

officer

19, the head of

familiar

with Continental's lending practices.

On

the agency responsible for examining and supervising all

national banks, C. T. Conover, Comptroller

of

the Currency, appeared before the

Subcommittee. Two weeks later, FDIC Chairman William Isaac provided testimony on the
assistance plan and the need for Congressional consideration of deposit Insurance reform
measures.

In addition to formal testimony and questioning by Subcommittee Members,

numerous documents and reports were placed in the hearing record during the course of
the hearings to broaden the information available to the public about Continental, its
supervision by federal regulatory agencies, and the structure and cost of the assistance
program.
This report Is an effort by the staff inquiry team to bring together In one place the




principle ( M i n g s of the Inquiry drawing on witness testimony, documents reviewed by the
Subcommittee, and Information

provided

for

the record by entitles

such as the

Congressional Budget Office and the General Accounting Office. This report reflects the
views of the staff Inquiry team only and should not be Interpreted at representing the
views of the Chairman or any Member of the Financial Institutions Subcommittee or full
Committee.

This staff report, moreover, Is not Intended to serve as a substitute for a

thorough reading of the hearings themselves. The hearings contain much Information and
documentation that Is not contained Irr this report, and only from reviewing the hearing
record can one gain a full appreciation of the complexity and depth of concern about the
handling of Continental Illinois National Bank.




C H A P T E R I!

INQUIRY FINDINGS A N D RECOMMENDATIONS

I.

The problems of Continental Illinois National Bank ( C I N B ) w e r e the direct
result of decisions made at the highest management l e v e l .

a.

In 1976, CINB's top management embarked upon an ambitious program of
growth and market expansion intended to raise C I N B from the eighth
ranked c o m m e r c i a l lender to one of the three top commercial lenders in
the United States to the third. This goal was reached in 'j9SI. (See

j

Chapter VI, Market Evaluation.)

b.

A t t a i n i n g CINB's management goal involved market expansion, asset
g r o w t h , and purchased funds dependency, which profoundly a f f e c t e d both
the size and soundness of the institution.

(1)

From 1977 through 1981, CINB's loan p o r t f o l i o rose on average 19.9%
per year f r o m $13 bilUon to $32.6 billion, and its total assets grew on
a v e r a g e I6.d% per year f r o m $22 billion to $47 billion. This pace
placed C I N B first among its peers in growth. (See Chapter IV, C .
P e r f o r m a n c e R e l a t i v e to Peers.)

(2)

CINB's e q u i t y capital l e v e l did not keep pace with loan and asset
growth.

Its r a t i o of equity capital to total assets declined and its

rank within its bank holding company peer group with regard to
c a p i t a l i z a t i o n f e l l f r o m sixth to last place. (See Chapter IV, C .
P e r f o r m a n c e R e l a t i v e to Peers.)

(3)

C I N B b e c a m e increasingly dependent on v o l a t i l e and r e l a t i v e l y more
expensive funds. A l l during the 1976 through 1981 period, C I N B
ranked last among its peers in net liquidity.

Asset and liability

composition and maturities were not adjusted to achieve • r e l a t i v e
balance between interest sensitive assets and liabilities. Heavy use
of overnight funds and shortened C D and Eurodollar maturities were




(56)

used to support the aggresive loan policy. Deposits from
commercial banks, particularly foreign banks, were attracted by
paying high interest rates. Core deposits from individuals,
partnerships and corporations remained constant but lagged behind
CINB's peers. (See Chapter IV, C . Performance Relative to Peers.)

(4)

A f t e r declining from 121% in 1976 to 61% in 1980, the ratio of loan
assets classified by examiners as "Substandard/* "Doubtful,** or
" t o s s , " to gross capital funds turned upward in 1981 to 67% and rose
to 219% in 1983. (See Chapter V, B.I. Overview.)

In 1979, both the Comptroller of the Currency and the Federal Reserve
warned Continental top management about the linkage between asset
quality and purchased funds. The Comptroller of the Currency said
speclllcallyi

"...since the bank is heavily dependent upon purchased funds

to support assets and proved liquidity, maintenance of good asset quality
Is necessary to Insure a continued high degree of market acceptance".
(See Chapter V, B. Comptroller and Federal Reserve Examiner Findings.)

CINB's top management failed to maintain a level of asset quality
sufficient to preserve market confidence in the institution. (See Chapter
V, B. Comptroller and Federal Reserve Examiner Findings and Chapter VI,
Market Evaluation.)

CINB top management did not r e f l e c t an appropriate degree of regard (or
Comptroller and Federal Reserve warnings. CINB's 1980 and 1981
quarterly performance evaluation reports contained numerical targets for
earnings per share, asset growth, and other performance criteria, but no
comparable performance standards for asset quality. (See Chapter IV, A.
Strategic Planning.)




6
i.

CINB's top management failed to develop and maintain an internal loan
quality control system of sufficient timeliness and thoroughness to
balance the risks Inherent In CINB's growth goals and d | entrallzed credit
<<
extension procedures.

(1)

The Comptroller's examiners pointed out that

$1.6 billion In loans

had not been reviewed on an annual basis as required by CINB's
corporate policy. The 1981 examination report stated that the level
of unrevlewed loans had risen to $2.<l billion. (See Chapter V, B.2.
Loan Management and R e v i e w . )

(2)

CINB's internal audit department failed to function In a manner
which could have alerted senior management to the breakdown In
internal controls and loan quality in a timely manner.

(a)

The internal audit department attempted to resolve weaknesses
in internal controls by communicating their findings directly to
line management rather than reporting them to the audit
c o m m i t t e e of CINB's board of directors.

(b)

There is no indication that the internal audit department was
aware o ! the material breakdowns in internal controls related to
the Penn Square National Bank loans until requested by
management to review these loans in late 1981.

(c)

There is no indication that the internal audit department notified
Ernst dc Whinney, CINB's independent certified public accounting
firm, of the internal control weaknesses it uncovered relating to
the Penn Square National Bank. Had they been informed, Ernst
& Whinney may have reviewed loan procedures more intensively
during their annual audits or independently reported weaknesses
in the lending operations to senior management.

g.

Even outside the context a formal control system, there were numerous
instances when specific information about problems relating to Penn
Square came to light within CINB. This information surfaced in internal




memos, notesheets, reports o( investigation, and conversations, but there
was no mechanism for top level managment to take timely action in
response to these warning signals.

2.

The record of CINB's supervision by the Comptroller of the Currency Indicates
major deficiencies in the agency's examination methodologies and followup
practices.

a.

Despite having noted in examination reports the adverse e f f e c t s of CINB's
high growth goals on the bank's capitalization, the Comptroller took no
decisive action to slow the bank's growth and enable capital to increase
relative to assets prior to 1983.

b.

Despite having warned CINB's top managment about the need for close
monitoring of asset quality in 1979, and having noted documentation, loan
rating, and loan review deficiencies in each examination report
thereafter, the Comptroller took no decisive action to require CINB to
put Its loan management system in order prior to 1982.

c.

Aside from mentioning CINB's growing concentration In the oil and gas
industry in a portion of Its examination reports labeled "For Information
Only," the Comptroller did not consistently and forcefully point out to
CINB management the potential problems arising from excessive
concentrations in any industrial group. While oil and gas did contribute to
CINB's profitability in the late 1970s and early 1980s, the possible
repercussions of the level of exposure to oil and gas borrowers in the
event of adverse conditions were not emphasized clearly and repeatedly
by the Comptroller prior to the failure of Penn Square National Bank.




12

Comptroller examination report comments were, at crucial times,
ambiguous and difficult to interpret, at least in part because the
examiners tempered critical comments with complimentary remarks. The
result of this could have been to downplay the significance of the critical
comments in a way that prevented timely corrective action.

The full severity of CINB's loan quality problems was not promptly
detected by the Comptroller's bank examiners In part because the
agency's loan sampling methodology depends to a considerable degree on
the e f f e c t i v e n e s s of a bank's own loan quality control system.

Rather

than employing a fully representative, statistical sample of all loans, the
Comptroller's methodology focuses primarily on very large loans and on
loans already identified as problems by the bank. For banks with
decentralized loan management systems such as CINB had, the
Comptroller's loan review procedures are Insufficient in scope to test
whether the bank's loan review accurately presents the true quality of the
loan portfolio.

The Comptroller's screening system that identified deviations In financial
ratios from the peer group norm listed CINB ratios as conforming to the
peer group norm because the peer group's financial ratios shifted
downward along with CINB's. Thus, no anomalous CINB ratio behavior
was reported.

The Comptroller's data processing examination manual requires that
examiners review the quality of the output of a computer as well as the
physical equipment and its management. In 1980, 1981, and 1982, the
Comptroller's examiners found CINB's data processing system to be sound
and well-managed.

These findings contrast sharply with evidence and

commentary from other sources that the computer's loan management
information reports were unreliable. (See Chaper V, B.3. Capital.)




h.

The Comptroller allowed an unacceptable amount of time to pass — up
to eight months — before requiring CINB to respond to examination
comments. An e f f e c t i v e examination program requires banks to respond
promptly to supervisory correspondence concerning adverse examination
findings.

The record of the Federal Reserve's supervision of Continental Illinois
Corporation Indicates deficiencies In that agency's holding company
supervision practices and expansion approval policies.

a.

The Continental Illinois Corporation (CIC), the holding company of CINB
audit a f f i l i a t e s , was examined by the Federal Reserve every year from
1979 to the present. The results of their examinations were set forth in
bank holding company inspection reports made available to CIC's top
management.

The Federal Reserve in 19S0 and 1981 did not utilize the

Inspection report transmittal letters to highlight critical inspection report
findings, as they did in 1979, 1982 and 1983.

The 1979 transmittal letter

warnedt "Continental Illinois Corporation continues to rely heavily on
volatile funds to sustain growth in assets and earnings. The success of
such a policy is dependent on the quality of underlying assets. ... While
asset quality control systems appear adequate, we urge continued close
attention to this vital area, especially during prolonged periods of high
Interest rates and retarded capital formation." Despite the fact that the
matters raised In this warning actually became more serious in each
subsequent year, no mention of this situation was made in subsequent
inspection report transmittal letters. This may have conveyed the
impression that the warning in the 1979 letter was no longer applicable.

b.

The transmittal letters to the inspection reports did not require CIC
o f f i c i a l s to respond formally to the findings in the inspection reports.
Therefore, there was no written mechanism to insure that CIC
management had taken remedial action in response to the Federal
Reserve's inspection findings.




c.

The Federal Reserve approved 3<» of CIC's applications from 1979 through
July of 1982, and 5 applications thereafter until the Spring of I98<», to
expand CIC's operations. Such application approvals may have conveyed
to CIC and the public that the Federal Reserve basically approved of the
operating and financial characteristics of CIC and its subsidiary bank,
CINB. These applications were approved despite the fact that: (See
Chapter V,C. Federal Supervision Weaknesses.)

(1)

Both the Comptroller's CINB examination reports and the Federal
Reserve's CIC inspection reports during this time frame contained
numerous critical comments expressing concern about capitalization,
volatile funding and asset quality; and

(2)

CIC's nonbank subsidiaries were not a meaningful source of financial
strength lo CIC or C I N B . (See Chapter IV, D. Nonbank Subsidiaries.)

(a)

From 1971* through 1980, CIC's nonbank subsidiaries paid no
dividends to the parent company while at the same time the
parent company advanced $388 million in loans to these
subsidiaries; and

(b)

From 1981 through 1983, the nonbank subsidiaries made
contributions to the parent company through dividend payments,
net income, and loans; however, these contributions were o f f s e t
to a significant degree by increases in equity investments and
loan advances f r o m the parent back to the nonbank subsidiaries.

A review of the audit findings of Ernst A Whinney, Continental's independent
c e r t i f i e d public accountants, Indicates that the methodology of the auditing
profession as applied to large commercial banks needs to be Improved.




5.

The need for added disclosure of bank financial and operating Information as a
means of providing increased market discipline is clearly demonstrated by the
Continental experience.

a.

Neither bank debt rating companies or security analysts had an accurate
understanding of CIC/CINlVs true portfolio condition.

b.

More disclosure, such as through the FDIC Reports of Condition and
Income (Call Reports), is an important first step in Improving market
discipline.

6.

The Continental Assistance Program developed by the FDIC and the other
federal bank regulatory agencies indicates that, under current policy, certain
banks are "too big to f a i l " .

a.

This policy Is the result o f :

(1)

A conscious policy of avoiding potential alledged ripple e f f e c t s in the
economy from a large bank failure, and

(2)

The FDIC's professed administrative inability to quickly pay off
accounts in failed large banks.

b.

A federal " f a i l s a f e " policy leads to serious safety and soundness concerns,
since management in " f a i l s a f e " banks could lack fundamental incentives
to limit riskiness. The " f a i l s a f e " policy is inequitable in that:

I.




Stockholders in " f a i l s a f e " banks are more likely to see their
investments protected than are stockholders in banks that are
allowed to fail;

12
2.

Under current policies, depositors with more than the insured
amount in their accounts are In e f f e c t fully Insured In " f a i l s a f e "
banks, in contrast to their treatment when a small bank fails and
they are forced to endure delay and less-than-full recovery of
their deposits;

3.

Investors, depositors, creditors and borrowers are more likely to
be impressed with the solidity and stability of a " f a i l s a f e " bank,
resulting in a competitive disadantage in the funding and
ultimately the profit arenas for banks that are not " f a i l s a f e . "

7.

The combination of current law, which provides no limitation on the amount of
assistance to a bank found to be "essential" under Section 13(c) of the Federal
Deposit Insurance A c t , and the F D I C s announced commitment to provide
whatever capital assistance Continental may need, means that the potential
cost of saving Continental could be even larger than the CBO estimate of $3.8
billion.

S.

The Continental Assistance Program suggests that undue discretion has been
vested in the FDIC to provide aid under section 13(c) of the Federal Deposit
Insurance A c t .

a.

The explanation provided by regulators in justifying the need to amend
section 13 (c) to bring about the present text of this section was expressed
in terms of assisting thrift institutions, not assisting depository
institutions generally.

b.

The wording of recent legislative changes to make assistance more easily
accessible to institutions deemed "essential" to their "communities" has
led to confusion over whether the FDIC has authority in e f f e c t to
guarantee all depositors in banks it assists, notwithstanding the<$l00,000
thousand statutory limit on deposit insurance.




13
A fundamental rethinking by Congress of (lie purposes of section 13(c) is
needed, with consideration given to:
(I)

equipping the FDIC with the resources to liquidate large depository
Institutions;

(?)

clarifying Congressional Intent regarding the meaning ol
"essentiality";

(3)

establishing clear procedures for providing federal assistance to
depository institutions Including cost test standards, consultation
with Congress, and supervisory documentary access by the
appropriate committees of Congress and the General Accounting
Office.

One of the appropriate actions that FDIC may take in providing assistance
under section 13(c) is to attach conditions to the extension of assistance.
In CINB's case, several top o f f i c e r s of the bank received lucrative
separation packages (so-called "golden parachutes"), even though those
same o f f i c e r s ' policy decisions led in great degree to the conditions that
resulted in CIND's need for federal assistance. FDIC was hesitant to take
action to void these agreements, at least in part because of the lack of
clarity In the standards that apply In such cases. A standard that focuses
on whether such agreements are fair and equitable under the particular
circumstances and do not threaten the toss of public confidence in the
entire banking industry may be an appropriate standard for FDIC to apply,
rather than simply whether the agreement adversely a f f e c t s the
Institution's safety and soundness.




CHAPTER

M

P O U C Y COMMENTS
T t * circumstances that led to Continental's difficulties and the ensuing federal
rescue e f f o r t , In one fashion or another, touch upon every banking policy question of
significance today.

At the heart of concern about the handling of Continental is the

controversy over whether a bank Is more a private enterprise or a public utility.

Related

to this are the questions that can be raised about the equity of permitting in the U.S.
banking system a category of "failsafe" or "no risk" banking institutions which compete
directly with all other banking companies.

That Continental needed to be rescued at all

reflects a banking risk situation in this nation which for a variety of reasons appears to be
serious and has broad Implications for evaluating deregulation proposals. Lastly, the need
for a rescue and the rescue itself has made deposit insurance reform, and possibly agency
reorganization also, a matter deserving Congressional attention.

Role o l Banking in the U.S. Economy

Continental

is one ol

enterprises in this nation.

the oldest

and was one of

the most venerable banking

Its one hundred thlry-year history is a recapitulation of the

best and worst In American banking. The relationship of Continental to the Insull utilities
empire in the 1920s is a thoroughly studied and often cited example of why the legal
separation between banking and commerce must be maintained.

Continental's rescue in

the 1930s by the Reconstruction Finance Corporation is in turn an example of e f f e c t i v e
government Intervention.

To its credit, modern, high technology companies such as Apple

Computer can point to Continental as early providers of essential financial support.

To

its detriment, Continental permitted an excessive concern about growth and "performance




(14)

banking* to cloud and eventually undermine its credit judgments and management
practices.
The Continental rescue Itself Is a reflection of far older elements In the history of
banking.

Since Its earliest beginnings, banking and governing have been Inextricably

Intertwined.

The financial relations between the Vatican and Florentine bankers, and

those of King William III and the newly formed Bank of England, were no less close than
those of modern governments and their central and large private banks. Responsibility (or
monetary security, a critical element of national economic health and growth, has been
borne for centuries by governments and banks together and still Is.

The special role of commercial banks In the U.S.

economy Is traceable to the

original diarter of the Bank of England In 1694. In that charter, Parliament provided a
bank with corporate privileges and specified "banking powers" In return for raising capital
for national purposes.

When the first banks were chartered in the U.S., they were

established In the Image of the Bank of England.

The public responsibility of a bank,

particularly a bank chartered by the federal government, was clearly stated in early court
cases Involving the National Banking Acti

National banks are Instrumentalities of the federal government, created tor a public
purpose...
(Smith v. Wltherow, C.C.A.Pa. 1939, 102 F.2d 638)
National banking corporations are agencies or instruments of the general
government, designed to aid in the administration of an important branch ol the
public service, and are an appropriate constitutional means to that end. (Pollard v.
State, 1180, 63 Ala. 628)
The national bank system was devised to provide a national currency secured by a
pledge of United States bonds, and national banks are agencies or instruments of the
government for that purpose. (Davis v. Elmira Savings Bank, N.Y.I896, 16 5.Ct.
302, 161 U.S. 273, 40 L.Ed. 700)
ccnturles old relationship between banks and the governments which charter
Item has always Involved the imposition of some measure of government supervision and
availability of government assistance should a bank fall Into financial jeopardy.
Oucouit window credit from the Federal Reserve and financial assistance from the FDIC
M tha first-line sources of aid to commercial banks in the U.S. In Continental's cjse,
m




16
support from private banks, the Federal Reserve, and the FDIC were combined In an
asistance package for which the FDIC had overall responsibility and In which It had the
greatest investment.
The Federal Deposit Insurance Act authorizes the FDIC to provide assistance to a
failing bank within two general categories.

First, the FDIC is directed to provide

assistance, if providing aid would reduce the FDIC's overall cost of handling the (allure.
Second, the FDIC is authorized to provide assistance II the bank is "essential" to attaining
the "public purposes" of banks, that is, in the words of the statute, "essential to provide
adequate banking services to its community."
The aid extended to Continental was In the second category

— Continental was

deemed "essential* and therefore deserving of assistance regardless of whether a cost
analysis focusing narrowly on Continental alone Indicated that the FDIC's costs would be
lower by not providing assistance.

Whether the FDIC properly utilized Iti "essentiality"

assistance authority and adequately documented that Continental Is Indeed "essential"
*were matters which received the Subcommittee's close attention.

The Subcommittee's

detailed review of these matters was motivated by concern about the potential long term
costs of creating an adverse incentive system for banks versus the perceived short run
benefits of containing a potential banking crisis.

Clearly some banks, or depository

institutions generally, are essential for national, regional, or local economic well-being.
What is not clear is the merit of permitting the present degree of FDIC discretion In
determining which institutions are "essential" and which are not, to continue.

"No Risk** Nature of Large Bank Deposits
On May 17, when the agencies attempted to assure all creditors of Continental bank
that their interests were secure, the FDIC's modified payoff experiment was brought to an
end. That experiment was an effort to introduce a greater degree of market discipline in
banking by requiring investors with amounts on deposit in a failing bank above the
insurance coverage limit to incur a loss proportional to the liquidation value of the bank.

The FDIC's experiment is an important milestone in contemporary U.S. banking
history.

Theretofore, the sequence of aid extensions to the United States National Bank

of San Diego, Franklin National Bank, and First Pennsylvania National Bank, by our




government

and to major banks In other countries such as National Westminster Bank by

the British government, had established a widespread belief that the very largest banks in
any country were "failsafe" and could be Invested In without fear of loss.
The FDIC perceived that this view was contributing to Increased banking risks In the
U.S. and that It would ultimately have to bear the cost. First with the closure of the Penn
Square National Bank and then with the Implementation of an experimental modified
payoff

program, the

depositor/Investors.

FDIC attempted

to limit

the "no risk" expectations of

large

It was expected that large depositors would be more reluctant to

Invest In riskier banks It they perceived a meaningful potential for loss. The termination
of the modified payoff experiment accompanied by assurances to Continental creditors
and financial aid for the Institution, could only be Interpreted as a reinstatement of the
•no risk" expectation with the possible refinement that "essentiality" rather than sheer
•lie Is the appropriate Investment criterion.

It Is Important to keep In mind that the "no risk" or "failsafe" In this context does
not mean that the Institution cannnot or will not be permitted to fail.

The Franklin

National Bank ultimately failed, and there is no guarantee that Continental will be a long
Urm commercial success.

What It means li that an "essential" banking firm will not be

permitted to fall in a manner that would cause widespread economic hardship through an
abrt{>f curtailment of banking services or cause a calamitous decline in public confidence
In tha banking system.

While ultimate failure may have many of the benefits market advocates praise, that
Is, management and equity investors incur losses with appropriate disciplinary lessons to
•iters, for Urge depositors there is no meaningful difference between no failure and
tslayad failure.

So long as the government prevents precipitous bank closures, large

•^Insured depositors will have time to get out of a troubled bank without loss. From their
f**»p«ct|ve, slow failure is the same as no failure and also the same as 100% deposit
insurance.

The competitive implications of this fact are important. A small bank in an isolated
tunity might qualify as an "essential" bank and be eligible for aid. Several such banks




18
have been provided "essentiality" assistance by the FDIC.

For all practical purposes,

however, it appears that a banking institution would have to be larger than the Penn
Square National Bank to be deemed "essential", and thereafter, the larger a banking
institution is, the more "essential" it would seem to be. For large Investors the decision is
simple, place uninsured funds only in ihe largest Institutions.
This suggests that over time large banks will be able to attract capital at a lower
cost than comparably sized nonbanking companies and smaller banks.

There will, no

doubt, always be a place for the locally owned bank in isolated communities, banks which
have taken on very specialized purposes for themselves, and so called "boutique" banks.
However, in those market areas and product lines representing the bulk of banking and
related financial services, the advantage of lower capital costs for the largest institutions
is an advantage the confirmation of which should be weighed carefully.
In a world where banking Institution size and "essentiality" are virtually synonymous,
^al! large banks and companies of any type affiliated with a large bank will have a capital
cost

advantage.

Over

time that advantage may result in preventing U.S. banking

customers from receiving the full benefit of an actively competitive banking structure.
Eliminating the competitive advantage of large institutions requires as a first step that
consideration be given to proposals which would eliminate the "no risk" protection for
large depositors, or extend "essential" status to depository institutions of all sizes.

Before

reviewing

some

of

the

proposals

advanced

I
|o

achieve

constructive

modifications in the deposit insurance system, Continental's problems need to be looked at
in the context of banking risk generally.
Banking Risk
Since 1980, the ratio of loans classified by examiners as "substandard," "doubtful," or
"loss," to gross capital at all federally insured banks rose from an average of 28% to 38%
in 198).

Over the same period, the number of problem banks rose from 217 to 6<i2, and

number of banks failing in a year rose from 10 to <»8 (See Table 18.)




The trends suggested by such evidence are not what regulators or legislators would
prefer to see. Tl>e apparent upward trend in risk may have several causes. The transition
from the inflationary economy of the late
today, rendered obsolete

1970s to the low inflation environment of

many management

mlnlmlie risk In a high inflation environment.

practices

and portfolios

structured

to

The I9SI-1982 recession weakened many

previously sound borrowers, and the high dollar exchange rate and the resulting trade
deficit continue to put pressure on many U.S. firms. The competitive pressures released
by deposit Interest rate deregulation in the late 1970s, required many banking institutions
to take on greater portfolio and operating risks.

In addition to these macroeconomic forces, institutional factors are also cited as
causes of the risk trends.

Academic observers, such as Professor Edward Kane at Ohio

Slate University, point to the very existence and structure of federal deposit Insurance
ItMlf, as an inducement to greater risk-taking by Insured institutions.

Others, such as

IVofetaor Anthony Santoinero at the Wharton School, have suggested that raising bank
capital adequacy standards causes banks to make riskier, higher yielding loans In an elfort
to maintain a satisfactory return on equity levels.

The consequences noted by observers

•ucft as Kane and Santomero are explained to be the result of the profit maximization
goais of banks and bank holding companies.

The macroeconomic

and institutional

forces that have contributed to greater

Iwiring risk generally do not fully explain or excuse Continental's problems. Other large
U.S. b*iks have and are coping with these forces and adapting to them. One aspect of
thtae larger forces Is particularly worthy of concern.

In the mid-1970s the banking

Industry at a whole and Continental in particular had In operations, capitalization, and
earnings, a capacity to cope with major economic disturbances that is reflected to a
tfjrUflcant degree in the earnings, capitalization and asset quality ratios that prevailed
those years. The decline in those ratios since the 1970s suggests that the banking
Muatry hat less ad|ustment capacity than It did In earlier years.




20
Risk and Deregulation
The examination and supervision ol Continental raise difficult questions about
whether the federal regulatory process is capable of assessing and restraining the trends
noted earlier. Factors which ultimately led to Continental's difficulties were hoted in the
late 1970s by examiners and supervisors but were not viewed as significant enough to
warrant active regulatory intervention in the early 1980s when aggressive action might
have caused or enabled Continental to correct the problems which later overwhelmed it.

Considered together, the Mno risk" nature of large banks and the seeming difficulty
of federal supervisors to assess and act on undue risk before it manifests itself in costly
failures, highlights the long standing Congressional concern about whether expanding the
list of permissible bank holding company powers would worsen the risk situation in
banking.

That such a potential exists is reflected in the fact that the most widely

considered proposals to permit new activities specify that they can be engaged in only by
tjolding company affiliates and not by the subsidiary banks themselves.

It Is argued by

supporters of such proposals that the use of affiliates Is an effective way to separate the
risks of the new powers from a holding company's bank subsidiaries.
This line of reasoning is disputed by the relationship between Continental bank and
its holding company.

Regarding that relationship, Margaret Egglngton, Acting FDIC

General Counsel, commented, "...for all practical purposes each of the two entities is the
other's alter

ego..."

(FDIC

Memorandum

toi Board of

Directors, From: Margaret

Egglngton, Acting General Counsel, Subjecti Legal Authority for Section 13(c) Assistance
to Continental National Bank and Trust Company, July 23, I9f#, p. 3) The covenants in
Continental's holding company debt instruments which forced the FDIC to provide its
assistance to the bank through the holding company, are not unique to Continental and
weigh against claims that a bank subsidiary is financially separable from its parent or its
nonbank affiliates.

This does not necessarily mean that banking organizations should be prohibited from
engaging in new activities.

Professor George Benston has argued that many of the new

activities banking organizations propose to enter may be less risky than commercial
banking and that their participation in these activities might strengthen the banking
system, ratlier than weaken it.

In an Increasingly competitive environment, the risks ol

relying soley on business strategies developed in a time when money market conditions
were more predictable are likely io be greater. Until the ability of the regulatory system




to oversee (he pursuit of a multitude o( business strategies is enhanced, every conceivable
course is likely to entail an uncomfortable degree ol risk.

The failure of Continental

served as a warning that the task of improving the system of regulating depository
institution holding companies and their affiliates should be actively pursued.
Viewing the separability question broadly, the FDIC In its 191) deposit Insurance
report to Congress said,
Although no precise tabulation has ever been made, the weight of opinion
seems to be that it is impractical to think that the future of the bank can be
separated from the future of the company of which it is a part. The public, it
Is argued, will Inevitably view the Institution as one.
(Deposit Insurance in Chanting Environment, Federal Deposit Insurance
Corporation, April, 1983, p. xiii)
Former Citicorp Chairman Walter Wriston addressed the separability question quite
blifitly In 1981 congressional testimony:

,.Jt is Inconceivable that any major bank would walk away from any subsidiary
of Its holding company. If your name's on the door, all of your capital funds
are going to be behind it in the real world.
Lawyers can say you have
separation, but the marketplace is persuasive, and it would not see it that way.
(Financial Institutions Restructuring and Services Act of 1911, Hearings before
the Committee on Banking, Housing, and Urban Affairs, United States Senate,
October, 1981, pp. 589-590)

U risk separability within a holding company is not an operative concept, the focus
governmental attention shifts from the bank subsidiaries alone to the holding company
ftfiafally, and the historically Important responsibility for national monetary security
from the shoulders of government and banks to government and bank holding
cw^wiics.

For those holding companies that could be deemed "essentiar to national, or

International,

economic

well-being,

the

financial

support

resources

of

the

y i i r w m i n l would be available. For such companies, capital could be obtained at a lower
cool and their competitors would be at a disadvantage unless they too were, or were
tlfiiiated with, an "essential" bank holding company.
fha Implication of Mr. WristonS statement in the new powers debate is clear: a
g i l ni which eapands bank powers within a holding company affiliate constraint, will not
afUct I t * true allocation of risk within the company nor the market's perception of that
n*.

II this If true, new powers legislation should reflect this reality and bank holding

f j m s t should be regulated and supervised accordingly.




22
Deposit Insurance Reform
Of all the Issues touched upon In the course of the Continental Inquiry and in the
public debates concerning Continental's rescue, deposit insurance reform has been the
most often pointed to as an area In which Congressional .ictlon could have concrete and
beneficial results.

The reforms most often cited are ones designed to Introduce greater

market

Into the banking supervision process.

discipline

proposals Includei
organization

Broadly categorized, these

Increasing the disclosure of problem conditions within a banking

directly

premiums) limiting

or

through published changes In risk-related federal Insurance

FDIC payments

to uninsured depositors in a failed or assisted

Institution to the liquidation value of the Institution; reducing the current level of federal
deposit Insurance while providing for utilization of private insurance for deposits over the
federal coverage level) and extending the use of subordinated debt as a form of bank
capital.

All of these proposals merit close attention and will probably receive them.

They are not, however, the reforms that were discussed most extensively during the
Continental hearings.
In those hearings, the Subcommittee Members expressed a need for a variety of
changes in the way in which federal assistance is provided to problem banking institutions.
Among the Items cited In colloquies between the Members and witnesses were needed
statutory changes to provide fori clarification of what constitutes an "essential" banking
institution, a more structured assistance review and decision process, thorough cost
justification standards, equal treatment of all banking institutions, and if "no risk" banking
is undesirable, FDIC acquisition and development of the ability to liquidate a large
banking Institution.

These reforms represent refinements of the existing insurance and assistance system
and reflect a basic belief that assistance had to be and should have been extended to
Continental. They also reflect a sense that proposals to reform the federal insurance and
assistance system in major ways may not attain the intended goals.

In the academic

literature proposing and analyzing major reform proposals, one of the most telling




23
statements on the subject ol deposit Insurance reform appears in a footnote which sayss
Interestingly, just as policy makers have now picked up the arguments of the
academics, there are now signs that at least some (academics) may now be having
second thoughts.
(Market Discipline and tl>e Prevention of IVink Problems and Failures, K.A. Eisenbels
and
Gilbert, mimeograph, August I98<«, p. I)
For

the most part, proposals

for

major

Insurance reforms depend

for their

effectiveness on banking institution stockholders, bondholders, and/or uninsured depositors
being required to incur losses if the institution falls or requires assistance.

In the past,

the market disciplines inherent in such reforms were viewed as unambiguously desirable.
More recent analysis and the Continental experience suggest that the "market* does not
always discipline, it sometimes punishes, and some of the reforms regarded as attractive
In the past,

...involve Increasing a particular kind of discipline which Increases the
likelihood that runs will occur. This holds the potential, both to destablue the
banking system and to increase the costs of individual failures to the insurance
agency.
(Ibid, p. 16)
Nevertheless, if any benefits of market discipline are to be obtained, appropriate
disclosure of material information is essential to restrain managers who might otherwise
be tempted to expose institutions to excessive business risk. Differences in accounting
and disclosure practices among various segments of the depository institutions industry
trill limit the ability to effect changes in a timely manner.

Therefore, appropriate

Changes In the deposit insurance system should be adopted in sufficient time to permit
thsm to take effect in an orderly way.

fhe Continental rescue has changed the course of modern banking history.

It has

reestablished and clarified the need to actively examine and supervise banking institutions
•I all sites and diminished the expectations of relying heavily on market forces.
viytfang, the Continental experience
Mrkelplace at work.

was a very

impressive

demonstration

of

If
the

The fact that in the current era, neither the banking industry nor

Its regulators were willing to let the market have its way is a revealing statement about
few much the wellbeing of our society and banking are interlinked and how much
^regulation the banking industry and this government are really prepared to permit.




CHAPTER IV
MANAGEMENT

A.

Strategic Planning

An essential element to the management of a large organization such as Continental
Illinois Corporation is an effective strategic planning process.
enterprise's definition of its objectives and business.

A strategic plan Is an

It establishes Its program and

priorities and integrates the Impact of the operating programs on its Income, expenses,
and cash flow.

Continental Illinois Corporation(CIC) appeared to have relied heavily on

strategic plans as did other large entitles. CIC prepared an annual Three Year Strategic
Plan which set forth numerical

targets and goals.

In 1976, CIC's overall goal, as

announced by its chief executive, was to achieve a position as one of the top three U.S.
banks as perceived by U.S. and foreign multinational corporate markets In I9SI.

In implementing the goal to become a major lender to corporate customers, CIC
revamped Its organization and adopted a strategy of decentralized lending, delegating
major responsibilities to lending officers in the field and encouraging them to respond to
customers and make more loans more quickly and competively. Such an approach required
fewer controls and fewer levels of review.

In conjunction with the loan expansion, CIC

adopted a strategy of specifically targeting the energy sector for Its most aggressive
lending expansion. During the late 1970's, CIC outperformed its peers In growth, earnings,
and market acceptance and its loan loss record gave an excellent appearance (for further
detail see section D).

By 1981, five years after announcing its goal, CIC became one of the largest
corporate lenders in the U.S. From 1976 through 1981, CIC's total assets increased $22.3
billion from $18.6 to $<il.l billion.

The growth was made possible by a management

accountability framework that gave individual loan officers more lending authority than Is
generally found in other money center banks and that encourage rewards loan growth.
The management objectives of CIC/CINB were clearly reflected In the 1980 and
1981 corporate plan "Performance Relative to Corporate Goals," Internal Competitive and
Performance Analysis." CINB's corporate goals were ranked as followsi




(24)

1.

Earnings per share

2.

Average assets growth

).

Average earning assets growth

k.

Return on average stockholders equity

J.

Return on average assets

6.

Return on average earning assets

7.

Average assets/Average total capital

I.

Average earning assets/Average total capital

9.

Average risk assets/Average equity and reserves

10. Average debt/Average total capital
I I . Dividend payout
12. Internal funding rate

Associated with each corporate goal was a specific and clear numerical target. In
Hfit of CINB's later problems and the practices of other money center banks, It is
noteworthy that there was no specific target tor loan quality.

Ultimately the very strategies that brought about this growth turned against CIC.
la mid-1911, the economy entered a deep recession, and the quality of available lending
•fporiirfiJtiei declined.

Nevertheless, CIC continued to increase its corporate lending,

* « v t u b l y making loans to weak borrowers.

By mid

1982,

It

became

clear

that

Continental's

problems

stemmed

from

A M f t m e n t strategies and policies of achieving rapid growth, that depended on a strong
w m m y in general and the energy Industry In particular, at the expense of asset quality.




ft.

Internal Control!

The American Institute of Certified Public Accountants (AICPA) defines a system of
internal controls In Its statements on "Auditing Standards" as:
as the plan of organization and all the methods and procedures adopted by the
management of an entity to assist in achieving management's objectives of
ensuring, as far as practicable, the orderly and efficient conduct of

its

business, including adherence to management policies, the safeguarding of
assets, the prevention and detection of fraud and error, the accuracy and
completeness of the accounting records, and the timely preparation of reliable
financial Information.
An accounting

system supplemented by effective Internal controls can provide

mangement with reasonable assurance that assets are safeguarded from unauthorized use
or disposition and that financial records and statements are reliable.
The

environment

effectiveness of

in which

internal

control

the specfic control procedures.

operates

has an

impact

on

the

A strong control environment, for

example, one with tight budgetary controls and an effective internal audit function, can
significantly complement specific control procedures.

However, a sti*or.g environment

does not, by Itself, ensure the effectiveness of the overall system of internal control.
stated

in

the

AlCPA's

"Statements

on Auditing

Standards,"

the

Internal

As

control

environment may be affected by three factors discussed below.

Organization Structure
The organizational structure of an entity serves as a framework for the
direction and control of Its activities. An effective structure provides for the
communication of the delegation of authority and the scope of responsiblities.
It should be designed, Insofar as practicable, to preclude an individual from




overriding

the control system and should provide for the segregation of

incompatible functions. Functions are incompatible if their combination may
permit the commitment and concealment of fraud or error.

Functions that

typically are segregated are access to assets, authorization, execution of
transactions, and recordkeeping.

Personnel
The proper functioning of any system depends on the competence and honesty
of those operating it. The qualifications, selection, and training as well as the
personal characteristics of the personnel involved are Important features In
establishing and maintaining a system of internal control.

Management Supervision
Management is responsible for devising and maintaining the system of Internal
control.

A fundamental aspect of management's stewardship responsibllty is

to provide

shareholders

adequately controlled.

with reasonable

assurance

that

the business is

Additionally, management has a responsibllty

to

furnish shareholders and potential investors with reliable financial information
on a timely basis.

An adequate system of internal accounting controls Is

necessary to management's discharge of these obligations."

Of the three items mentioned above, management supervision may have the most
toftel

on tha Internal control environment, in carrying out its supervisory responsibility,

• migtmtnt should review the adequacy of internal control on a regular basis to ensure
all significant controls are operating effectively.
Bi1

In accomplishing such a task,

- | — — • will in most cases have audits performed by their internal audit department
fcmfcparvknt public accountant.
I,

kttcrral Audit and Independent Public Accountant
4. Internal Audit Role
Internal auditing for a banking entity Is defined by the Dank
Administration Institute as "an independent evaluation within that entity
to review accounting, financial, and other operations for the primary
purposes of fraud prevention and detection." According to CIC's internal




audit manual, the Internal audit function had primary responslbllty to
safeguard corporate assets for the shareholders fn<J depositors by
ascertaining whether the procedures and methods used to record and
process transactions were in accordance with policies prescribed and
Internal control standards authorized by management. The Internal
Audit Department reported directly to the Audit Committee of the
Board of Directors as well as to the Corporate O f f i c e . The Department
was organized along the lines of a public accounting staff and was
functionally divided Into areas of responsibility such as Bond and
Treasury, Commercial and Real Estate Lending, Personal Banking,
Loans, Trust, International (foreign branches and subsidiaries), and
Electronic Data Processing. These functional lines tended to follow the
organizational structure of the Corporation, which afforded the auditor
the opportunity to specialize in a segment of the organization and to
Interact with smaller groups. Worldwide Internal audit consisted of a
staff of approximately 200 by 1983. They were located in Chicago (staff
of 160 to cover domestic operations and the Americas), London (staff of
30 cov

ig Europe and the Middle East), and Hong Kong (staff of 10

covering the Far East units).

In accomplishing

Its objective, CIC's Internal audit

department's

policy was to examine ail branches, departments, and subsidiaries on an
unannounced basis.

Major concerns of the auditing department included

a review and evaluation of the system of internal controls; the accuracy
of

financial

records, as well

as the activity

corporate policies and regulatory guidelines.
auditing

department

recommended

actually Implement them.

control

for compliance

with

Although the internal

changes, they could not

The purpose of this policy was to retain the

independence necessary to continuously evaluate controls and point out
any weaknesses or potential weaknesses.
adequacy

It should be noted that the

and maintenance of controls was the reportsibility of

divisional/unit management charged with performing that function.




the

Thus, the Internal audit function as represented In CIC was viewed as
a separate component of internal control undertaken by specifically
assigned staff within the entity with the objective of determining
whether other Internal controls were well designed and properly
operated.

b. Independent Public Accountant's Role
From 1970 to October of 1984, Continental Illinois Corporation (CIC)
had engaged Ernst & Whinney as their independent public accountant to
perform an examination of

its financial statements.

The primary

objective of an examination of financial statement made in accordance
with generally accepted auditing standards leads to the expression of an
opinion on the fairness of those statements In conformity with generally
accepted accounting principles consistently applied.

As part of each

financial statement audit, the independent public accountant is required
by generally accepted auditing standards to perform a proper study and
evaluation of

the existing internal control.

The Independent public

accountant's objective in studying and evaluating internal control is to
eaublish the reliance he can place on those controls In determining the
nature, timing and extent of his substantive auditing procedures.

In complying with this standard, the auditor Is interested primarily in
the reliability of data and the safeguarding of assets and records.

This

emphasis stems from the auditor's need to determine whether

the

financial statements are fairly presented in accordance with generally
accepted

accounting

principles.

Although

the

auditor

emphasizes

controls concerned with the reliability of data for external reporting
purposes, he should not disregard controls concerned with operational
efficiency and adherence to prescribed policies.

If an entity (ails to

follow the rules and procedures set forth by management or is highly
inefficient, it Is less likely to have accurate financial records.




In accordance with generally accepted auditing standards, the study
and evaluation of CIC's system on internal control are used by the
independent public accountant to perform the following functions:

*

Determine Whether an Audit Is Possible.
The adequacy of the system of internal control Is crucial to the
accumulation of accounting data for preparation of the financial
statements. If the system is inadequate or nonexistent, it is virtually
impossible for the independent public accountant to evaluate whether
the financial statements are fairly presented.

-

Determine the Audit Evidence to Accumulate.
The system of internal control is an essential consideration affecting
audit procedures, sample size, timing of the tests, and particular
items to select.

~

Inform Senior Management and the Board of Directors.
When

the

independent

public

accountant

identifies

significant

weaknesses in the system affecting the control over assets or any
other aspect of internal control, including instances of Inefficiency in
operations, there is a professional responsiblity to inform the entity
of the findings. The entity is informed by a letter (required SAS 20)
which must be sent to senior management and the board of directors
or the audit committee.
c. Relationship Between and Internal and Independent Public
Accountants
The role of the Internal audit function within CIC was determined
by management, and its prime objective differed from that of
independent

public

accountant

who

independently

on financial information.

was

appointed

to

the

report

Nevertheless, some of

the

means of achieving their objectives were often similar, and thus, much




of the work of the Internal auditor could be useful to the Independent
public accountant.

The Independent public accountant In turn should, as

part of his audit, evaluate the internal audit function. Ernst A Whinney
stated in its work papers that they performed a detailed evaluation of
CICs internal audit function and believed that internal audit was the
strongest and single most Important element of internal control within
the Corporation.

The number of staff had increased steadily to 200 over

the years, as well as the quality, and audit's scope, and performance.
Thus, Ernst & Whinney believed that the internal audit function, as an
element of Internal control was quite strong.

As a result, Ernst ic

Whinney had reduced its audit work significantly by relying quite heavily
on the work performed by the internal audit function.

Although an adequate internal audit function will often justify a
reduction in procedures performed by the independent public accountant,
it can not eliminate them.

An internal audit function is part of the

entity, and irrespective of the degree of its autonomy and objectively,
can not meet the prime criterion of independence which is essential
when the independent public accountant expresses his opinion on the
financial Information.

The report of the Independent public accountant

b his sole responsibility which Is not reduced by any use he makes of the
Internal auditor's work. Thus, all judgements related to the audit of the
financial

information

must

be

those

of

the

independent

public

accountant.

In addition, other auditors should not rely upon an unqualified opinion
bsued by the an independent public accountant as a substitute for
evaluating the banks internal controls and systems.

&

U M Quality, Management and Evaluation

OCfc principal earning asset was the overall loan and lease portfolio of CINB.
with any type of
with the quality of

loan activity, management

those loans.

An analysis of

should be greatly
loan quality

is of

r fcMporiance to institutions which assume both a credit and an interest rate




rbk on their loans.

Loan quality is mainly concerned with the level, distribution,

and severity of classified loans; the level and distribution of

non-accrual and

reduced rate loans) the adequacy of valuaiton reserves; and management's ability to
administer and collect problem loans.

CIC's Corporate Plan from 1976-1980 Included as one of its specific financial
goals a section dealing with asset quality.
upgrade

systematically

the quality of

The goal as stated in the plan was "to

the asset portfolio consistent

with the

precepts of prudent bank management and the protection of our depositors and
suppliers of capital."

The annual strategic plans from 1977 through 1979 stated that

one of its goals was "to maintain the historic high quality of the asset portfolio."

In meeting this overall objective, management had further stated In policy
statements that the Corporation must maintain a loan portfolio of the highest
quality borrowers with a view towards balancing the size of the loan portfolio
against the corporate net worth, '.he cost of captial, the degree of rbk represented,
and the return on the assets utilized as compared to other alternative Investments.
To ensure these objectives were achieved, CIC placed the loan portfolio under the
general supervision of the Credit Policy Committee (CPC).

The CPC consbted of ten executive or senior vice presidents from General
Banking Services and Real Estate Services.

The Committee met once a week and

had the responsibility for establbhing policies and procedures with respect to the
pricing and quality of all loan credits.
viewed

as

internal

controb

which

These policies and procedures could be
provide

reasonable

assurance

that

the

corporation's objectives were achieved.

According to CIC's policies and procedures, the decision to bsue credit
initiated activity within the loan cycle.

The Corporation's principal credit Issuance

controls focused on the delineation of lending authority as presented in the Loan
Guidance Memorandum.

The Loan Guidance Memorandum, which was prepared by

the CPC established lending grades for each lending officer and maximum credit
authorizations for each lending grade.

Also, the memorandum stated that at least

two lending officers must approve each credit regardless of the size. Once a credit
was approved, a loan analyst in Loan Operations would prepare a credit summary,




containing financial and credit information applicable to the loan.
summary was then submitted to the Loan Rating Committee.

The credit

This Committee,

which consisted of five vice presidents of diverse credit experience, met twice
weekly to rate credits. Individual credits were rated as follows! " A " prime quality;
"B" satisfactory from a credit standpoint; "C" more than normal risk; and "D" poor
quality.

After the rating was assigned, the loan was placed on the CPC agenda and was
reviewed and approved at the next CPC meeting.

The CPC reviewed all C and D

rated credits and all other credits over $1 million. In addition, some credits needed
prior CPC approval. Such examples were fixed rate credits in excess of $1 million,
C, or D rated credits in excess of $20 million, and all subordinated credits.

The loan review process also included maintaining a "Watch List" of credits
with higher
submitted

than normal risk.
to

Loan

Quarterly, "Watch

Administration

(or

tabulation

List
and

Reports" (WLR)
reporting

to

were
senior

management and the Board. A loan was scheduled to be placed on the Watch List in
several ways. The primary input was Irom the individual lending officers, who had
an ongoing responsibility for monitoring the quality of the credit and identifying any
deteriorating situation. Any "Or rated credit was to be automatically placed on the
list. Credits rated " C , which were to be regularly reported to CPC, may have been
added if CPC decided It should be so classified. Further, any credit criticized in an
examination report was required to be in the WLR system. All credits, once put into
the system, were presented quarterly for re-review by the rating committee.

Loans

could be deleted from the WLR system by lending officers, except those put into the
system by examiners of the CPC.

Quarterly reports were made to the Board

reflecting "C" and "D" rated WLR credits as they related to capital and total loans.
These WLR's also provided input for determining the provision necessary to maintain
the adequacy of the Reserve For Possible Loan Losses.
Although the above mentioned policy and procedures were established,
material weaknesses occurred in the system of internal control and specifically with
the loan evaluation activities.

Significant asset quality problems in tl»e Bank's oil

and gas lending department were highlighted by the Penn Square failure In July 1982.




In 1933 and I98<», significant credit quality and documentation deficiencies were
revealed in all aspects of the Bank's loan operations.
loans were labeled as nonperforming.

As a result, more and more

By 3une 30, I98<», nonperformlng loans

amounted to $2.8 billion as compared to $Ukk million as of January 1981.

3.

Interna] Control Breakdowns

CIC's established internal controls had not prevented the purchase of massive
amounts of problem loans.

The bank's management was more concerned with its

aggressive growth strategy and appeared to dismiss the need for compliance with
adequate safeguards even though management was made aware of the deteriorating
conditions on a number of occasrions. One of the first occasions was the OCC's 1979
and 1980 examinations of CINB. In particular the examinations revealed that

A reappraslal of the credit rating process and system is approprlatei
deficiencies disclosed relating to the identification and rating of

problem

loans;
other loans were found to have eluded the credit rating process.

Capital adequacy and asset quality require continued dlr4c|or attention
ratio of equity capital to total assets has decreased significantly from its
already poor base;
classified assets have Increased during each examination, and Is considered
high at 122% of gross capital funds.

Credit file completeness Is In need of Improvement
missing note sheets, memos, and pertinent data on watch list.

A second alert came from a July 29, 1981 memorandum to management
prepared by Kathleen Kenefick, Vice President in the Bank's Mid Continent Division.
In the memorandum, she stated that the status of accounts particularly at Penn
Square Bank Is a cause for concern and corrective action should be Instigated
quickly.

She complained that potential credit problems could be going unnoticed

because initial credit write-ups were not done correctly, or at all, and other
necessary documentation often was incomplete.




A third alert was the OCC's 1981 examination findings of CINB. In general the
results revealed:

deterioration in the level of classified assets and criticized assets;
classlfied/critized credits were not appearing on the Watch List Report|
no formal charge-off policy for installment lending;
decline in return on assets;
concern over the capital adequacy on asset quality levels.

In particular the examiners noted that approximately 373 credits aggregating
$2.% billion had not been reviewed in accordance with specified control procedure of
one year.

Also, it was noted that f i f t y - f i v e of these credits were not reviewed

within two years.

Based on this examination, OCC concluded that It was evident

that no one was monitoring the situation to ensure that all credits were receiving
timely reviews as required by the corporate o f f i c e .

The fourth alert occurred on November 4, 1981 when two oil and gas engineers
notified the Senior Vice President of the Oil and Gas Group that reserve evaluations
•rtrt being Ignored because other collateral was used to justify lending more than
Iht loan value of the reserves.

They also discussed concern about the high volume

*wJ low quality of the Penn Square participations being purchased.

A filth alert came from two internal audit investigation reports dated October
Ji, 1181 and January <), 1982 on the loan participations at Penn Square Bank. In the
report dated October 26, 1981, the auditors noted that the outstanding principal
balance of participations purchased from Penn Square as of September 30, 1981 was
%% of the entire portfolio of the Mid Continent Division. Continental's purchases
90% of the original Penn Square Bank advance for 80% of the notes and
4»iUr

amounts.

CINB's records of

transactions with Penn Sqaure Bank were

MwnpJeU And Inaccurate and the quality of CINB's security interest in certain
toM

was questionable. The report cited OCC's severe negative comments directed

at Pern Square for inadequate loan documentation and procedures.

The auditors

41m iMitioned Arthur Young's qualification of First Pennsylvania's 1980 financial




statements due to its loan participations with Penn Square where a lack o( sufficient
loan documentation existed to rate loan quality and thus the adequacy of
reserves

for possible loan loss.

Furthermore, the auditors noted that

the

CINB's

purchased participations were 134% of Penn Square Bank's net loans and at least
twenty times Penn Square's total equity.

During the second audit of Penn Square the auditors noted additional areas of
concern:

there were situations in which CINB's lien position or collateral had been

put into question by transactions directly between Penn Square and Its customers;
and there were twelve loans for which CINB had apparently purchased more than the
outstanding balance booked by Penn Square Bank.
one

of

CINB's

executives

had received

This audit also uncovered that

personal

ioans

totalling

$363,000

at

preferential interest rates from Penn Square.

A sixth alert was the OCC's April 30, 1982 examination. In general the results
revealed continued deterioration of the 1981 findings.

In particular, examiners

noted that 436 credits had not been reviewed within 12 months and an additional 76
credits were not reviewed within 24 months.
loans

not

rated

respectively of

for

March,

Also an exception report concerning

April, and May,

I9S2 reflected S6, 89, and 79,

which 62, 59, and 48, respectively

were in the

Mid-Continent

Division. Of more concern to the examiners was the fact that 119 credits criticized
or classified totalling approximately $1.4 billion had no WLR's prepared.

Based on

this examination, OCC concluded that the function and operation of the rating
system and WLR system was staffed by inexperienced personnel.

Therefore, the

independence, and thus credibility must be questioned.

The seventh alert was a bank initiated review of unrated and stale-rated
credits.

A review of the Special Industries Division lor the fourth quarter of 1981

showed $392 million of unrated loans which increased to $893 million by the first
quarter of 1982.

Also, at June 30, 1982, approximately $143.3 million, 13.4% of the

$1.1 billion of Penn Square-related loans and participations were unrated, and $186.7
million, 17.49b were stale-rated.




Finally, on July J, 1982, the system's Ineffectiveness was surfaced to the public
when Penn Square Dank of Oklahoma was declared insolvent and closed by the
Federal regulators. On that date, CINB had approximately $1.2 billion of outstanding
participation loans from Penn Square Bank, of which a significant portion was
determined to be non-performing. For a detailed explanation of CINB's Penn Square
energy lending see Chapter 7.

The evidence appears very clear that there were breakdowns in internal
controls. CIC/CINB's own investigation reported in the Special Litigation Report

loans were disbursed without the approval of officers having the requisite
lending authority; that the creditworthiness of borroweres was not sufficiently
checked; that loans secured by reserves were disbursed without confirmation
by CINB's engineers of the value of the reserves; that loans which could not be
justified by proven reserves were approved through the use of additional types
of collateral which were insufficent and not in accordance with corporate
policies; that In a number of Instances security Interests were not perfected,
that groups of Penn Square participations were purchased without proper
credit Investigation) that there were severe problems of lack of loan and
collateral documentation and past due payments In connection with Penn
Square loans; that the past due notices and exception reports generated as a
result of these deficiencies were largely ignored and that management had
knowledge of or at least warning about many of these matters and that no
e f f e c t i v e action was taken until the situation had severly deteriorated.

Internal audit failed to notify senior management in a timely manner that the
internal controls were not operating in compliance with established policies and
procedures. Internal audit was not aware of material breakdowns In internal control
until management had requested specific investigations and even when aware they
failed to notify senior management and the independent public accountant of such
weaknesses in a timely manner.

As a result, senior management was not able to

take the appropriate action necessary to prevent the purchase of massive amounts
of problem loans, which ultimately led to Continental's demise.




Continental's Special Litigation Report Indicated that CIC's own Internal
audit's investigation regarding the General Banking Services Division's treatment ol
loan exception reports as ot July 25, 1981 concluded that loan operations were
accurately

reporting documentation exceptions.

Nevertheless the same report

pointed out that the Bank's management, direct lending line officers, and members
ol General Banking Services loan operations staff generally recognized that Loan
Operations was Issuing reports that contained many errors.
Also, the report Indicated that internal audit was not sufficiently aware of the
problems raised prior to the Kenefick memorandum dated July 29, 1981 or the
complaints raised by the Oil and Gas engineers on November <», 1981.

Not until

Internal audit was requested to conduct a special review on loan participations with
Penn Square were any concerns raised. After the review, Mr.

Hvlaka, Senior Vice

President and Auditor of the Bank, personally thought the level of Penn Square
participations was too high and that the Bank was "too close to Penn Square for
comfort."
of

the

However, Hvlaka never Informed his nominal supervisor, Vice Chairman

Board of

Directors,

Ernst

A

Whinney, the

Bank's independent

public

accountant, or the Audit Committee of the Board. Furthermore, Internal audit staff
members assured Ernst A Whinney that Penn Square problems related to processing
and that collectabillty

was not an issue.

As a result, the vast bulk of

the

participations were purchased, Increased, or renewed between last quarter 1981 and
July 5, 1982.

On the other hand Ernst A Whinney, the Corporation's independent public
accountant, had not discovered weaknesses in its examination of CINB's statements.
As mentioned earlier, Ernst A Whinney rendered an unqualified opinion on the
Corporation's financial statements during this time period stating that in their
opinion the financial statements fairly presented the financial performance of the
Corporation.

The opinion also implied that no weaknesses in internal control were

discovered that would materially affect the fair presentation of such financial
statements.

Although the independent auditor is not required to detect errors and

Irregularities he does have a responslblity to search for those errors which have a
material e f f e c t an the financial statements.

Thus the independent auditor should

approach an audit with an attitude of professional skepticism.




According to Price Water house, In its Investigation concerning Ernst &
Whinney's performance of its auditing duties, there was inadequate compliance with
the system of Internal accounting control at Continental.

In the opinion of Price

Waterhouse this Inadequate compliance was a material weakness in the system of
internal accounting control as defined by Generally Accepted Auditing Standards in
Statements of Auditing Standards No. 20 as Issued by the American Institute of
Certified Public Accountants.

Price Waterhouse's review of Ernst A Whinney work papers revealed that Ernst
A Whinny had placed significant reliance on Ute work of CINB's Internal Audit
Department

who,

as

mentioned

Continental's internal controls.

earlier,

failed

to

assure

effectiveness

of

Also, it was determined that Ernst A Whinney's

testing of CINB participations purchased or sold appeared to have been limited to
only a review of Internal Audit Department reports.

With respect to past due and

non-accrual of loans, the Ersnt A Whinney work papers Included only a comparative
analysis of past due loans by profit center even though the analysis revealed a
significant Increase in the past due loans of the Mid Continent Division.

Furthermore, the Ernst A Whinney work papers included a memo dated July
10, 1982 (after the failure of Penn Square) which stated that no Penn Square loans
were Included in Ernst A Whinney's sample of the watch list process and concluded
that after Ernst A Whinney learned of the past due situation regarding Penn Square
generated loans, . Ernst A Whinney spoke with internal audit representatives who
assured Ernst A Whinney that the situation was only a processing problem that was
being corrected.
Based on the facts uncovered by Price Waterhouse coupled with the
deteriorating conditions mentioned earlier, it would appear that Ernst A Whinney's
audit procedures while perhaps in accordance with professional standards, did not
detect

weaknesses in CIC's and CINB's system of internal accounting controls,

specifically in the area of loan management.




C. Performance Relative to Peers
In analyzing CIC financial condition from 1976 to 1983 13 financial ratios were
selected under 3 major categories used to measure an institution's financial performance.
For each ratio CIC was compared to two peer groups: (1) 16 of the largest multinational
banking organizations and (2) k of the Chicago area's largest bank holding companies. (See
table I for a list of companies.)

The ratios used in the analysis were obtained from

financial information as filed by bank holding companies with the Federal Reserve.

The

data obtained are based on year-end financial data which has not been adjusted for prior
year restatements.

To supplement the Federal Reserve data, comparative ratios from an

outside consulting firm and reviewed data from the Office of the Comptroller of the
Currency, including bank examination reports of Continental Bank from 1976 through 1983
were reviewed.

(See table on page <i9 for the ratio performance of Continental as

compared to other multinational banks.)

Listed below are the 3 major categories used to measure an Institution's financial
condition.

Included in these categories are the 13 selected financial ratios.

Profitability/Earnings

Ratio 1

Return on Equity

Ratio 2

Return on Assets

Asset Quality

Ratio 3

Net Charge-offs to Total Loans,
Net of Unearned Income

Ratio k

Allowance for Possible Loan Losses to Total Loans,
Net of Unearned Income

Ratio 3




Nonper forming Assets to Total Assets

Capital Adequacy

Ratio 6

Equity Capital • Allowance (or Possible Loan Losses to
Total Assets • Allowance (or Possible Loan Losses

Ratio 7

Equity Capital • Allowance I or Possible Loan Losses •
Subordinated Notes and Debentures to Total Assets •
Allowance tor Possible Loan Losses

Equity Capital • Allowance lor Possible Loan Losses to

Ratio S

Total Loans, Net of Unearned Income

Liquidity

Ratio 9

Total Loans, Net of Unearned Income to Total Assets

Ratio 10

Liquid Assets - Volatile Liabilities to Total Assets

Growth

Ratio 11

Growth in Loans

Ratio 12

Growth in Assets

Ratio 13

Growth in Earnings

The remainder of this section analyzes each performance category and provides
specific information about CIC's financial condition as it relates to other multinational
organizations.

Table I lists performance measures for CIC and its peer group for the

period 1976 through 1983.




Profitability

Profitability ratios are designed (or the evaluation of an organization's operational
performance.

The ratios an indicator of an organization's efficiency in using capital

committed by stockholders and lenders.

The ratios analyzed are return on equity capital

and return on assets.
Return on equity capital

Return on equity capital (ratio I) is the most important measure of profitability for
shareholders because It relates net Income to the book value ol their claims. An analysis
of the multinational and regional data revealed that CIC's return on equity capital for the
period 1976 to 1981 was high and very stable, averaging l<*.31 percent, almost 2 percentage
points above Its multinational peer group. This high return on equity capital was a result
of continued improvement In net income due primarily to a significant Increase in interest
and fee income from an increasing volume of loans.
In 1982 and 1983, CIC's return was M.36 and 3.95 percent, respectively.
and 3 percentage points

This was 7

below the average of the multinational peer group.

analysis, Continental ranked last and next to last.

In the

The extremely low return was due

primarily to a significant increase in the provision for loan loss expenses, a result of Penn
Square National Bank's failure and the bankruptcy and near bankruptcy of several of the
C I C s large Midwest and manufacturing corporate borrowers.

Return on assets
Return

on Assets (ratio

2), which measures the average profitability

of

the

institution's assets, is designed to indicate the effectiveness of management in employing
its available resources.

An analysis of both the multinational and regional data revealed

that C I C s return on assets for the period 1976 to 1981 was high and very stable, averaging
.33 percent, approximately .06 percentage points

above its multinational peer group.

This high return on assets was due primarily to the continued increase In the dollar level
of domestic and foreign earning assets.

Also, CIC channeled a large amount of funds

traditionally held in the form of short term money market investments into loans offering
higher yields but less liquidity.




In 1982 and 198), CIC's return was .18 and .26 percent, respectively.
and .26 percentage points

This was . ) l

below the average of Its multinational peer group.

The low

return was due primarily to an Increase In loans designated as nonperforming. CIC's loan
loss reserve to total loans and net charge-offs to total loans Increased significantly from
.89 and .29 percent in 1981 to 1.24 and 1.37 percent by the end of 1983, respectively. Also,
CIC's net interest margin, the total cost of all its funds contributing to earning assets
subtracted from the yield of all Its assets, was as much as three-quarters of a percentage
point below the average for Its multinational peers.

This financial analysis coupled with a review of bank examination reports from 1977
through 1983 showed Increased earning assets In the period leading up to 1981.

These

higher levels of earning assets were the result of a substantially increased loan volume
which Increased Interest and fee Income.

Also, non-Interest Income was Increased with

the expansion of the credit card operation In 1978.

However, In mld-1982, poor asset

quality, as evidenced by an unprecendented volume of nonperforming loans, dominated
CIC's condition.

CIC's earnings became severely depressed resulting in a signlfIcantly

reduced return on assets.

Asset Quality

An analysis of asset quality is of particular importance to Institutions which assume
both a credit and an interest rate risk on their assets. Asset quality Is mainly concerned
with

the

level,

distribution, and severity

of

nonperforming

assets)

the

level

and

distribution of non-accrual and reduced rated assets; the adequacy of valuation reservesi
and management's ability to administer and collect problem credits.
ratios analyzed arei

The asset quality

net charge-offs to total loans, allowances for possible loan losses to

total loans, and nonperforming assets to total assets. These asset quality ratios (3, 4, and
3) focus on indicating areas of concern in the loan portfolio, since assets of a financial
Institution are represented primarily by loans.
During the period 1978 to 1981, the asset quality ratios of the multinational and
regional peer groups revealed the following.

CIC's ratio of allowance for possible loan

losses to total loans was as much as .09 and .23 percentage points below the average for
the peer groups. CIC's ratio of net charge-offs to total loans was consistently below Its
peers, averaging .29 percent as compared to the peer group's average of .43 and .46




During 1982 and 198 3, Continental experienced a icvere deterlotatlon In iti
quality ratios as compared to the multinational peer group.

The Bank's allowance (or

possible loan losses to total loans Increased significantly from .89 percent In 1981, to 1.1)
and l.2(i percent in 1982 and 1983, respectively.

The Bank's net charge-offs to total loans

increased dramatically (rom a low of .29 percent in 1981 to 1.28 and 1.37 percent in 1982
and 1983, respectively (.7 3 percentage points above its peer group average of .35 and .6<i
for those years).

Finally, Continental's ratio of nonperlorming assets to total assets also

increased dramatically from an average of 1.30 in 1979 to 1981, to 4.6 percent in 1982 and
1983 (2.k percentage points above the peer group average of 2.2 percent).

Capital Adequacy

The primary

function of bank capital is to demonstrate the ability to absorb

unanticipated losses. Capital ratios represent the primary technique of analyzing capital
adequacy.

The capital ratios analyzed aret equity capital to total assets and equity

capital to total loans.

Equity capital to total assets

Equity capital to total assets (ratios 6 Ac 7) indicates the percentage decline in total
assets that could be covered with equity capital and, where applicable, subordinated notes
and debt. The ratios are inversely related to the size of the bank. This reflects the more
conservative stance of small banks and the ability of larger banks to reduce their need for
capital because it is believed they can reduce the adverse e f f e c t s of the default risk and
market risk through the law of large numbers. An analysis of the multinational peer group
data revealed that CIC's equity capital to total assets (ratios 6 and 7) declined from (>.88
percent in 1976 to U.22 percent in 1981. During this period, CIC's rank among its peers
for ratio 6, which includes primary equity fell from seventh to thirteenth. On the other
hand the analysis of ratio 7, which Includes primary equity plus subordinated notes and
debentures, ranked CIC constantly next to last during the period averaging .7V percentage
points below the peer group.

Also, an analysis of the regional data ranked CIC last

averaging .62 percentage points below the peer group for ratio 6 and .75 percentage points
below the peer group for ratio 7.




llMt . .Ml I I .. . O ,

» v..I, « < I. t>
|

II M. X f , I M

•,

U

» . I

denominator based on the belief that the majority of the risk in total assets is in the lo.in
portfolio.

An analysis of the multinational peer group data revealed a steady decline In CIC's
ratio from 7.13 percent in 1976 to 3.26 percent In 1982. During this period, its rank fell
from sixth to last within the peer group.

Regional data also placed Continental last

during the period, averaging 2.43 percentage points below the peer group average.

This financial analysis along with a review of the bank examination reports from
1976 to 1982 reveals that CIC's level of equity capital over the period did not keep pace in
relation to the extremely high volume of loan and asset growth.

According to OCC

examinations, Continental's 1976 capital base was not sufficient to support a rapid loan
expansion.

Also, the 1976 examination pointed out that unlike most other large national

banks, Continental had no definite capital growth plan.

Despite Continental's efforts to

remedy the situation, the bank's strained capital base that existed in 1976 failed to keep
pace with the asset growth and continued to decline through 1981. Continental was able
to assume the additional risk and maintain a strained capital base, whereas others In the
same peer group could not, because of Its successful track record from the early 1970's of
substantial Increases In earnings performance.

However, in 1982 and 1983, when the

quality of Continental's assets was determined to be poor and the earnings on those assets
were depressed, the risk of insolvency significantly increased.

Liquidity

An individual bank's liquidity is its ability to meet deposit withdrawals, maturing
liabilities, and credit demands and commitments over two time periodsi ( I ) the short-run,
a period of less than I year and (2) the long-run, a period Influenced from cycles in
economic and financial activity and the growth In deposits and loans.

Liquidity ratios

provide the primary means of judging a bank's liquidity position. The two liquidity ratios
analyzed are loans to assets, and liquid assets minus volatile liabilities to total assets.




40

Loans to assets

Total loans net of unearned income to total assets (ratio 9) Is a measure of an
Institution's liquidity.

An analysis of the multinational and regional data revealed that

Continental's loans continued to increase, becoming far and away Its major source of
assets.

During the period 1976 to 1983, the Bank's ratio rose significantly from an

average of 58 percent for 1976 to 1978, to 62.8 percent for 1979 and 1980, and to 71.6
percent for 1981 to 1983, approximately 1.3, 3.83, and 10.3 percentage points above its
peers.

In general, this ratio revealed the existence of a poor liquidity position which

dictates the need to further evaluate other liquidity ratios.

Liquid assets minus volatile liabilities to total assets

Liquid assets minus volatile liabilities to total assets (ratio 10) measures the net
liquidity of a bank's total asset portfolio after making deductions for volatile liabilities.
The numerator is reduced because a significant portion of the liquid assets are pledged
against Treasury and other public debt.

An analysis of both the multinational and regional data revealed that Continental's
ratio was extremely poor during 1976 to 1983, averaging - 43.97 percent, or at least 21
percentage points below its peers.

Not only did Continental rank last during the entire

period, but its ratio also increased significantly (from an average of -37.7 percent for
1976 to 1978 to - 46 percent for 1979 to 1980 to - 34.2 percent for 1981 to 1983).

During the period of this analysis Continental was increasing its assets with heavy
loan volume and had to

finance them with more volatile, more expensive

money.

Continental was not adjusting its maturities and asset and liability composition in order to
achieve a relative balance between interest sensitive assets and liabilities. For example,
to support its aggressive loan policy, Continental maintained a high degree of

rate

sensitivity through the heavy use of overnight funds and shortened CD and Eurodollar
maturities.

In addition, Continental began attracting deposits of foreign institutions,

particularly

foreign banks, by in some cases paying them more interest than other

domestic banks.

A t the same time, core deposits from individuals, partnerships, and

corporations remained constant during the period, lagging behind the 8 percent growth
rate reported by Continental's peer group.




47
Growth

Steady and controlled growth Is a desirable characteristic (or an institution.

The

examination of growth ratios reveals useful information about an institution's overall
performance. The three ratios analyzed are growth in loans, growth in assets, and growth
in earnings.

A high correlation existed among all three ratios, growth In loans, assets, and
earnings (ratios I I , 12, and 13). Assets which represented Continental's use of funds had
been primarily driven by a growth In loans whose Interest Income has stimulated a growth
in earnings.

An analysis of these ratios from 1977 to 1981 revealed a steady growth In earnings
averaging 14.8 percent.

This consistent earnings growth, mandated by Continental's

management, was driven by a 16.0 percent steady growth average in assets which was
maintained by a significant growth in loans averaging 19.9 percent.

During this period,

Continental outperformed its multinational peers in both asset and loan growth by 3.<i and
3.2 percentage points, respectively. However, the growth in earnings considered strong by
management was as much as 3.6 percentage points below Its peer group.

In 1982 and 1983, rapid growth trends were eliminated.
significant concern centered on the quality of CIC's assets.

By mid to late 1982

This caused management to

take an extremely cautious approach In acquiring additional loans.
loans were classified as nonperformlng and were written o f f .

Also, a number of

As a result, eernlngs from

interest and fees on loans were severly depressed.

The data confirm an increase in the growth of loans, assets, and earnings for CIC
during the period 1976 to 1981. As mentioned earlier, growth in loans was a major reason
for the growth In assets and earnings.

An example of the growth in loans was sltown by

Continental's loan portfolio increases in overseas loans, energy loans, and loans to lesserdeveloped countries.

From 1976 to early 1982, CINB's loans grew from 60.4 to about 79

percent of total assets.
loans.




Particularly, growth was shown in energy, specifically oil and gas

In summary, from 1976 through 1981 CIC's financial condition, while generally
consistent with its peer group, was gradually deteriorating.

As mentioned in other

sections, CIC's asset growth was the result of a goal to become one of the leading
domestic wholesale banks.

However, this goal was driven by a need to show higher

earnings to the marketplace. Although earnings growth (in dollars), during the period 1976
through 1981 had been impressive, it had not kept pace with asset growth.

Therefore, in

order to show better earnings (in dollar terms) management adopted the strategy of
generating more assets, especially during 1980 and 1981.

CIC's asset growth was based primarily on growth in loans. During the period 1976
through 1981 CIC's loans as a percentage of total assets always exceeded Its peers.

By

1981 this ratio reached 67.k percent as compared to 60.3 percent for Its peers. In general
this situation placed Continental in a poor liquidity position.

CIC's liquid assets minus

volatile liabilities as a percentage of total assets was extremely poor during 1976 through
1981, averaging 20 percentage points below its peers.

This situation occurred because

Continental had to finance its heavy loan volume with more volatile more expensive
money.

Associated with generating a substantial volume of loans over an extended time
period is the high probality of encountering problem loans. Statistically greater lending
results in greater losses. However, CIC's reserves for potential Ipsses as a percentage of
total loans and the actual amount of charge-offs net of recoveries as a percentage of
total loans decreased substantially from 1978 through 1981, averaging approximately .13
percentage points below the peer groups.

Banks experiencing last growth will need to retain a greater portion of their Income
than banks experiencing slow asset growth If they intend to maintain their capital ratio
level.

Continental, however, sacrificed a high capital ratio level to enable greater

earnings per share.

From

1976 through

1981 CIC's equity

capital

which included

subordinated notes and debentures as a percentage of total assets decreased averaging .7 3
percentage points below the peer group.

This reduced capital position would make it

difficult to absorb any Ipsses encountered in the future.




4u

Table I

Peer Groups

16 Largest Bank Holding Companies

1)

Bank of Boston C o r p o r a t i o n

2)

BankAmerica C o r p o r a t i o n

3)

Bankers Trust N e w York Corporation

<»)

Chase Manhattan C o r p o r a t i o n

5)

Chemical New York Corporation

6)

Citicorp

7)

C r o c k e r National C o r p o r a t i o n

8)

First C h i c a g o C o r p o r a t i o n

9)

First Interstate Bancorp

10) Irving Bank Corporation
M)

J.P. Morgan 6c C o . Incorporat

12)

Manufacturers Hanorver C o r p o r a t i o n

13)

Marine Midland Banks, Inc.

m)

Mellon National C o r p o r a t i o n

15)

Security P a c i f i c Corporation

16)

Wells F a r g o <c Company
3

< L a r g e s t Bank Holding Companies in the C h i c a g o A r e a
1

1)

Exchange International C o r p o r a t i o n

2)

First C h i c a g o C o r p o r a t i o n

3)

Harris Bankcorp, Inc.

<0

Nortrust C o r p o r a t i o n




50

D.

Nonbank Subsidiaries

Through

its nonbank subsidiaries, CIC was engaged in a variety ol

activities

including leasing, energy development lending, commercial lending, real estate lending
servicing, venture capital investing, and domestic and international trust activities. While
CINB accounted lor the majority of

the Corporation's assets and earnings, non-bank

subsidiaries of the holding company made some contribution to CIC's profitability In 1981,
1982 and 198).

The impact of nonbank subsidiaries on a bank holding company depends on the scale
of nonbank operations and the performance of those subsidiairies over time.
analysis of

Thus, the

the nonbank subsidiaries Impact on CIC's consolidated financial position

focused on such Items as total nonbank assets to total consolidated assets, nonbank
income

to consolidated

Income, parent

company

loans to the nonbank

subsidiaries,

nonbank loans to the parent, dividends paid to the parent from both the bank and the
nonbank subsidiairies, and investments by the parent in nonbank and bank subsidiaries.
Tables 2 and ) provide (his analysis from 1974 to 198).

An analysis of

CIC's consolidated assets during the period

revealed that CIC was highly dependent upon CINB's growth.

1974 through 1983

Total nonbank assets as a

percent of total consolidated assets were 2.98 percent in 1974 Increasing to slightly over 3
percent in 1982 and 1983. The increase was not due to an increase in nonbank subsidiary
assets, but rather to a significant decrease of $4.8 billion in CIC's consolidated assets, due
to

CINB's

deteriorating

financial

condition.

Without

taking

1982

and

1983

into

consideration, the average ratio of nonbank assets to consolidated assets for the years
1974 to 1981 amounted to only 3.2 percent.

Net income from nonbank subsidiaries were primarily dependent upon CINB during
the period from 1974 to 1983.

Nonbank income increased progressively from a loss of

$12.9 million in 1974 to a gain of $41.7 million in 1981 and $43 million in 1982, before
failing back to $33 million in 1983. Consolidated income for CIC also Increased steadily
from $93.7 million in 1974 to $254.9 million in 1981 before plunging to $77.9 million in 1982
and $108.3 million in 1983. Nonbank net Income as a percentage of CIC's consolidated net
Income reflected a steady increase to 6.1 percent in 1980.

By 1981, nonbank Income

increased to 16.38 percent due primarily to Venture capital subsidiaries. Although these




51
particular subsidiaries represented less than one percent of CIC's consolidated assets at
year-end 1981, they contributed $30 million or 11.6 percent to consolidated revenues.

In

1982, nonbank subsidiaries contributed over 35 percent of CIC's consolidated net income.
This Increase was due primarily to a significant reduction in CINIVs earnings, which were
severly impacted by a large extraordinary addition to the loan loss provision as well as by
Increasing levels of nonperforming assets.

In 1983, as income from CINB increased, the

percentage of nonbank net Income to consolidated net Income decreased to 30 percent of
total net Income.

An

analysis

of

parent

company

loans

to

and borrowings

from

the nonbank

subsidiaries indicated that nonbank subsidiaries were dependent upon the parent from 1970
through 1979.

As of December 31, 1979, nonbank subsidiaries' loans advanced from the

parent had a balance outstanding of $378 million.

However, from 1980 through 1983, the

balance outstanding of loans to and borrowings from the nonbank subsidiaries approached
equal levels, with a balance of $623 million and $321 million respectively.

Thus, the

parent was just as dependent upon the nonbank subsidiaries as they were on the parent.

The parent company's investments in nonbank subsidiaries as a percentage of total
Investment In all subsidiaries was insignificant for the period from 1970 to 1979 averaging
only 0.5 percent. However, the parent's investments in nonbanks doubled in 1980 from $52
million to $163 million, and doubled again by

1983 to $300 million.

The parent's

Investment in nonbank subsidiaries as a percentage represented 9.50 percent in I9S0 and
15.55 percent by 1983.

These increases were due primarily to a $30 million initial

capitalization of Continental Illinois Overseas Finance Corporation, N.V. in 1980 and
further capital injections of $35 million in 1981 and $102 million in 1982. These capital
Injections were made to this subsidiary even though C1ND was encountering unfavorable
condition.

An analysis of dividends paid to the parent during the period 1970 through 198)
revealed that CINB was the primary contributor. According to CIC's Corporate Treasury
Group, which recommended the payment of dividends from subsidiaries to the parent
nonbank subsidiaries were not able to make dividend payments from 1970 through 1980
based on their capital position relative to their size and growth expectation.

Prior to

1981, CINB was the only subsidiary upstreaming dividends to the parent.

In 1981,

however,

the parent

received

26.5

million

In dividends solely

from

the nonbank

subsidiaries. Overseas, Leasing and Mortgage paid dividends of $13 million, $8 million




and $2.5 million, respectively with an additional $3 million in dividends from liquidating
Advisors. According to the Federal Reserve, no dividends were paid by CINB in 1981 In
order to enhance the Bank's capital position and increase its legal lending limits. In 1982
and 1983, CINB resumed its dividend payments to the parent contributing $62 million and
$50 million, representing 82 and 77 percent, respectively.

The remaining dividends

received by the parent during this period were paid solely by the Overseas nonbank
subsidiaries which contributed $14 and 15 million, respectively.

This analysis also highlights the e f f e c t CIC's dividend payout goal had on CIC's
ability to retain earnings.

During 1974 to 1977 CIC retained a portion of the dividends

received from CINB since it paid out less than that to its shareholders. From 1978 to 1983,
however, CIC paid out more in dividends to Its shareholders than it received from all of
its subsidiaries.

CIC's goal of maintaining a steady Increase In dividends paid to its

shareholders caused CIC to reduce the amount of earnings It could retain.

Had CIC

maintained a policy of limiting its dividends paid out to the amount of dividends received
from bank and nonbank subsidiaries reductions in retained earnings of 15.3 million In 1978,
$8 million In 1979, $34.7 million in 1980, $46.6 million in 1981, $3.4 million in 1982, and $
million in 1983 would not have occurred.

In summary It Is clear that the nonbank subsidiaries had a negative Impact on CIC
from 1974 through 1980.

During this period, the nonbank subsidiaries did not pay any

dividends, averaged only $3.4 million in net income, and were advanced $388 million.
From 1981 through 1983 however, it appears that the nonbank subsidiaries made some
contributions with

$56 million In dividends, an average of $19 million in net income, and

$541 million loaned to the parent company.

On the other hand, the parent during this

period Increased its investment In the nonbank subsidiaries by $177 million and its loans to
the nonbank subsidiaries increased by $234 million.

The following two tables show the

impact of nonbank activities on CIC during the period I97<i through 1983.




IMPACT OF NONBANK ACTIVITIES ON CIC
(In thousands)

Year End
1974
19 75
1976
1977
1978
1979
1980
1981
1982
1983




Balances of
Assets
CIC
Non Bank
19,640,747
20,225,633
21,984,899
25,800,280
31,058,665
35,790,119
42,089,408
46,971,755
42,899,424
42,097,371

585/483
559,790
576,889
768,213
921.475
1,320,596
1,741,022
1,667,000
2,199,000
2,129,000

Nonbank
Assets as a
% of CICs
Assets
2.98
2.77
2.62
2.98
2.97
3.69
4.14
3.55
5.13
5.06

Net Income
CICs
Non Bank
95,690
112,890
127,804
143,123
167,817
195,807
225,941
254,623
77,887
108,319

(12,868)
(1,376)
1,463
7,230
5,479
10,190
13,702
41,707
43,000
33,000

Nonbank Net
Inc. as a % of
CICs
Net Income
N/A
N/A
1.14
5.05
3.26
5.20
6.06
16.38
55.21
30.47

IMPACT OF NONBANK ACTIVITIES ON CIC
(In Thousands)

Year End
1974
1973
1976
1977
1978
1979
19S0
19S1
1982
19S3

Balance of
Loans to
Nonbank
from
Parent
183,626
159,411
180,134
252,681
278,563
377,677
388,220
660,530
773,435
622,520




Balance of
Parent
Borrowings
from
Nonbank

—
—

Dividends Paid
to Parent
from
Bank
Nonbank
49,195
60,194
46,996

_
—
—

51f0$l
—
—

147,437
245,844
540,694
540,694

—

33,996
49,995
29,997

—

—

61,994
49,996

—

—

26,465
14,053
15,000

Dividends
Paid by
CIC
37,137
38,754
40,938
43,699
49,336
58,001
64,757
73,081
79,434
80,035

Balance of
Investment by
Parent in
Nonbank
Bank
25,505
38,853
43,817
56,399
62,017
82,515
163,304
230,000
322,600
340,248

806,661
867,041
1,012,141
1,101,721
1,225,954
1,359,826
1,549,093
1,747.403
1,794,271
1,847,194

Nonbank
Inv. as
a % of
Total
Investment
3.06
4.48
4.15
4.87
4.82
5.72
9.54
11.60
15.24
15.55

CHAPTER V

SUPERVISION

A.

Federal Supervisory Framework

1.

Agencies

Three Federal agencies — the Federal Deposit Insurance Corporation (FDIC),
the Federal Reserve System (FRS), and the O f f i c e of

the Comptroller

of

the

Currency ( O C C ) — are responsible for regulating and supervising 14,780 commercial
banks and 5,371 bank holding companies in the United States;

OCC supervises all federally chartered national banks which are required
to be both FDIC insured and members of the FRS.
FRS supervises all State-chartered banks that are FDIC insured and are
members of the Federal Reserve, and all bank holding companies; and
FDIC supervises all State-chartered banks that it insures which are not
members of the Federal Reserve;

Each agency maintains its own structure, including a separate, nationwide network
of regional o f f i c e s , field o f f i c e s , and examiners to supervise banking institutions.

The Government's involvement with banking has led to a unique system of
regulation dispersed among the 50 States and three Federal agencies.

While the

structure of the three Federal bank regulatory agencies is similar, each agency Is
responsible for a distinct set of institutions.

As of 1984, the number and type of

institutions supervised were as follows.

Type of Institution

Reftulator

Number

National Banks

OCC

4,823

State Member

FRS

1,107

State Nonmember

FDIC

8,850

Bank Holding Companies

FRS

371

TOTAL




20,151

(56)

56
To assist the regulators, commercial banks and bank holding companies are
required to file a variety of reports with their regulator.

The Federal Financial

Institutions Examination Council (FFIEC) prescribes the content and form of
reports for banks and monitors the data gathering activities while the

the

Federal

Reserve performs the same function for bank holding companies. Regulators use the
data

to

systems.

monitor

the

institutions

financial condition

through

offsite

screening

The o f f s i t e systems provide data which assist examiners in onsite bank and

bank holding company examinations.

At the culmination of each bank examination,

the examiners give each bank a rating, called a CAMEL rating (for bank holding
companies it Is called a 6 0 P E C rating), which indicates in general the financial
soundness of the institution.
generally 3,

Those banks or holding companies with low ratings,

or 3, are examined more frequently than institutions rated I or 2.

The regulators are also responsible for enforcing compliance with applicable
laws and regulations.

Bank examinations or bank holding company inspections are

the factfinding arm which the regulators use in discharging these responsiblities.
The regulators use various types of bank examination programs and inspections to
meet

their responsibilities.

commercial
financial

or safety

institution

The most common type of examination is called a

and soundness examination
operations

as

and Is used to analyze

deposit-handling,

loan-making,

investment, liquidity, capital adequacy, earnings, and management.

such

securities
Commercial

bank examinations and bank holding company inspections are also used to monitor
internal controls, policies, procedures, and compliance with laws and regulations.
Additionally, the regulators have developed special programs for examining trust
and international departments, electronic data processing services, and compliance
with consumer protection laws and regulations.

2.

Early Warning Systems

Until 1975 the three bank regulators — FRS, FDIC, and OCC — determined the
financial condition of banks solely through onsite examinations.
mid-to-late

1970s,

each

of

the

regulators

had

researched,

implemented an early warning computer screening system.

However, by the
developed,

and

The primary goal of

these systems is to aid the examination process by identifying changes in the
financial condition of banking organizations between examinations.




OI

The computer screening systems are used to analyze quarterly bank data and
semiannual bank holding company data.

The FDIC and FRS use their systems to

d e t e c t changes In bank and bank holding company financial data which indicate
emerging weaknesses. The O C C uses a d i f f e r e n t methodology to achieve the same
purpose.

OCC

uses analysts to monitor

about

100 large national banks and a

combination of computer screening and human analysis to monitor the remainder.

In

those cases where computer screening is used and where banks have been previously
Identified as a problem, all three agencies provide additional monitoring and in some
cases computer

screening.

Because

each o l

the agencies has researched

and

developed its own screening system, each system Is unique to the respective agency.
The regulators have been working to make the process more uniform and have
recently approved a proposal that would provide for uniform screening of financial
data.

Early warning screening systems are not Intended as substitutes lor existing
bank examinations, nor are they designed to predict bank failures or to identify all
unsound banks.

They are intended only to highlight major changes in the financial

condition of individual banks.

Additional analysis, Inspection, or examination Is

needed to determine whether the flagged banks are weak or potentially unsound. If,
after additional

analysis, questions remain

about

a bank's soundness, a

special

examination may be conducted or scheduled examination accelerated.

Because the automated screening systems are based on computer programs
that are limited to certain calculations, the major one being that they will not flag
all problem banks.

A computer screen is only as good as the financial information

used to generate the data and the ratio's used in the screen. Moreover a screen will
not normally Identify those banks subjected to fraud, e m b e z z l e m e n t , or other theft
nor will It readily identify understated amounts on the financial statements.

And

since screens are based on predetermined ratios, they will not necessarily identify
problems f r o m an emerging industry trend, such as problems caused by bad energy
loans, unless a special program has been included in the system.




btt

The screens also have limited capacity to identify changes In management
philosophy which a f f e c t bank soundness.

When a bank's management

philosophy

changes In subtle and unannounced ways, such changes are not easily captured b.y
financial ratios.

A change in mangement philosophy of objectives a f f e c t i n g the

bank's riskiness, profitability, and eventual soundness, may become apparent

to

examiners or analysts from other data before it a f f e c t s the screen's financial ratios.

Finally, the screening systems have limited value when the scores used by the
agency for comparative purposes are too high or too low.

If the passing score is too

high, a large percentage of banks may fail the screening tests, resulting in a high
percentage of banks that require follow up or additional analysis.

a.

OCC's Anomaly Severity Ranking System (A5R5)

Unlike FRS and FDIC, the OCC divides the banks it regulates into two
groups and uses d i f f e r e n t methods to monitor changes in the financial condition
of banks of each group.

The Comptroller's Anomaly Severity Ranking System Is

designed to identify financial changes in most OCC regulated banks, but a
d i f f e r e n t approach is used for multinational and large regional banks.
banks, which number about

100, are monitored daily by O C C analysts.

These
The

analysts review stock prices, public pronouncements, and other Information on
each bank and enter the information Into a computer.

These data are used to

produce a quarterly Internal document, called a fact sheet, which is distributed
to examiners, other regulators, and OCC bank supervisory personnel.

For those banks that are not monitored by analysts on a dally basis, OCC
uses a combination of computer screening and human analysis to track the banks.
For tracking purposes, OCC divides the banks into two groups according to the
C A M E L ratings received by the banks.

Banks rated 3,

and 3 are assigned to

analysts in the Multinational and Regional Bank Analysis Division where close
attention is given depending on need.

Those banks that are rated 1 and 2 are

tracked using a combination of ASRS and human analysis.




In OCC's surveillance section, one or two analysts are assigned lor each
region to track banks that have been screened by ASRS.

In addition to being

screened by ASRS, which Is an automatic process using set ratios, the I and 2
rated banks r e c e i v e special attention from the assigned analysts. As an example,
II the agriculture

Industry Is having a bad year, analysts may be asked to

determine how many banks have a certain amount ol agrlcluture loans or, If
interest rates are rising, the analysts may check bank margin requirements.
Thus, OCC's system
analysts.

includes ASRS as well

as special screens by

assigned

Banks flagged by either the special screen or ASRS are reviewed to

determine whether emerging problems exist.

The ASRS calculates basic ratios and a number of variants of these ratios.
Year-to-year changes In seven critical balance sheet measures are r e f l e c t e d in
two summary ratios which are the principle indicators of bank condition and the
primary determinants of which banks warrant further investigation.

All the

measures used in ASRS are converted into relative values where each bank Is
compared to other banks in its peer group.

There are 21 such groups defined by

asset size, branching status, and rural/urban location.

A list of banks flagged by ASRS Is forwarded to each region.

Regional

specialists evaluate each bank's recent examination reports and the statistical
data contained in quarterly reports on bank performance to determine

what

problems caused the ASRS flag. In the process the specialist may also telephone
or write to the bank to obtain new information on areas of particular concern.
Information developed by the specialist is entered into a system called Action
Control along with any weaknesses uncovered during examinations.

Resporses to

the flag by the OCC regional o f f i c e and by banks are also entered into Action
Control.

A list of all banks in the system, along with their status, is updated

every day.

b.

Warning System Deficiency

ASRS Is more complex than the FRS and FDIC systems. As implied by the
name, anomalous (unusual) behavior of any sort relative to peers flags a bank for




60
analysis by an OCC analyst.
deviates

from

investigating.

A fundamental ASRS principle Is that a bank which

its peers, either

above

or

below

the

peer

norm,

is

worth

A perfect score under ASRS would be zero, that is, close to the

peer group norm for every ASRS measure.

The fundamental weakness in the OCC's survielleqce system was starkly
highlighted by the Continental experience.

Because the

ASRS is based on

spotting individual national bank deviations from its peer group, if the peer
group's financial ratios shift downward together, no anomolous behavior will be
reported.

CINB's peer group, the other large, money center national banks, was

m the late 1970s and early 1980s registering linanciai
CINB.
were

pressures very similar to

So similar in fact, CINB's loan quality, capitalization, and earnings ratios
not

sufficiently

different

from

the

peer

group

averages

to

trigger

aggressive OCC action.

3.

Bank Examinations

On-site examinations have been for many decades and remain the regulators
basic tool for exercising their supervisory responsibilities.

Examinations arose out

of the need to ascertain the financial condition of banks. The growing complexity of
the banking business, however, and the increase in consumer protection legislation
have enlarged the scope of bank examinations beyond the purely financial area and
have led to the existence of several types of bank examinations.

Today, separate

examinations may be made of commercial departments, consumer protection laws
compliance, electronic data processing systems, trust departments, International
branch operations, and bank holding companies.

Despite the expanded scope and the different types of examinations, the
primary concern of the regulators remains the financial condition of institutions.
Thus, the most

important

examination

is focused on bank

soundness.

In its

Comptroller's Handbook for National Bank Examiners, the OCC states that the
essential objectives of an examination are;

(I)

to provide an objective evaluation of a bank's soundness) (2) to permit
tl»e OCC to appraise the quality of management and directors) and (3) to




O&

identify those areas where corrective action Is required to strengthen
the bank, to improve the quality of its perfomance, and to enable it to
comply with applicable laws, rulings and regulations.

In conducting an examination, examiners use a variety of techniques and focus
on a variety of subjects.

Questionnaires are used to test the adequacy of a bank's

Internal controls In providing Institutional protection and in assuring adherence to
management's policies. Bank employees are interviewed and observed as they carry
out their duties.

Sampling techniques are applied to a variety of bank records to

accomplish such goals as ascertaining the elfectiveness of audit systems, assessing
the quality of various types of
regulations.

assets, and checking compliance with laws and

More complete review may be made of such items as past due loans,

loans previously classified in a subpar category, and investment securities.

Over the last two decades or so, as both the volume and types of activities
engaged in by banks have increased, the emphasis in examinations has shifted from
detailed audit and verfication procedures by examiners to review of the adequacy of
a bank's planning and control measures.
bank police itself.

The objective of this shift was to have a

Problems such as excessive bad loans, inadequate capital, and

concentration ol credits are said to receive considerable attention, but substantial
attention it is claimed is now also given to the competence of a bank's board of
directors and management and their involvement in the affairs of the institution.
Accordingly, examinations are said to include an analysis of

a bank's policies,

practices, procedures, and controls with the view towards identifying managerial
weaknesses that could lead to the kinds of problems that were the focus of attention
In the past.

An examination results in a comprehensive report that is reviewed at higher
levels in the regulatory agency and that serves as a basis for discussions between
examiners, bank management, and the board ol directors.

An examination also

results in a rating under the Uniform Interagency Bank Rating System.

Problems

that cannot be resolved to the satisfaction of the regulators by informal meetings
and discussions may result in formal enforcement actions.




62

Tta OCC's current examination policy for sound banks is an examination every
12 months for banks with assets of $300 million or more and every 18 months for
banks with assets under

$300 million.

The maximum interval

between examinations of sound banks is 36 months.
the norm, however.

FDIC will allow

More frequent examinations are

In addition, when an examination is not conducted, at least one

visitation or o f f - s i t e review must be performed in each 12-month period.
policy Is for an examination every

FRB's

18 months provided that there has been no

material deterioration in financial condition since the last examination and no
change in ownership or control at the policy making level during the time.

For

banks that do not meet criteria for sound financial condition, each of the agencies
conducts more frequent examinations.

•.

Bank Holding Company Supervision

The Federal Reserve supervises bank holding companies using an on-site
examination (inspection) process as the primary means to verify holding company
soundness.

The Federal Reserve had not been active in examining bank holding

companies until the mid-1970s.

In 1975, for example, only 13 percent of the holding

companies were inspected, and most of these inspections were made by 3 of the 12
Federal Reserve district banks.

Since 1975, the Federal Reserve has standardized its holding company
inspection

procedures,

reports,

and

rating

system.

It

has

implemented

a

computerized surveillance system and has designed special training courses for
holding company inspectors.

More recently, it revised the frequency criteria for

making onsite inspections to improve flexibility.

The Federal Reserve's program for supervising bank holding companies
includes the following principal features:

A headquarters responsible for suggesting holding company supervision
policies and procedures and for coordinating and evaluating district bank
activities.




Ol)

A headquarters-level computer-based system (or monitoring financial
data reported by holding companies.
Uniform criteria concerning the timing, performance, and reporting of
periodic

on-site

inspection

of

Inspections
bank

of

holding

bank

holding

companies

companies.

that

exhibit

On-site
problem

characteristics are conducted on an annual basis or more frequently, if
needed.

Annual inspections are generally conducted on all bank holding

companies.

Bank holding companies that have total consolidated assets

of less than $100 million and not requiring special supervisory attention
are inspected once every three years.
Some form of organizational subgroup at each of the 12 Federal Reserve
district banks with staff responsible for making onsite holding company
inspections and for performing additional holding company monitoring
activities considered to be appropriate by district bank management.
A requirement to file periodic reports.

All bank holding companies are

required to file Form F.R. Y-6, Annual Report ol Domestic Bank Holding
Companies, on an annual basis.

The report requires the submission of

consolidated and parent only financial statements of the bank holding
company, financial statements of nonbank subsidiaries, an organizational
chart, and information on principal shareholders, officers, and directors.
Bank holding companies that have total consolidated banking assets of
$100 million

or

more

are required

to submit

financial

statements

certified by an independent accountant.

J.

Soundness Ratings

A f t e r each bank examination and holding company inspection, regulators rate
the soundness of the institutions based on specific predetermined criteria.
rating for banks, called CAMEL, is based on five factors
Management, Equity, and Liquidity.
also based on five factors

The

Capital, Assets,

The holding company rating, called BOPEC, is

—the condition of Bank subsidiaries, Other subsidiaries,

Parent company, Earnings, and Capital.




—

A discussion of each rating system follows.

ft.

CAMEL Rating

The determination of a bank's financial condition is not an exact science.
Banks take in funds from a variety of sources and place them in a variety of
investments, or assets.

The funds being taken in, liabilities, a good portion of

which are deposits, are merely on loan to the banks.

If all or a substantial

number of those who made such loans to a bank decided to ask for the return of
their funds at the same time, the bank would be unable to comply.

The bank

could not liquidate, or call In, Its investments fast enough.

This problem makes it difficult to decide what constitutes soundness in a
practical sense.

There being a great many opinions on this topic, It was natural

that each of the federal banking agencies developed Its qwn view.

In response to

Congressional directives In the 197S Financial Institutions Reform and Interest
Rate

Control

Act

and a General

Accounting

Ollice

study

criticizing

the

existence ol divergent approaches, the three federal banking agencies adopted
the CAMEL System in 1979.

This system provides a general framework for a

uniform approach to rating financial Institutions.

Given the substantial degree

of subjectivity inherent In Judging the components of soundness, however, the
CAMEL

System has not brought, and most likely will not bring, complete

uniformity to the approaches of the regulatory agencies.
also more

The CAMEL System is

formally known as the Uniform Interagency Bank Rating

System

(UIBRS) or the Uniform Financial Institutions Rating System (UFIRS).

The CAMEL System has two principal elements. First, an assessment is
made of five critical aspects of a bank's operations and condition.
arei

( I ) adequacy of capital;

These factors

(2) quality of assets; (3) ability of management

and effectiveness of administration; (4) quantity and quality of earnings; and (5)
liquidity, or the capacity to meet the demand for payment of obligations.

The

five factors produce the acronym CAMEL - Capital adequacy, Asset quality,
Management, Earnings, and Liquidity.

Each of the factors is rated on a scale of

I through 3 with I being the most favorable.




A detailed description of the rating guidelines for each of the factors
would be quite lengthy.

Several general observations can be made, however.

First, peer group comparisons in such matters as capital ratios and earnings are
of importance. Second, access to capital markets and other sources of funds can
o f f s e t to an extent certain negative elements; thus larger banking organizations
having ready access to capital markets generally have been permitted by the
regulators

to

have

lower

capital

ratios

than smaller

banks.

management factor can significantly influence the other factors.

Finally,

the

For example,

demonstrated ability to manage lower quality assets can result in a higher asset
quality rating than would normally be the case.

The second element of the C A M E L system Is the combination of the f i v e
factor ratings into a composite rating. Again, the range of ratings Is I through 3
with 1 being the most favorable.

Composite rating I indicates a sound bank In

almost every respect, and composite rating 2 indicates the fundamentally sound
Institution that may have modest weaknesses correctable in the normal course of
business.

Composite rating 3 indicates a combination of

from moderately severe to unsatisfactory,
to be only nominally

resistant

weaknesses ranging

banks with this rating are considered

to the onset of

adverse

business

conditions.

Composite rating 4 indicates an immoderate volume of asset weaknesses, or a
less than satisfactory combination of other conditions.
the bank is present but not pronounced.

A potential for failure of

Composite rating 3 Indicates that

Immediate corrective action and constant supervisory attention are necessary.
There is an extremely high immediate or near-term probability of failure.

The three banking agencies usually do not begin to give banks extra
attention until composite rating 3 is reached.

Thus, composite ratings I and 2

indicate financially sound institutions in the sense that these institutions do not
receive any extra regulatory attention.

The composite CAMEL ratings given to CINB by O C C for 1979 through
1983 were:

1979

1980

1981

1982

1983

2

2

2

3

4




uu

The potential for different interpretations of the financial factors in the
CAMEL rating by d i f f e r e n t agencies is illustrated in the dispute that arose in
1983 between the OCC and the FDIC concerning whether CINB should be given a
CAMEL

rating of

4 or

3.

Continental a 4 CAMEL

According

to FDIC officials, the FDIC

assigned

rating in 1983 because in their views there was an

immoderate volume of asset weaknesses or a combination of other conditions
that could impair CINB's future viability.

FDIC officials said there existed a

potential for CINB failure.

The OCC analysts disagreed with FDIC's rating. OCC said CINB warranted
a 3 CAMEL rating because it was not likely to (ail In the near term and It had
made a $4.82 million extraordinary loan provision to cover losses and still had an
$81 million profit for the year.

In the OCC's view, CINB's 1983 overall financial

condition warranted a 3 rating.

Although these two agencies discussed their

disagreement, neither was willing to change its rating.

For copies of FDIC and

OCC memoranda discussing this debate see Continental Bank hearings before the
Subcommittee on Financial Institutions, Supervision, Regulation and Insurance,
House Banking C o m m i t t e e , pp. 330-332.

b.

BOPEC Ratings

The bank holding company rating system (BOPEC) is a management
information and supervisory tool developed by the Federal Reserve which defines
the condition of bank holding companies in a systematic way. The system adopts
the "component" approach by:

(1) evaluating the financial condition and risk

characteristics

component

of

each

assessing

the

important

analyzing

the

strength

major

interrelationships
and

significance

operating performance characteristics.




of

the bank holding company;

among
of

key

the

components;

consolidated

and

financial

(2)
(3)
and

In order to arrive at an overall assessment of financial condition, the
following elements of the bank holding company

are evaluated and rated on a

scale of one through f i v e In descending order of performance quality:

B -

Bank Subsidiaries

O -

Other (Nonbank) Subsidiaries

P -

Parent Company

E -

Earnings - Consolidated

C -

Capital Adequacy - Consolidated

The first three elements of the rating, I.e., the bank, other subsidiaries, and
parent company, r e f l e c t the contribution of each to the fundamental financial
soundness of

the holding company.

The rating of

consolidated earnings and

capital recognizes the importance that regulators place on these factors and
their crucial role in maintaining the financial strength and supporting the risk
characteristics of the entire organization.

The ability and competence of holding company management bear
importantly on every aspect of holding company operations and, consequently, is
Included as a major factor in the evaluation of

each of

the

five

principal

elements of the bank holding company rating, as well as in the assignment of an
overall holding company rating.

In addition to the individual elements described above, each company is
accorded

an overall

or

managerial component.

composite

rating, comprising

both

a

financial

and

The financial composite rating is predicated upon an

overall evaluation of the ratings of each of the f i v e principal elements ol the
holding company's operations as defined above. The financial composite rating is
also based upon a scale of one through f i v e in descending order of performance
quality. Thus, I represents the lowest and 5 the highest degree of supervisory
concern.

The

managerial

composite

is predicated

upon

a

comprehensive

evaluation of holding company management as r e f l e c t e d in the conduct o ( the
affairs of

the bank and nonbank subsidiaries and the parent company.

The

managerial composite is indicated by the assignments of "S," " F , " or " U " for,
respectively,

management

"unsatisfactory".




that

is

found

to

be

"satisfactory",

"fair",

or

68

The complete rating represents a summary evaluation of the bank holding
company in the form of

a rating "fraction."

The "numerator" r e f l e c t s

the

condition of the principal components of the holding company and assessments of
certian key consolidated financial and operating factors.
represents

the composite

components.

The "denominator"

rating, including both its financial and managerial

While the elements in the "numerator" represent

the

essential

foundation upon which the composite rating is based, the composite does not
reflect

a

simple

arithmetic

performance dimensions.




mean

or

rigid

weighting

of

the

individual

Comptroller and Federal Reserve Examiner Findings

1.

Overview

CIND was examined by the OCC once every year from 1976 through the
present except 1978.
from

CIC was inspected by the Federal Reserve every year

1979 through the present.

In the sections which follow the principal

findings of O C C and Federal Reserve examiners are presented In summary
form with attention given first to a brief overview of CINB's recent financial
history, then to a close review of examination findings concerning CINB* s loan
management, capitalization, management information system, and
to examiner comments.

response

The boldface emphasis in some quotations has been

added by s t a f f .

In 1976, CINB's ratio of classified assets to gross capital funds was 121%.
This level was viewed by examiners as troublesomely high and meant that the
volume of Continental's loans classified as "substandard", "doubtful", or "loss",
was well over the loss absorption ability of

the bank.

This was particularly

worrisome because Continental's classified assets to gross capital funds ratio had
risen from 30% in December 1973 to 63% in September 1974, and to

109% in

June 1973.

O C C examiners rated CINB's 1976 condition as only Fair and cited
as matters requiring attention:

Classified assets amount to $1.2 billion which Is 121% of gross capital
funds versus 109% at the time of the previous examination.

Gross capital funds amount to 5.3% of total resources, down from 6.1% last
examination.

The bank continues to rely heavily on purchased funds to carry Its assets.
As of the examination date, 46% of net assets, as compared to 49% last
examination, were supported by funds whose cost was a money market
rate.

This matter and the related issue of liquidity are of

concern.




continuing

tu

Credit files are missing, or Incomplete in comments, In cases where swaps
have been entered into.

In the confidential section of the report, the OCC examiner evaluated CINB's
capital position as:

Inadequate. Gross capital funds are loaned 10.5 times which Is unchanged
f r o m last examination and the capital/asset ratio is 5.5% versus 6.1% last
examination.

However, the volume of classified continues high at 121%

versus 109% last examination.

Management is seriously considering going

to the capital market before year end but nothing is definite at this time.

The

examiner,

however,

rated

both

Continental's

management

and

future

prospects as "Excellent".

Though examiners expressed concern in every examination report about
capital adequacy and credit quality, the outward signs of portfolio soundness as
bank examiners measure it seemed to be improving steadily. Continental seemed
to simply outgrow its level of classified loans.

The problem loan to capital ratio

declined to 86% from its 1976 level of 121%, and continued to decline to 80% in
1979, and 61% in 1980, but in 1981 rose to 67%.

In 1981, Continental became one of the largest corporate lenders in the
U.S.

From 1976 to 1981, Continental's total assets increased from $ 18.6 billion

to $ 41.1 billion, a compound annual growth rate of about 13%. This remarkable
s u e increase was the result of a heavy dedication throughout the Continental
corporation
budgeting

to loan expansion, reflected clearly
documents.

The

growth

was

made

in Continental planning and
possible

by

a

management

responsibility and accountability framework that gave individual loan o f f i c e r s
more lending authority than is generally found in other money center banks and
that encouraged and rewarded loan growth.




The risks inherent in CINB's growth oriented planning became apparent in
1982.

The economic recession that gripped the U.S. economy in that year hurt

all the money center banks badly.

The lending and management practices that

Continental had to adopt In order to reach its corporate goals, however, made it
particularly vulnerable to the e f f e c t s of the recession.

Significant credit quality and loan documentation deficiencies in
Continental's oil and gas lending were spotlighted by the Penn Square National
Bank failure in July 1982. But problems were not limited to oil and gas lending
alone.

Continental's 1982 examination report classified $ 3.6 billion in loans as

"substandard", "doubtful" or "loss".

Of these, $ 1.2 billion were oil and gas loans

with Penn Square related classified loans totalling $ 620 million.

The causes of CINB's problems were explained in the 1982 OCC
examination report to be the result of CINB's management:

Although the level of credit problems is related, to some degree, to the
general downturn in economic activity both nationally and on a global
basis, the magnitude of existing problems must be viewed as a r e f l e c t i o n
upon management's past decisions regarding growth and the system of
decentralized authority and responsibility/accountability.

This management style has allowed, and may In fact have fostered, many
of the problems at hand, as adequate systems to insure that responsibility
was being taken were not in place....

The asset growth was partially the result o l a goal to become one of the
leading domestic wholesale banks, but was also driven by a need to show
higher earnings to ;he marketplace.

Although earnings growth, in dollars,

has been impressive, it has mirrored asset growth. Earnings e f f i c i e n c y has
remained relatively unchanged over the past f i v e years.
order to show better earnings (in dollar

Therefore, in

terms) more assets had to be

generated. Recent asset growth, especially over the past year, was not




72
generated in concert with strategies necessary to insure that the growth
was controlled (roin the standpoint of quality and the organization's ability
to handle tl>e increases e f f i c i e n t l y .

It had become increasingly d i f f i c u l t to

maintain asset quality for a combination of reasons.
the pool of
Secondly,

First, the quality of

available assets had decreased due to economic conditions.

the

internal

support

staffs

(operational

and

lending)

were

insufficient to properly handle the loan volume involved.

The Federal Reserve's bank holding company inspectors also pointed
directly at CINB's management:

Management is rated as less than satisfactory under the premise that It
was management's policies of agressive lending (during the 1976-1982 prePenn

Square

period)

in

a

decentralized

environment

which

directly

contributed to the Penn Square situation and other problems In the energy
portfolio.

These policies as promulgated by Chairman Anderson, plus weak

domestic economy, contributed to classifications at CINB increasing to an
unacceptable

level.

CINB

is presumed

to have

the highest

level

of

classified assets among Its peers plus the highest level of nonperforming
assets.

The information in the examination reports regarding the volume and range
of classified assets was not known to the financial markets, and through the rest
of 1982 and 1983, financial analysts tended to view Continental's difficulties as
limited to Penn Square related loans or to oil and gas lending generally,

It was

not until Continental's year-end financial statements became available that the
size of the loan loss w r i t e o f f s and their e f f e c t on income became clear.

In the Spring of 1984, financial market concern about the true condition of
Continental became serious.
market

confidence

Rumors abounded about potential bankruptcy, and

in Continental's

assurances of regulators.

financial

strength

The resulting outflow of

declined

despite

the

funds necessitated quick

development and implementation of a multibillion dollar FDIC assistance plan.
It is clear that without the federal assistance program, Continental Bank would
have gone out of existence.




t.i

2.

Loan Management and Review v
The OCC examiners confirmed in staff interviews what is generally

accepted—that

the problems associated with a bad loan generally do not

appear until a year or two after the loan is made. If a bank Is growing rapidly,
its problem loan levels will lag behind its loan growth by a few years.

If Its

loan management system is e f f e c t i v e , the problems will be detected early and
kept within acceptable ranges. A t the same time, if capital levels are kept up
as the bank grows, It will have the capacity to absorb the greater losses that
are inevitably associated with making more loans.

In CINB's case, however, high capital levels were sacrificed to enable
greater

earnings per

share, and in

their

drive

for

asset

growth,

CINB

executives ignored setting corporate loan quality standards. Consequently, as
loan growth got underway and the paperwork increased, loan management
deteriorated and credit

problems went undetected.

Statistically, greater

lending would have resulted In greater losses in any case, but the delays in
detection and treatment of credit problems caused loan losses to be even
greater.

The reduced capital position made it difficult to absorb the losses

associated with both greater lending and a deteriorating loan management
system.

Adding to this, the losses associated with an economic downturn

placed an impossible burden on CINB's capital.

The

failure

in OCC's

supervision of

CINB

was

not

appreciating

the

potential for harm inherent in the combination of high growth policies and lax
credit

practices

deterioration.

and not

detecting

the

severity

of

the

degree

of

loan

The examiners' comments regarding loan management year-by-

year are set out below.

Commenting in 1977, the examiner said:

Management of the loan portfolio Is considered excellent. Senior positions are
staffed with

well

seasoned lenders

and considerable

depth

is

evidenced

throughout the various divisions. An informative system of performance




74
evaluation is employed (or personnel and divisional units that encompasses the
entire lending operation. The c o m m i t t e e system employed is considered sound
with a majority ol

the members drawn froin senior

levels.

Sound hiring

practices are pursued and a comprehensive training program is in operation.

The underlying causes ol the present burdensome volume ol criticized loans
stem from external conditions primarily.
rellect

The majority ol

loan criticisms

the e l l e c t s ol a period ol rapid Inflation followed by an economic

recession.

It is now evident these external conditions are improving with a

resulting direct e f f e c t upon the troubled loan area; however, many credits
have fallen into a workout condition and will take considerable time to fully
resolve.

In all such cases it is evident your bank management is moving to

resolve these situations as quickiy as conditions permit.

The examiner also said:

The initial review of credit files revealed numerous instances of incomplete or
non-cur rent

information.

As

this

material

was

made

available

during

Divisioftal loan discussions, It is apparent that an improved system to monitor
the

flow

of

credit

information

from

the

lending

areas

to

the

Credit

Department is needed.

At the tune, the examiner did not view the credit file situation as serious and
did not iiKlude it in his letter

to the Continental board of directors.

hindsight,

the

it

may

have

been

first

sign of

future loan

In

management

problems.

Two

years

Continental's

later,

in his

board

Multinational Banking

of

19/9 examination report

directors,

the

OCC

transmittal letter

Deputy

Comptroller

to
for

raised the issue of credit administration more pointedly

and related it to Continental's heavy dependence on purchased funds and its
need lor a strong market reputation.

Our

review

of

the

credit

administration

system disclosed

relating to the identification and rating of problem loans.
not reviewed by bank staff




deficiencies

Some loans were

in keeping with Byuicui o b j e c t l v c b .

In m l d U l o n ,

several loans which are internally rated "B", and which have traditionally
been regarded as sound from a review evaluation standpoint, are criticized
in the report o l examination. The importance of reliability of internal loan
evaluation procedures as an early warning mechanism to control credit
quality in a growth environment cannot be overemphasized.

The examiner-in-charge o l the 1979 examination, provided more detail on
Internal credit management in his letter to the board o l directors;

Several

credits

which

were

rated

"B"

by

the

system,

and

therefore

expected to possess the qualities to preclude criticism, are criticized in
this report. Other credits, which are subject to review, were found to have
eluded the credit rating process.

These factors combined with the 15%

growth goals cited In the strategic plan suggest that a reappraisal of the
credit rating process and systems Is appropriate.

Additionally, since the

bank is lieavily dependent upon purchased funds to support assets and
provide liquidity, maintenance of good asset quality is necessary to Insure a
continued high degree of market acceptance.

The all-important relationship between asset quality and CINB's funding
capability was also pointed out in the letter transmitting the Federal Reserve's
1979 CIC inspection report:

Continental Illinois Corporation continues to rely heavily on volatile
funds to sustain growth in assets and earnings.
policy
quality

is dependent on the quality of
control

systems

appear

The success of such a

underlying assets...While asset

adequate,

we

urge

continued

close

attention to this vital area, especially during prolonged periods ol high
interest rates and retarded capital formation.

By mid-19S0, Continental's total assets reached $ 39 billion and its net
Income was well on its way to another annual record. Its ratio ol problem




tu

loam to capital also declined significantly from 80% the year b e f o r e to 61%.
In his 1980 letter to the board ol directors, the OCC examiner saidi

White it is recognized that management is capable of successfully working
down the listing of criticized assets - and in fact has demonstrated such it should be recognized

that the present level is still somewhat

above

traditional standards.

Concerning the deficiencies he had cited the year belore in the area of credit
management, the examiner wrote:

Our

review

of

the

loan

approval

and

review

process

was

more

comprehensive this examination than in previous years and included the use
of both judgmental and statistical sampling.
were

favorable to the bank and revealed

The results of these e f f o r t s
what

is considered

to be a

generally e f f i c i e n t loan process.

However,

the examiner

felt it necessary to warn CINB o f f i c i a l s about an

inherent weakness in their loan management system:

...the results of our examination do not point to any material deficiencies
in either the original accuracy or timeliness of reports on asset quality.
However, since the integrity of these reports is partially dependent on
input (Watch Loan Report) from o f f i c e r s around the world, a means of
periodically checking the performance of lending personnel In this matter
might be considered.
followed by

This point is raised because the existing procedure

the Rating

Committee

interim independent review.
unless subsequent

negative

does not

include any "on-site" or

Once a credit is assigned a quality rating,
press/knowledge or a watch loan report is

submitted, a deteriorating situation may go unnoticed until the next rating
period.




In light of CINB's later problems, this warning was very significant. CINB's
decentralized, growth-oriented loan management system gave individual loan
o f f i c e r s a great deal more Independent lending authority than was or is found
in other money center banks.

This was a significant competitive advantage

because a borrower could get a quicker approval from a CINB o f f i c i a l than
could be obtained from loan o f f i c i a l s of other money center banks who needed
approvals and confirmations from higher management.

If a loan developed

problems, it was the responsibility of the CINB loan o f f i c e r to put the loan on
a "watch list".
senior

If the loan o f f i c e r chose not to put the loan on the watch list,

management

would nut know

the loan had problems

until

it

was

independently reviewed and rated by the Loan Review Division.

An early sign of future credit problems appeared in 1980. The level of nonaccrual loans increased to $ 402 million from $ 191 million in 1979.

Non-

accrual loans are those on which interest or principle payments are 90 days
past due but which appear

to be well secured and are in the process of

collection.

By the 1981 examination, the ratio of problem loans to capital began to
rise again.

From the 61% 1980 level, it rose to 67%.

Regarding this, the

examiner in his letter to the board of directors wrote:

The majority of our e f f o r t s were again directed toward evaluating asset
quality with particular emphasis on the loan account.

The reversal of an

earlier trend of decreasing classified ratios was observed across the board.
In aggregate,

this

examination

showed

the

level of

increasing from 61% of gross capital funds to 67%.

classified
A more

assets

detailed

analysis revealed that doubtful assets now equate to nearly 10% of gross
capital, with directed and voluntary losses this examination
$29 million.

level of total criticized to 99% of gross capital funds.




aggregating

The addition of specifically mentioned Items Increases the

78
This examination is interesting because of two anomalies in It which cast a
shadow over its credibility.

The first relates to the examiner assessment of

the significance of a near doubling in the loans going unreviewed by the bank,
and

the second concerns the accuracy of the examiner review of oil and gas

lending.

Regarding the first matter, the examiner wrote:

A review of these internal reports for domestic credits only r e f l e c t s a
significant

increase

in

old-rated

credits

from

last

examination.

In

analyzing this report, It was determined that approximately 373 credits,
aggregating $2.4 billion had not been reviewed within one year, with f i f t y f i v e of these credits riot r e v i e w e d within two years.
approximately

This compares

I9S0, with t w e n t y - f i v e credits not rated within two years.
currently
review.

to

270 credits over one year, totalling $1.6 billion in June,
Responsibility

rests solely with the divisions to provide information for reHowever, it is evident that no one b monitoring this situation to

ensure that ail credits are receiving timely reviews, as required by the
corporate o f f i c e .

Failing to review first $1.6 billion one year and then $2.4 billion the second
year, would seem to represent a significant and worsening situation in CINB's
credit review and quality control mechanism.

The examiner in his letter to

the Board of Directors, however, said nothing more strongly than:

... the issue of

timeliness or

frequency of

review is noted since bank

records indicate a general increase in the number and volume of loans not
being reviewed in accordance
Although

this list

is up from

with the wishes of the Corporate O f f i c e .
last

examination,

it

has not

impacted the reported results f r o m Loan Administration.

adversely

It seems clear

however, that any success in reducing the number of these exceptions is
dependent

upon the

managers.




voluntary

positive

responses ol

the many division

Regarding the system o v e r a l l , the examiner said:

We found it to be functioning well

and accurately

reporting

the

more

s e v e r e l y rated advances to the Board and senior management.

When the s t a f f i n t e r v i e w e d the examiners, questions w e r e posed regarding
The examiners responded that absent detailed Information

such situations.

concerning the loans not r e v i e w e d , a situation such as that described sounded
significant.

The examiner responsible (or the 19SI examination pointed out

that he v i e w e d the m a t t e r as significant in r e t r o s p e c t , but at the time in light
of CINB's o v e r a l l declining classified loan levels arid asset growth, he did not
view it as an overriding problem.

The second anomaly is the examination report's description of the oil and
gas divisioni

One of the primary g r o w t h areas within the bank over the past t w o years is
the

Oil

and

Gas

(O&G)

division

within

the

Special

Industries

Group.

D o m e s t i c O & G loans now total $2,862 million and represent over 10% of
the bank's t o t a l loan p o r t f o l i o .
1979

to

date,

with

O&G

loans up 65%

staffed

adequately
(engineers

Significant g r o w t h has occurred since early

with

both

sound

and g e o l o g i s t s ) personnel

from

year-end

lending

1978.

officers

to handle current

and

CINB

is

scientific

relationships and

m e e t continued strong growth anticipations.

The bank has developed a

presence

the

in

establishment

most
of

of

the

active

areas

in

industry

through

regional o f f i c e s in Texas (which have g e n e r a t e d

the
loans

representing 38% of O & G credits), Denver, C o l o r a d o and C a l g a r y , A l b e r t a ,
Canada. N o significant problems are evident as noted by the f a c t that only
two O & G c r e d i t s w e r e classified herein.

In c o n t r a s t , K a t h l e e n K e n e f i c k , a loan o f f i c e r in the oil and gas division,
described the situation this w j y In July 1981:

The status of the Oklaltoma accounts (particularly Penn Square Bank) is a
Cause for c o n c e r n and c o l l e c t i v e




u c l l o i t atiould be lnut l^ut eil c|ulckly t«>

80
stem any future deterioration.

Potential credit problems could be going

unnoticed, thus possibly missing opportunities to improve our position
and/or prevent some losses. Management of credit relationships has not
consistently taken place, with minimal forward planning ol CINB and/or
customer actions occurring.

In some cases the initial credit wrlteup had

customer information missing, out of date or incorrect; in other
there has not been a credit writeup.
been rare.

Thorough monitoring

weaknesses of

cases

Followup and accountability have

is hindered when both strengths

the customer are not discussed.

and

Housekeeping problems

(missing notesheets and approvals, documentation errors and omissions,
past due principal and interest, e t c . ) compound the situation.

All of this

may result in delayed or possibly lost income to the bank.

Potentially

missed opportunities both for future business and for correcting possible
problems

are

the result

when "reaction"

is all

we can handle.

The

Oklahoma calling personnel continually fight to keep their heads above
water, with time spent putting out fires, and therefore falling further
behind.

Both of the above comments were written in the Summer of 1981.

One

year later, the financial dimensions of the loan management and credit quality
problems in the oil and gas division were clear.

From $83 million In 1981, the

level of classified oil and gas loans rose to $ 6U9

million in 1982.

The

potential deficiency in CINB's loan management system that McCarte warned
about in his 1980 report apparently became a real deficiency.

Just before

finishing the

1982 examination report, |he examiner in an

internal OCC memorandum explained what happened to Continental and Its
relationship to Penn Square this way:

Although
portion of

the

Penn Square relationship accounts

problem

lor a relatively

loans (less than 20%) the publicity

closing was surely the one event that has done the most damage.




small

surrounding

its

01

It Is my opinion that there are two inter-related causes of the present
situation. First, the aggressive growth philosophy of CIC was not tempered
by increased controls (loan quality safeguards) and second, the management
style

of

great

authority

and

responsibility

resting

In individual

unit

managers, was without proper supervision from their superiors.

Although in the first instance it can be said the lack of quality control is
universal for the bank, the second cause is more localized - particularly in
the Special Industries and Real Estate Groups.

Regarding the question of whether Continental loan o f f i c e r s were filing
watch loan reports on their loans that had developed problems, the examiner
wrote in the 1982 examination report:

Our review of credits criticized at this examination r e f l e c t s 99 " B " rated
credits.

Differences are generally due to timing in the rating system (23

had riot been rated
opinion.

within one year) and to subjective differences ol

It should be noted that many of these credits were added to the

WLR system by loan o l f i c i e r s at 4-30-82, and subsequently downgraded by
the Rating Committee in the normal rating process.

Of more concern is

the f a c t that 119 credits criticized or classified did not have WLR's. These
totaled approximately $1.4 billion, compared to 34 such credits totalling
$299 million at the previous

examination.

The totals of these exceptions

are of such magnitude to conclude that WLR's and updated ratings are not
being provided on a timely basis.

Before turning to a review of what examiners said over the years about
CINB's capitalization, one final piece of
management needs to be presented.

evidence concerning CINB's loan

This evidence consists of what Chemical

Bank, First Chicago National Bank, and Citibank found when they went into
CINB in the Spring of 19X4 to evaluate it prior to making the FDIC a purchase
and assumption o f f e r .

The individuals overseeing each bank's review of CINB

were interviewed by the s t a f f .

The findings of each of the banks as reported

to the staff tended to be identical with each other and consistent with FDIC
memoranda from which the excerpts below are drawn.




82
The

Latin American

portfolio

was mostly private sector

number of customers with which the

with loans to a

people were not familiar.

The

saine is true for Europe; there were about 100 loans totaling $300 million to
customers

that

people

had never

heard of.

There

was

somewhere

between $2 and $2K billion in c h a r g e - o f f s in the loans they had reviewed,
concentrated

in

the

real

estate,

energy,

shipping,

corporate

and

Latin

American portfolios.

The internal loan review procedure at Continental Is very similar to

's.

Both use a numbering system of I to 8 or 9, with one being the highest rating,
and 8 or 9 being the lowest.

indicated that on the higher end of the

scale, Continental normally treated a loan one better than

would have

and, at the lower end of the scale, the difference was normally more than one.
compared their
system at Continental
banks.

internal

loan rating system (1-9) against

the

rating

(1-9) on 21 borrowers which were common to both

Only six of the 21 credits were given the same rating by both banks.

On another 6, Continental's rating was one better than the rating at
another 5, Continental's rating was 2 better than

credits, Continental's rating was 3 or more better than
this review,

1 on

's and, on another four
's.

Based upon

indicated that Continental's internal loan review process

was very lenient and that the volume of classified loans was really much
higher than that presented by Continental.

On some of

the common loans at the two banks,

has taken at least

partial charge-offs, while Continental continues to carry them at full value
and in a performing status.

Continental also makes new loans to customers in

order to keep the interest payments current.

people estimate that there

is an additional $650-700 million in loans which should be classified as nonperforming.

They also estimate an additional $1.6 billion in non-performing

loan within 12 months.




Other negative comments regarding Continental's lending areas included the
lack of 'credit culture/ all o l the reports generated are done lor the bcne/it o l
the line o f f i c e r s , not for the benefit of upper management.

There appears to

be a large number of credits (up to $30 million each) to corporations with
which the

people were not familiar.

None o l the top level people at Continental are credit people, all have coine
from the funding or treasury side.

There is no loan workout department at

Continental; the o f f i c e r s which originally made the loans are also expected to
collect them.

had found two major problems; the quality of the assets and the funding
problem, which they indicated was going to get much worse during the next
week or

two.

They also felt that the total of non-performing loans was

considerably in excess of the $2.3 billion which Continental was reporting;
probably the total was in excess of $3 billion.

The excerpts presented above indicate that the money center banks which
were interested in acquiring CINB found the situation significantly worse than they
anticipated.

It is also noteworthy that the situation these banks found reflected

CINB management e f f o r t s and OCC supervisory e f f o r t s spanning almost twenty-four
months since the Penn Square Bank failure.

3.

Capital

In 1976, CINB's capital position was rated "Inadequate" due to its absolute
level and its relation to classified assets.

Some improvement by 1977 enabled the

OCC examiner to write:

Over

the last three years, your earnings have allowed the bank's capital

accounts to be increased by $223 million through retained earnings and in 1976,
$62 million was addejf to the surplus account from the proceeds of a debt
o f f e r i n g by C f C .

Equity capital at $I,0<*9 million represents 3.1% of

resources compared to <*.6% at the February 1976 examination. Loans to




total

54
equity capital at 11.32:1 also shows improvement lrorn 12.1 III in February
19/6.

Aitltough these improvements are viewed positively, it must also be

noted

tliat

your

bank's capital

ratios still remain below

the norm

when

compared to your peer group o! banks.

CINB's subsequent growth led the Deputy Comptroller ol the Currency in 1979 to
say:

The growth in earnings has been achieved by virtue o ! increasing loan and
a*iet volume leverage.

The interest margin has remained relatively

level

since 1977. The ratio ol equity capital/total assets has decreased significantly
since 1976 in spite of good retention of

earnings.

If

the rate of

growth

continues to outpace internal capital formation, external sources should be
identified to support asset leverage.

> In 1980, in his analysis of CINB's capital position the examiner commented:

During 1979, average equity capital equalled 3.89% of average total assets,
representing a 27 basis point decline from 1978's position. Generally consistent
with its peer group, CIC's equity capital position has deteriorated each year
since 1975, with the greatest decline coming in 1979. The principal reason for
the decrease can be attributed to strong asset growth between March 31, 1979,
and 1980 (21.3%), ...

Loan growth exceeded 26% during this period, which

ranked

the

first

among

top

nine

(Continental's definitional peer group).
Continued

strong asset growth

domestic

bank

holding

companies

Total equity increased only 10.8%, ...

throughout

the first

half

of

1980 further

perpetuated the decline in equity capital, which averages 3.63% of average
total assets, compared to 3.90% for the first six months of 1979.

In the letter transmitting the 1980 examination report, the Deputy Comptroller said:

Capital is currently considered adequate.

However, capital accumulation has not

kept pace with asset growth and the capital base is becoming strained.

The

Directorate should be aware that capital adequacy for banks in general is a growing




concern of the Comptroller's O f f i c e . While neither the present level of capital
nor the current capital planning e f f o r t * are subject to criticism, management
Is encouraged to continue seeking alternative sources of capital and to bring
the capital and asset growth rates into balance.

Perhaps the most significant aspect of these comments is the degree to which
CINB's capital position was tolerated even though it was continually somewhat less
than fully satisfactory. Of additional interest are the references to CINB's "peers".
So long as CINB's capitalization was within the ranges of its peers, even though the
capital of all the peer banks was steadily declining, CINB's situation was somehow
acceptable.

Despite a rise in 1981 in the ratio of classified assets to gross capital funds
and a continuation of the upward trend in CINB's dependence on purchased funds,
the Deputy Comptroller and the examiner's comments about capital remained mild
and only urged the CINB directors to give the Bank's capital their close attention.

The rapid growth in assets has certainly contributed to earnings levels, but in
terms of a return on assets, a slight decline is noted.

Continued increase in

leverage combined with the high level of classified assets cause increased
pressures on capital.

In the context of capital adequacy, both balance sheet

leverage and asset quality are deserving of the Directorate's close attention.

It must be realized however, that leverage and risk ratios continue to increase
thus placing increased strain on the capital

foundation of the institution.

While it is recognized and accepted that on a peer group comparison this bank
is favorably viewed in the marketplace, the evidence of increased risk is an
internal view that management must continually appraise.

In light of

the

above, it Is obvious that the topic of capital adequacy is one that should
continue

to receive

the high prioritization currently

being

given

by

the

Corporate O f f i c e .

For the examiners to continue to refrain from outright criticism of CINB's
capital position for so many years is difficult to understand.

To continue to refrain

in 1982, a f t e r the revelations that took place that year, begins to undercut one's
belief that the OCC was truly




concerned about bank c a p i t a l

udetjuuey.

90

before reading the 1982 examiner's comment, it is Instructive to compare
Continental's 1976 and 1982 capital and problem loan circumstances.

Recall that in

1976, Continental's ratio ol classified loans to gross capital funds had reached 121%
and its ratio of

total assets to total capital was 21%.

Moreover, In the staff

interview, the examiner reponsible lor the 1976 examination estimated that CINB
was between 60% and 70% dependent on purchased funds.

In comparison, in 1982

the classified loan to gross capital ratio had risen to 172%, the degree of asset to
capital leveraging had risen to 23%, and dependence on purchased money was up to

80%.
In 1976, CINB's capital was rated a clear and emphatic "Inadequate".

In 1982, CINB's capital was commented upon as follows:

As a result of

the above factors, particularly

the underlying strength of

maivagement and the recent trend of improving capital ratios, CIC's capital
Uue

is presently considered adequate.

However, the inordinate level of

classified assets and the loss of confidence by the financial community lend
definite reservations

to this assessment.

Capital needs will continue

to

require close monitoring, with returning the earnings stream to an adequate
level imperative to resolve both the loss of market confidence and as a basis
tor future growth.

This was the same examination in which the examiner said in his letter to the
board of directors, "The examination reveals the bank to be in serious difficulty,"
and the Deputy Comptroller

in his report transmittal letter said, "Examination

results show the condition of the institution to be seriously deteriorated."




C.

Federal Supervision Weaknesses

1.

Agency Failure (o Halt CINb/CIC Undue Dependence on Volatile Funds

In their 1979 examination and inspection reports and in the letters to top
CINB/CIC o l l i c i a l s transmitting those reports, the Comptroller oI the Currency and
the Federal

Reserve

both highlighted

the all-important

quality and dependence on purchased funds.
lindings

in subsequent

reports

that

linkage between

asset

Despite this locus ol attention and

indicated

weaknesses

in Continental's

loan

management system in the context of the institution's aggressive earnings and asset
growth goals, neither the O C C nor Federal Reserve took firm, overt actions to get
Continental's management to modify their operating practices.
bank failures, this circumstance is not novel.

In the analyses of

A review of every major bank failure

indicates that the signs ol later problems were clear many years earlier and a
pattern of agency acceptance is apparent.
even the specific nature of

In some instances such as Continental,

the later problems were identilied years before the

actual failure.

2.

Examiner Comment Ambiguity

OCC

and

Federal

Reserve

examiner

ambiguous and difficult to interpret.
CIC/CINB

operations

accurately.
this respect.

and on

comments

were,

at

crucial

times,

On the one hand, the examiners criticized

the other

indicated

it

was functioning well and

The 1980 and 1981 examination and inspection reports are significant in
Both years were crucial because they were the last two full years

before CINB's precipitous decline in the financial world.

In 1980, the Federal Reserve inspection report stated:

Concern is rendered over the deteriorating trend of CINB's capital position.

...the

combination of such factors as the high dependency on volatile liabilities to lund
assets, the above peer asset growth, and .... earning performance has caused capital
to deteriorate at proportionately greater levels than the money center peer average.




T l * IIH i t * » c d dependency ol leverage that li not oll>ct w i th t OIK oini lant return In
Cdtikin^ and retention

will

require

capital

enhancement

If

the

present

trend

continues.

The well above peer asset growth has contributed to the relative decline in
CINB's capital position. This adverse trend may require management action to
raise equity or target growth significantly under historic trends.

A f t e r making these relevant, Important points, the examiner seemed to have
second thoughts. The report said:

The apparent improvement In asset quality and the demonstrated ability to
work out problem credits appear to mitigate present above peer loan and risk
asset

volume.

However,

the declining

trend in CIC's capital ratios is of

concern ax>d will probably require specific actions jf historic operating trends
continue.
...capital

is becoming

strained, but

the deterioration

controlled within other relative peer parameters.

appears

to be

well

Asset quality has shown

continued progress and liquidity appears to be well under control.

The 1981 inspection report again expressed concern about capital and followed
it with the statement that CINB's position on capital (which essentially was that no
new equity capital injection would be made within the next f e w years) warranted
merit. The report stated:

Above peer consolidated asset growth is basically responsible for a below peer
consolidated capital position. The holding company's capital position is further
pressured by the increased consolidated asset classifications, r e f l e c t e d in this
inspection report; depressed net interest margins on the parent
unaffiliated

investments;

subsidiary, Continental

and

for

company's
a

proposed

capital

injection

Illinois Overseas

Finance

Corporation N.V.

nonbank
While

consoldiated asset growth for the first four months of 1981 has been limited,
the consolidated capital position could require enhancement should additional
pressures ensue.




Hullici 1 I*ii i ic«|tiiiiiig CIC lo put lis HOUSE in order, I K S simply SUIJI
1

Management does not anticipate any equity capital injections within the next
f e w years and appears reliant on earnings retention to match asset growth to
enhance capital.

Void of increased assets, and void of reduced net interest

margins or decreased earnings, tlietr position warrant m e r i t ; however, a new
subsidiary bank or a new bank headquarters could severely complicate CIC's
capital position.

OCC

examiner

comments

were

similarly

ambiguous.

In

ft981

the

OCC

examiner said with respect to c r i t i c i z e d assets that:

The reversal of an earlier trend of decreasing classified ratios was observed
across the board. In a g g r e g a t e , this examination showed the level of classified
assets increasing f r o m 61% of gross capital funds to 67%.
analysis revealed that doubtful assets now equate

A more detailed

to nearly

10% of

gross

capital, with directed and voluntary losses this examination aggregating $29
million.

The addition of specifically mentioned items increases the level of

total c r i t i c i z e d to 99% of gross capital funds.

With respect to old-rated credits the examiner said:

... a r e v i e w of these internal reports for domestic credits only r e f l e c t s a
significant

increase

in old-rated

credits

from

last

examination.

In

analyzing this report, it was determined that approximately 375 credits,
aggregating $2.4 billion had not been r e v i e w e d within two years.

This

compares to approximately 270 credits over one year, totaling $1.6 billion
in June,

1980, wilh

Responsibility
information

for

twenty-five

currently

rests

re-review.

credits

solely

However,

not

with
it

rated
the

within

divisions

is evident

that

two

provide

no

one

monitoring this situation to ensure that all credits are receiving
r e v i e w s , as required by the corporate o f f i c e .




years.

to

is

timely

'JU

A C Aj iiu i c a i c

in classified assets lu

capital fund* and CINB's

(ailing to review first $1.6 billion in credits one year and then $2.<f billion In
credits the second year, would seem to represent a significant and worsening
situation in ClNlVs credit review and quality control mechanism.

OCC's

letter to the board of Directors, however, said nothing more strongly than:

...the issue of timeliness or frequency of review is noted since bank
records indicate a general increase in the number and volume of loans
not being reviewed in accordance with the wishes of
Ofiice.

Although

the Corporate

this list is up from last examination, it has not

adversely impacted the reported results from Loan Administration.

It

seems clear, however, that any success in reducing the number of these
exceptions is dependent upon the voluntary positive responses of

the

many division managers.

Regarding the system overall the exam report said:

We found it to be functioning well and accurately reporting the more
severely rated advances to the Board and senior management.

3.

Inadequacy in O C C Loan Assessment Methodology

To asess the soundness of

a bank's loan portlolio,

OCC

examiners

carefully review a sample of the bank's loans. How the OCC sampled CINB's
loam was described in detail in the 1981 examination report: "The scope
included a review of all credits over $10 million, all bank rated " C " and " D "
loam, and selected non-accrual and past due accounts.

Additionally, for

domestic credits only, a statistical sample was taken of seventy credits with
balances exceed $300 thousand and a sample of thirty credits with balances
below $300 thousand."

As the description makes clear, the OCC's sampling

approach was biased toward reviewing large loans and loam CINB had already
earmarked as problems. Sampling bias such as this is understandable -- it




J i

lucusc* limited examination resoun e* on thuse loans whlL.li «:ou!d cause the
bank the most seriuus difficulties (large loans) and on those lending areas that
have already been identified as problematical.

The sampling bias is also

consistent with the OCC's current examination philosophy which places heavy
reliance on a bank's own internal control system and soundness findings.

Pur

banks

with

thorough,

centralized

loan

management

systems,

sampling bias toward the portfolio areas of highest apparent risk makes a
great deal of sense. The tune and resources saved, however, is paid for in the
form of a greater risk that the examiners will fail to detect a breakdown in a
bank's own loan evaluation system.
representative,

statistically

What is needed to do this is a fully

valid sample of

loans, and a comparison of

examiner ratings of the sampled loans with the bank's ratings of the same
loans.

Despite the acknowledeged importance of loan management in CINB's

specific

operating

circumstances

and

evidence

of

loan

management

deficiencies, a broader, unbiased loan sample was never analyzed.

Although O C C examiners did not detect the seriousness of the CINB
loan classification problems, outsiders
happening in CINB.

were

able

to see what had been

O f f i c i a l s from banks that visited CINB in the Spring of

1984 lor the purpose of considering a purchase o f f e r for CINB said that CINB
had overrated its classified loans.

They said that CINB continued to carry

some loans at full value which they would have partially charged o i l , that
CINB made new loans to customers in order

to keep interest

payments

current, and that CINB's total non-performing loans were considerably in
excess of the $2.3 billion which CINB was repurting.

One of the o f f i c i a l s compared his bank's loan rating system with CINB's using a
comparison of 21 borrowers common to both banks.

Only six o l the credits were

given the same rating by both banks. On another 6, CINB's rating was one better; on
another 5, CINB's rating was 2 b e l t e r ; and, on another 4 credits, CINB's rating was 3




of more belter.

The o f f i c i a l indicated that CINB's Interna! loan review process was

very lenient and that the volume of classified loans wa* really much higher than that
presented by Continental.

OCC

officials

should

consider

requiring

its

examiners

to review

a fully

representative, statistically valid sample of the loans of banks with decentralized
loan management systems such as CINB's, and of all banks every second or third
examination.

A statistically valid sample of each major loan category should enable

examiners to determine whether a bank has properly accounted for both performing
and non-performing loans.

O C C Data Processing Examination Deficiency

To the extent that accurate and reliable loan information is available to a
bank, its management

can adequately monitor and e f f e c t i v e l y manage trends in

eariungs, assets, etc.

If

management

the information system is not reliable, however, bank

may be lulled into believing that a bank is financially sound when

actually major problems can be developing.

The Comptroller's Handbook

for National Bank Examiners states

that

the

examination procedures in the Computer Services section are "... designed to assist
the examiner to identify computer services used by the bank and to evaluate those
services ..." Specifically, the examiners are to determine "... if output is meaningful,
sufficient in scope, and timely."

Emphasis is to be "...placed on the evaluation of

EDP services and related internal controls from a user's standpoint."

The 1980, 1981, and 1982 OCC examination reports did not state whether the
examiners

checked

with

users

in

validating

computer

output.

However,

the

examination reports had positive comments about CINB's data processing operation.
The only negative comments in the EDP section of the exain report related to




JO

disaster planning.

These comments are significant because CINIVs data pioccssing

operation was the basis for its information management system.

The examination

reports stated;

1980

Overall we found well controlled and managed data processing operations.
This is evidenced by the few weaknesses commented on in the examination
report.

1981

Overall, we find that the data processing function at this bank continues to be
sound and well managed.

1982

Overall we find that the bank's data processing function continues to be a
sound, well managed operation.

However, o f f i c i a l s from one of the banks that considered making an o f f e r for
CINB in the Spring of 1984 had this to say about CINB's management information
system.

The

management

information

system

at

Continental

is very

poor.

Top

management could not have been kept very well informed about what was
going on because the information system is all for the benefit of the line
o f f i c e r s and it is almost impossible to create useful inangemcnt information
reports.




14
)

CINB's internal Special Litigation Report prepared in early 1983 stated that It
was well know within CINB as early as 1977 by management and by line managers
that loan operation reports contained many errors. The CINB report stated:

The

Bank's

management

generally

recognized

troubled by an outmoded computer system

that

loan

operations

was

There was a general perception

among line lenders that the Loan Operations reports contained many errors.

The O C C examination reports did not identify how examiners tested CINB's
computer system but whatever the methodology used, it is clear that the examiners
came to drastically dillerent conclusions than did others who were familiar with
CINB's

operations.

One

way

that

examiners

could

have

complied

with

the

Comptroller's Handbook and thus fully evaluated CINB's computer and information
management systems was to interview users of the system at all levels in CINB
arid/or select various input and output data and trace it through the system noting
the extent and nature of errors.

The OCC

should consider

providing a more thorough check of

the bank's

information management systems by interviewing users of the system, testing input
and output data, and testing the effectiveness of internal audit work In the area of
information management.

3.

Ti/nely Reporting Needs Emphasis

Timely responses to OCC examination findings are important so that identified
problems do not become unmanageable.
CINB

The Comptroller of the Currency said that

took 7 to 8 months to respond to some of

response

the examination findings.

to the regulators should be made by the banks within

notification.

30 days

A

after

As a minimum, within 30 days banks should be required to state what

they intend to do to correct

deficiencies cited in the examination report.

The

regulators should establish a followup system to make sure that banks conform to a
30 day limit.




(Atlit \
T O T A L < WITH IZI I) A b i t l S

i w u n m

(In millions of dollars)
Dales of l ; > j i i i l i u l l o ) »
4/1 V M

2/2//71,

3/31/77

W30/7*

6/)0/B0

Substandard a/

760

«<»S

106

l,0<»)

921

1.025

/,i0i

Doubtful b/

3)7

JSI

197

II

110

>»t

l<*

II

21

12

2*

230

1))

1,1)1

1,2«»0

1,031

1,12V

1,00b

1,23%

3.6S6

%,73l

306

kl*

173

HO

W;

1,93%

2,1)3

I.Ht,

1,4160

1, >02

1, K b

I,«JI

),620

7,)»6

Category

Loss c/
Total Classified
Assets d/
CALM f/
Tolal C r i t i c u e d
Assets J/

lj622

72

H

•»/ 10/11
<i,M3

*!

A Substandard classification is assigned lu tliose assets Inadequately protected by the current sound
» o r l h arid paying capacity of the obligor, of pledged collateral, tl any.

^

A Doubtful cUt)iliC4liori is assigned lu
assets that l u v e all tlic w c j k i i c n f k tnlietciil in an « » e i
classified substandard and their collection or liquidation in lull u highly questionable.
A L o u classification Is assigned to tliose assets considered untofleciiblc arid ol such Itttie value that
their continuance as an active asset ol tlie bank is not % at ranted. Loss classification i k x t not mean
tliat an asset hat absolutely nu recovery or salvage value.

d/

Tolal Classified A s s e t ! is tlie sum of a, b, and t .

5/

Oilier Assets t: specially Mentioned are assets, not including iliose idcutilied as substandard, doubtul, or
loss, that lite regulator has sonic question about o« a concerned about lot an> reason such as l.»« k ul
loan documentation, lhal if not corrected or checked ma/ weaken tlie bank'> c r e d u position at some
future date.

y

Total C r i t i c u e d Assets Is t l « sum ol d and e.




%
TAttLK 5

s t L e c i t o suptHvi:>oKy DAIA
I97J to I 9 I J
(lit m i l l i o n * o l

dolUit)

L>4|g» o l t HallltlulllUMl
6/13/73

LMU^i

2/27/Z6

»/">/*»

1,19)

l,»|Q

16.tl

10.10

9/ . 2 )

1,011

Fu«.d» ( G C F ) • /

ILliLLL

92.))

lk0di

wjorn

%/ 30/82

I

®

I ,6)1

I 4><»l _ 2 x m

2,o;

60.bk

66.76

1/1.90

219.kl

11.30

99.01

262.19

331.72

| »

P«».eiit ol
Clunlicd

6/iu/au

2Ut

2)3

2>7

36)

.19

.19

1.2?

>,040

».<>»<<

Aucu
109.02

l o Gt_ F

120.9/

Petcent ol
Crtlicucd
Aucu

to G C F

kCACI VC l i *

Po»4lbt«

Lotsct ( H P L L )

HI

[U

P o c C f t l Ol
HPLL

Si*/«Jt>y

I

I . VI

33

.96

.IB

H3

1,198

2,2/2

Lelteii

ol C r e d i t ^ /

^

|. 20

>1)

u> T o t a l L U A I I I

2,til

C r t n s C t p i U l F u n d i r e p i c i e n l s t o t a l c * p i t * l plut r c i e r v e lor p o i i i b l e loan l o n c t .
!>i4/H)b|r
t>ch-»ll o l

Lctirit
lu

ol

Credit

cutlomcr,

icp<c»ent

to «

Ait u b l i g ^ l i o r i on I t *

dciig l u t e d

p*< I o l * b « n k , i i t u i n g i m h

third p * r t y c o n t i n g e n t

upon t l «

iallur*

ol

c u » t o i i i c « to p « r l i M i i i under tlic l e n i u of U*c u n d e r l y i n g c o n t r a c t with I lie t l i l i d p * f l y .




lit*

* d o c u m e n t oil
uiutrig

t«itk'a

\>i
D.

Federal Reserve Approvals of Continental Illinois Corporation Expansions

bank holding companies such as Continental Illinois Corporation must receive
prior

approval

from

the

Federal

Reserve

before

an

acquisition,

merger

or

consolidation of bank shares and assets occurs under section 3 of the bank Holding
Company A c t .

Also, prior approval of the Federal Reserve Is required for bank

holding companies seeking to engage In noitbanking activities or to acquire shares of
a

nonbank I ng

company

under

section

4 of

the

Bank

Holding

Company

Act.

Applications must likewise be filed with the Federal Reserve by bunks seeking to
establish

foreign

investments

in

branches,
overseas

to establish an Edge A c t
organizations

pursuant

to

Corporation or
Regulation

K

to make
entitled

"International Banking Operations."

Specific procedures are set forth in statutes and regulations requiring bank
holding companies,

member banks and subsidiaries to obtain the necessary prior

approval, preliminary permit, prior notificatlon, or specified consent, depending on
the type of application, from the Federal Reserve before engaging in a requested
activity.
the

While the approval procedures may vary, there are certain factors which

Federal

Reserve

considers

during

the

application

process

to

assess

the

appropriateness and suitability of the activity applied for, not only with respect to
its e f f e c t upon the community, but also its impact on the financial condition of the
applicant and future prospects.

For instance, when a bank holding company applies

under section 3 of the Bank Holding Company A c t (or an acquisition, merger or
consolidation,

the

Federal

Reserve

takes

into

consideration

the

antitrust

implications and the anticompetitive e f f e c t s of the new activity, the convenience
and needs of the community, and the financial and managerial resources and future
prospects o l the company or companies and the banks concerned. (12 U.S.C. Section
1842(c))




Similarly,
organization
Reserve

in

under

approving
section

Board considers

involved. (12 C.F.R.

applications

< of
f

the

the Bank

to

acquire

Holding

interests

Company

in

Act,

financial and managerial resources of

f.onbanking
the

Federal

the entities

225.2^) The standards for approving international applications

pursuant to Regulation K also emphasize the same factors. (12 C.F.R. 2ll.<» and 12
C . F . R . 211.3)

Federal Reserve publications shed further light and specificity as to what
factors are considered in bank holding company applications.
Federal

Reserve's

manual

Applications, analysis of

Processing

Bank

Holding

According

Company

and

to the
Merger

the applicant includes an evaluation of the consolidated

organization, the parent company, existing banks and nonbank subsidiaries, and the
proposed

subsidiary.

Capital,

management,

asset

quality,

earnings,

growth,

liquidity, leverage and future prospects of the consolidated entity and its component
parts are ail important considerations in the overall analysis.
areas

are

investigated,

in

some

instances

by

meeting

All potential problem

with

the applicant

or

requesting supplemental information.

The

way

those

factors

and

considerations

were

applied

to

Continental

applications during the critical time period between 1979 and the Spring of 198<i is
of particular interest.

The period from 1979 to the Spring of 198<t represented a crucial time in the
history of CIC and CINB.

Of significance during this time period is the f a c t that

every Continental application for expansion was approved by the Federal Reserve,
with the exception of one delay which was later approved.

In total, the Federal

Reserve considered 39 separate applications (not including extensions of time) in
this period.

Thirty-four of these applications were approved between 1979 and the

Penn Square National

Bank failure in July, 1982; and 5 more applications

approved a f t e r July, 1982.




were

Continental applications the Federal Receive actcd on from Wt'J lo the Spring
ol 1984, are luted below:

Applicant and Type of
Application

I.

CIC
(domestic)

Other Entity Involved
and Activity

Continental Illinois Equity Corp.
To establish a de novo subsidiary
to engage in a limited amount of
direct lending and investment
advisory services.

2.

CINb
(international)

CIC
(international)

CIC
(domestic)

CIC
(domestic)




04/20/79

Continental Illinois Trust Co. of Sarasota,
N.A. and Continental Illinois Trust Co. of
Florida, N.A.
To establish two de novo trust companies
before 10/28/80. However activity not
completed before deadline.
Uee 02*)

J.

03/12/79

Continental Illinois Overseas Finance Corp.
To acquire all shares at a cost of
$50 million.

4.

03/03/79

branch in Buenos Aires, Argentina
To establish a branch o f f i c e .

3.

Date of
Federal Reserve
Action

07/30/79

Continental Illinois Leasing Corp.
To establish a de novo o f f i c e in Dallas,
Texas.

01/11/80

100
6.

uiNb
(international)

Branch In Sasuiago, Chile
To establish a branch office.

7.

CIC
(domestic)

02/11/80

Continental Illinois Energy Development
Corp.
To engage In direct lending activities
02/19/80
through a de novo subsidiary located in
Houston, Texas. Direct lending activities
to consist of loans to finance energy
development and exploration projects. Loans
generally to be made on a secured basis to
smaller energy development and exploration
companies that do not qualify for traditional
bank financing.

I.

CIC
(international)

Continental Illinois (Canada), Ltd.
To make an additional Investment of $18
million.

9.

CIC
(international)

Continental Illinois Leasing Corp.
To Invest through this subsidiary into
Coinpanhia Leasing do Brasil "Leasco"
Soctedad de Arrandamento Mercantll,
Sao Paulo, Brazil up to $9 million.

10.

Continental
International
Finance Corp.
(international)

CINB
(international)

Continental
International
Finance Corp.
(international)




07/29/80

Edge Corporations
To reorganize Edge corporations.

12.

07/26/80

Continental Bank, S.A.j Brussels, Belgium
To invest in additional shares at a
cost of $3 million.

II.

03/30/80

07/29/80

Nigerian Acceptance, Ltd.; Lagos, Nigeria
To acquire 26% of shares for up to
$1 million.

08/30/80

I J.

CU(international)

Continental Illinois Oversea* Finance Corp.
To invest an additional $50 million.

14.

CIC
(domestic)

09/09/80

Continental Illinois Commercial Corporation
To establish a de novo subsidiary to make
09/29/80
and acquire loTTtself and others extensions
of credit and to be located in Chicago and Miami
serving the State ol Florida.

13.

CIC
(domestic)

Republic Realty Mortgage Corporation
To permit It to continue selling property
and casualty insurance directly related
to real estate loans not only in the
Chicago SMSA but also elsewhere In Illinois.

16.

CIC
(domestic)

Republic Realty Mortgage Corporation
To engage de novo in providing portfolio
Investment advice to other persons
primarily for real property investment.
To be conducted in Chicago, St. Louis,
Kansas City, Atlanta and Wawatosa,
Wisconsin.

17.

CINB
(international)

Continental Bank
International
(International)

CIC
(domestic)




12/01/80

Branches
To establish branches in Cleveland,
Dallas, Minneapolis, Philadelphia,
San Francisco, and Seattle.

19.

10/03/80

Branch In San Juan, Puerto Rico
To establish a wholesale branch
contingent on acquiring the failing
uninsured Banco Metropolitan de
Uayamon for approximately $7 million.

18.

09/26/80

12/08/80

Continental Illinois Commercial Corp.
To add the State of Illinois to the geographic area served by the activities of
the subsidiary.

01/20/81

102
to.

en:
(domestic)

l)r illainex, Inc.
To acquire certain assets ol it
thiough Continental Illinois Eneigy
Development Corporation.

21.

Continental
Inter national
Finance Corp.
(international)

Continental Bank S.A.| Brussels, Belgium
To request separate lending and
investment limits with respect to
loans and investments involving the
Kingdom of Belgium.

22.

CINb
{international)

CIC
(international)

06/22/81

Branch in Hong Kong
To establish a branch office.

2).

03/26/81

Continental Illinois Overseas Finance Corp.
N.V., Curacao, Netherlands, Antilles

07/09/81

09/28/81

To invest an additional $30 million.
2<*.

CINB
(international)

Continental Illinois Bank (Canada)
To invest an additional $17 million
(Canadian).

23.

CIC
(domestic)

Continental Illinois Trust Company of
Sarasota, N.A. and Continental Illinois
Trust Company of Florida, N.A.
To establish de novo trust companies.

26.

CINb
(international)

CIC
(inter national)




11/02/81

Branch in Manama, Bahrain
To establish a branch office.

27.

10/26/81

11/22/81

Continental Illinois Overseas Finance Corp.
To invest an additional $170 million.

02/02/82

107

28.

Continental
International
Finance Corp.
(international)

Nigerian Acceptances, Ltd., Lagos, Nigeria
To Invest an additional amount up to
$2.0)8 million.

29.

CIC
(domestic)

Continental Illinois Commercial Corp.
To establish de novo office in Los
Angeles.

30.

CIC
(domestic)

Continental
International
Finance Corp.
(international)

CIC
(domestic)

Continental
International
Finance Corp.
(international)

CIC
(domestic)




Od/13/82

Underwriters Bank (Overseas), Ltd.
To acquire additional shares
for $4 million.

3<».

03/30/82

bank of Oakbrook Terrace, Oakbrook
Terrace, Illinois
To acquire a bank.

33.

03/09/82

Commercial Continental, Ltd., Sydney,
Australia
To invest an additional $942,000.

32.

03/01/82

buffalo Grove National bank, Buffalo
Grove, Illinois
To acquire a bank.

31.

02/23/82

06/23/82

Continental Illinois Commercial Corp.
To establish a de novo office in Rolling
Meadows, Illinois serving the state of
Illinois.

06/28/82

104
)).

CIC
(international)

Decalr Corporation

11/08/82

To retain slock in corporation
held in satisfaction of a debt
beyond the permissible 2 year
period.
CIC
(internatloiial)

Continental Illinois Overseas Finance
Corporation
To Invest an additional $180 million
(originally submitted in 4/82 but
delayed until now).

37.

CINB
(international)

Continental Illinois Bank (Canada)
To invest an additional $14 million
(Canadian).

38.

Continental
International
Finance Corp.
(international)

CIC
(domestic)




09/3Q/83

Continental Illinois Bank Ltd., Cayman
Islands, British West Indies
To invest an additional $13 million.

39.

09/14/83

12/07/83

Continental Illinois Corporation Financial
Futures
To expand dc novo activities to
include execution and clearance lor
non affiliated customers of financial
futures contracts in Chicago, London
and Singapore.

03/13/84

105
The Federal Reserve's review of CINB and CIC applications focused special
attention upon the latest O C C examination and FRS inspection reports to assess the
financial and managerial conditions of CIC and CINB, respectively. Federal Reserve
internal

memoranda,

in reviewing

applications, referred to

and in making

recommendations

upon

these

various comments appearing in these reports, including

adverse comments, and explained their significance.

The central safety and soundness issue facing CINB and CIC was clearly stated
in 1979 in both

the

OCC's

examination

report

and in the

Federal

Reserve's

inspection report. The O C C said:

Our review of the credit administration system disclosed deficiencies relating
to the identification and rating of

problem loans.

Some loans

were

not

reviewed by bank staff in keeping with system objectives.

In addition, several

loans

traditionally

which are internally

rated

"B",

and which

have

been

regarded as sound from a review evaluation standpoint, are criticized In the
report

of

examination.

The

Importance

o!

reliability

of

internal

loan

evaluation procedures as an early warning mechanism to control credit quality
In a growth environment cannot be overemphasized.

Several credits which were rated " B " by the system, and therefore expected to
possess the qualities to preclude criticism, are criticized in this report.

Other

credits, which are subject to review, were found to have eluded the credit
rating process. These factors combined with the 15% growth goals cited in the
strategic plan suggest

that a reappraisal of the credit rating process and

systems is appropriate.

Additionally, since the bank is heavily dependent upon

purchased funds to support assets and provide liquidity, maintenance of good
asset quality
acceptance.




b

necessary

to Insure

a continued higft degree

of

market

loti
The f ederal Reserve holding company Inspectors said;

Continental Illinois Corporation continues to rely heavily on volatile funds to
sustain growth

in assets and earnings.

The

dependent on the quality ol underlying assets.

success ol

such a policy

is

In this connection, It is noted

that asset quality appears to be improving, although results ol

the recent

examination ol Continental Illinois Corporation's subsidiary bank are not yet
lully available.

While asset quality control systems appear adequate, we urge

continued close attention to this vital area, especially during prolonged periods
ol high interest rates and retarded capital formation.

Thus, from both the Federal Reserve and OCC, the focus of concern was on
the relationship between asset quality, volatile funding, and capital.

The subsequent examination and inspection reports expressed similar concerns
about CINB's level ol classilied assets, dependence on volatile funds, and high loan
growth as related to its capital adequacy.

Despite these repeated expressions of

concern,

was denied, or

not

one

Continental

application

approved

subject

to

conditions requiring CIC/CINB to address the concerns expressed by both OCC and
Federal

Reserve

examiners

Federal

Reserve

internal

during

this period.

memoranda,

critical

While usually acknowledged
comments

in OCC

in

examination

reports and Federal Reserve inspection reports were typically counter balanced with
more positive statements, or explained as being of no major concern.

Continental applications to acquire two banks in the Spring of 1982 just prior
to the Penn Sqare failure, provide a case in point.

The Federal Reserve's analysis of

the applications was based upon the 1981 OCC examination and FRS inspection
reports. A f t e r declining to 60.8% in 1980, CINB classified assets, as a percentage of
gross capital funds, rose in 1981.
OCC

in its

Hie increase was prominently set forth by the

1981 examination report cover letter

to the Board of

Directors of

CIC/CINB;

The primary locus of the examination again was on an evaluation of the credit
portfolio.

That credit review revealed a deterioration in the level of classified

assets to 67% of gross capital funds ( G C F ) and criticized assets to 99% of GCF
from 61% and 82% respectively the previous examination.




OCC examiner* also noted that stale rated credits were increasing and that
"no one is monitoring

this situation."

Despite

these observations,

the Federal

Reserve analysts recommended approval ol the bank acquisitions and attempted to
explain away examiner concerns;

Examiners also noted an increase in the severity ol those criticized assets as
evidenced

by

the

increase

in

weighted

classifications...

Primarily,

the

increase in adverse classifications r e f l e c t s a general deterioration of both the
domestic and foreign economies rather than less stringent credit standards by
Continental Bank's management.

Furthermore very few credit relationships

established during the 12 months preceding the examination were criticized.
It appears that Continental Bank's management
problem

credits

while

corporate philosophy.

generating

continued

is capable of handling the

loan growth

In keeping

with

In the future, extensions of credit will primarily be

targeted at the energy industry and multi-national firms, where Continental
Bank has had successful ventures.
(Internal Memoranda of the Federal Reserve concerning CIC's applications to
acquire Bank of Oakland Terrace, April, 1982 and Buffalo Grove

National

Bank, February 2U, 1982.)

O C C examination reports from 1979 to 1982 also expressed concern about
CINB's high loan growth and its relation to capital adequacy.

Many of these adverse

comments were reiterated in Federal Reserve memoranda, but rationalized away.
Much confidence wa* placed in the ability of

the regulatory agencics to handle

Continental's loan growth and its deterlorating capital separately from the actual
processing

and approving

of

certain applications (Internal

Memorandum

ol

the

Federal Reserve on CIC's $30 million investment In Continental Illinois Overseas
Investment Corporation, August 19, 1980. The trend of declining capital ratios as "a
current money center peer phenomenon" was cited in concluding that CINB WJS in
satisfactory condition in one application (Internal
Reserve on Continental Bank International's




Memorandum

of

the

Federal

108

Reserve on Continental bank International's establishment ol b branches, November
5, 1980).

Furthermore, CINB's management expertise was deemed to be capable ol

handling CINB's declining capital in the approval ol CIC's previously

mentioned

application to acquire two banks:

Aiiivough examiners expressed some concern with the erosion of Continental
Bank's capital with respect to both total assets and risk assets, capital was
deemed satisfactory due to the expertise Continental Bank's management has
historically

exhibited,

its consistent

earnings, and its

adequate

loan

loss

reserve.
(Internal

memoranda

ol

Federal

Reserve

concerning

CIC's application

to

acquire Bank ol Oakbrook Terrace, April 1, 19112 and Bulfalo Grove National
Bank, February 24, 1982.)

This confidence
1983.

in Continental's management was expressed once again in

Management's recovery plan is cited in FRS memoranda that recommended

approval of two applicationsi

It

now

appears, however,

Continental

management

that
has

Continental's crisis stage has passed, and
established

a

recovery

plan

involving

improvement of asset quality as a top priority, as well as expense control and
expansion of

funding sources.

While

the nonperforming asset

levels

and

provuon for loan loss expenses continue at higher than expected levels, Bank's
mid-year

1983 earnings

importantly,

Bank's

improved

traditional

to

an annualized 0.34

funding sources have begun

Continental's share price has shown moderate
primary capital ratio of

percent.

More

to return and

improvement.

Also, Bank's

3.3 percent as of June 30, 1983, exceeds the 3.0

percent minimum for multinational banking organization...Staff

recommends

approval...
(Internal memoranda of the Federal Reserve concerning CIC's investment of
180 million in Continental Illinois Overseas Finance Corporation, September 9,
1983; and Continental International Finance Corporation's investment of $13
million into a Cayman Islands subsidiary, December 2, 1983.)




10'J
Coitclusion

The Federal Reserve approved 39 Continental applications Involving the Bank
Holding

Company

Operations)

Irorn

Act
1979

and
to

"Regulation

the

Spring

o(

K"

(entitled

1984.

International

hanking

In its consideration of

these

applications, the Federal Reserve considered financial and managerial factors of the
entities involved, including such specific factors as capital, management, asset
quality, earnings, growth and future prospects.

Despite negative comments in O C C

examination and FKS inspection reports concerning CINB's level of classified assets,
volatile funding, and its loan growth relative to capital adequacy, the FRS approved
all applications.
the

Federal

These approvals may have conveyed to CIC and to the public that

Reserve

basically

approved

of

the

characteristics of CIC and of its subsidiary bank, CINB.




operating

and

financial

CHAPTER VI
MARKET EVALUATION OH CONTINENTAL
A.

Backgioutd
Continental's shift Iroin the conservative Institution it was viewed to be in the

past, as a provider of safe harbor settings lor people and businesses to keep their
money, to an institution striving for constant growth at home and abroad, took place
during tlte mid I960'* to the 1980 period.

During this time, the Bank developed

extensive international operations and created a number ol specialized service
groups auned at servicing the Bank's growing collection ol oil, utility and tinanCe
company customers, as well as a host of oilier service units, by 1983, the Bank was
I
being character ized as tt>e largest in Chicago and the 7th largest in order of assets
and deposits in tne U.S. Such growth, however, was not without its problems, and as
can now be seen through hindsight, Continental was eventually caught between a
past that could not be retrieved and a future that could be barely be discerned.
Given this vet ol circumstances, it is easier to understand the dilernna of the
rating agency, the institutional investment liouse, and the government regulator,
regarding tins health of Continental. In some respects. Continental was trading on a
market perception that had its origins Just beyond the reach of modern memory -- a
memory, it might be added, that bears out the observation attributed to G.K.
Chesterton Otat "the one great lesson of history is that we do not learn from
history."
pew who examine the trauma of Continental's decline and failure in the 1980's
will argue with the accuracy of Chester ton's observation. Indeed, if taken the next
step, the chain ol events climaxed by Continental's collapse in I98<» implies strongly
that those who fail to learn from history are (as the adage goes) condemned to
repeat it.

In 19)1, Jesse Jones, one-time chairman of the Reconstruction Finance

Corporation (RFC) had tlte following comment to make, concerning the Continental
of his day:

Continental Illinois was one of relatively few large banks in which we required
a strengthening of the management. Our controlling stock ownership and the




(110)

bank's previous management justified these requirements. (Jesse Jones, l illy
billion Dollars - My Thirteen Years with RFC, New York, 19)1, p. <»/.)

Jones, of course, was describing events that look place in 193), involving the
RFC bailout of the Continental Illinois Bank of that day.

The bank had faced an

earlier crisis due to heavy investment losses resulting in the collapse of the Insull
enterprises. Samuel Insull, a Chicago utilities magnate of the I920's-I930's era, was
president or chairman of the board of no less than 83 companies.

The significant

risks associated with interlocking directorates were realized when Insult's financial
empire collapsed, bringing down many of the nation's utilities and banks with it.

Continental's Insull losses were no less staggering in impact on the bank than
those it would face 30 years later in 1982. In 1932, the bank was obliged to write off
$30 million of potential losses.

This was followed by $60 million more in 19)).

Continental's deposits fell from $1 billion to an estimated $ 0 0 million and had it
not been for the intervention of Jesse Jones and the RFC, the bank would almost
certainly have "gone under completely."

In an almost clairvoyant statement, Jones

had the following to say about Continental!

It was a great correspondent -- a bankers' bank — in which a large portion of
the country banks of the Middle West and many in the South and Southwest
kept accounts. Had it collapsed, the e f f e c t would have been frightentngly felt
in fields and towns and cities over a large area of the country. (Ibid, p. M7)
In a manner later to be emulated by Wiliiain Isaac, chairman of the FDIC,
Jesse Jones injected $30 million, an enormous sum in that day, into Continental with
the then novel understanding that the RFC would have a hand in selecting the bank's
new chairman and other officers as well as board members.
the troubled bank was Walter J.

Jones' choice to direct

Cummings, then chairman of the newly created

FDIC. Cummings served Continental well and for the sake of restoring the bank's
integrity in terms of public confidence, did what has been heralded as an outstanding
job.




\\2

Never

iheless, over ihe decades ol his leadei

ship,

hierarchy were known lo chafe under his conservaiisin.

other echelons ol the bank's
Mis replacement by David

Kenrtedy in 19)9 signalled the beginning of a new era in the continuing Continental
saga.

In published reports, Kennedy was identified as a champion of

"creative

banking" —a term which seems to serve as a financial euphemism (or delegation of
authority to lower level personnel coupled with a caveat "to go forth and do good" aggressively.

Kennedy's ten-year term as chairman (he left in 1969 to become

NUon's Secretary ol the Treasury) prefaced the arrival of the "go-go" atmosphere
that was to plague Continental as time wore on, and to eventually cause its second
great financial and managerial crisis.

One of the minor, though not insignif icant, ironies to be noted regarding the
first Continental bailout concerns the financial results of the RFC'* action In the
1930's.

At the time of the 193) iniection of $30 million into CINB by Jones, the

bank's common stock sold at $23 a share. Four years later, those same shares were
selling at $223 a share — a 9-foid increase in their value, and due almost entirely to
U>e RFC presence and guarantee ol performance.

In the jame vein, Cumming's

lasting contribution (if lasting can be defined as until 1984) was a Continental that
had retired the last of the RFC's preferred stock, and a Continental that was again
pronounced healthy as a "going concern."

Continental Illinois National Bank and Trust Company
the National

Bank Act

on October

13, 19)2.

was chartered under

As such, the

new

institution

represented a union of Continental National Bank and Trust Company of Chicago
and the Illinois Merchants Trust Company and was the result of a series of earlier
mergers and consolidations involving a number of smaller banks, savings associations
and trust companies.

Historically, CINB's evolution can be traced from 1437 to the

present through the growth of small antecedent banks in the regioni their merger
and

consolidation

patterns;

and

the

emergence

of

the

modern

Continental

organization serving a national and international clientele as wtll as its Chicagoarea customers.




The earliest predecessor to CINB was the Merchant's having*, Loan and Trust
Company, established in 18)7 by a gionp ol Chicago businessmen and an original
subscription ol $300 thousand.

The bank changed its name to Merchant' Loan and

Trust Company in 1881 and functioned as such until its merger with the Illinois Trust
and Savings Bank in 1924. One archivist lor the bank described the organization ol
the Merchants Loan and Trust Company in 18)7, as taking place during a period of
"country-wide lolly and irresponsibility" when uniformity and stability had not yet
been impressed upon American banking through national law, and the "license for
mad financiering had wrought perilous insecurity to trade and finance." Answering
the necessity, leading mercantile interests united and established this bank on "sane
principles." (Illinois Merchants Bank Building, Illinois Trust Company, Chicago, 1922,
n.a., h.p.)

Paralleling

the evolution of

the Merchants' group into the Illinois Trust

component (and thus the "Illinois" in CINB) was the Continental National Bank,
chartered originally in 1883, with capital ol $2 million — a record of that day. By
the turn of the century, the stage had been set for the development of a large, bigclty

bank.

Chicago

was growing.

As various forms of regional commertcal

enterprise expanded, so did their need for capital and lending capacity.

Between

1910 and 1927, Continental National Bank went through several additions until in
1927, when it merged

with

the Commercial

Continental National Bank and Trust Company.

National

Bank, and formed

the

Two years later, in 1929, it joined

with the Illinois Merchants' Trust Company to form the CINB, and so doing, gave
Chicago its first billion-dollar bank, with capital funds of $140 million and total
resources of $1,162 billion.
consolidations

involved

in

(For a complete listing ol the various mergers and
the

eventual

creation

Investments, Part IV, New York (1932), pps. 1169-79.

of,

see

Moody's Manual of

By rough count, at least l2

similar consolidations and mergers led up to the Illinois Merchants Trust Company.)

The current version of the bank, Continental Illinois National Bank and Trust
Company of Chicago, received a national charter in 1932.

The bank's most recent

merger took place in 1961, when City National Bank and Trust Company merged
with CINB.

The merger completed the growth process by which those who directed

CINB felt the bank could best serve the interest of the city, the region, the nation




114
Ai»d the world.
nature of

A review of these market perceptions demonstrates the general

confusing assessments

that

accompanied

that

transition.

First

the

seiionty analyst4* view ol Continental.

El.

T)ke Security Analyst's Perception of Continental
The February 9, 1976 purchase recommendation made by Morgan Stanley and

Company typifies the earlier stages of optimism, reflected through the institutional
research of various Wall Street securities organizations:
Continental Illinois Corporation is a new addition to the list
of

bank holding

Company,

companies in our model portfolio.

in

our

view,

characteristics

that

today's

possesses
bank

stock

several

The

of

investor

the

greatly

appreciates and wants, including a strong capital position and
valuation reserve, relatively low credit-loss experience, and
most important, prudent, conservative management.

As 1976 drew

to a close, analysts' statements were depicting

Continental

Illinois as in the midst of a period of consolidation, meaning, in their view, that the
corporation was moving to strengthen its position in both domestic and international
markets.

Continental had reportedly just received a study of its organization done

for it by McKinsey and Company, that had concluded that greater overall market
penetration could best be achieved by specializing
customers.

the delivery of services to

This meant eventual reorganization of the Bank's lending departments

(which was to take place in 1977), with the announced purpose of achieving a position
as "one of the nation's top three banks serving business corporations with worldwide
operations." (Morgan Stanley, November 23, 1976) The Morgan Stanley stock analyst
added;

We believe that Continental is building on an already strong base and regard
this latest initiative as representative of the Company's highly professional
artd generally
contacts

with

very

conservative

senior

business system (emphasis added).

management

also

reveal

a

similar

Our

dedication

thoroughness and conservatism in the Company's international growth plans,




to

its electronic banK.ng endeavors, and its overall corporate growth objectives.
In short, we remain confident that, despite challenging circumstances, the
Company will maintain steady earnings progress which will be rewarded with a
higher stock price valuation. (Ibid.)

to become one of

Hi?

nation's three top banks serving multinational companies before the end of

Continental was seen as trying to structure Itself

the

decade (1980), and at that time was being viewed as one of the five leading banks
serving

major

corporate

customers,

along

with

Citibank,

Manufacturers Hanover Trust, and Morgan Guaranty Trust.

Chase

Manhattan,

These same analysts

were touting Continental as a realistic competitor by 1980 for third place in the
constellation, ranking just behind Citibank and either Manufacturers Hanover or
Chase.

Hindsight always provides more than an ordinary touch of irony, and 1976 was
no exception lor the analysts were then giving added emphasis to Continental's
continued stress on cost controls and loan portfolio quality. These were viewed as
strong points in the Continental game plan. In their estimation,

the current planning phase of Continental would be one in
which the bank would continue to emphasize cost controls. In
turn, that meant particularly good control of staffing levels.
(Ibid.)

Based on an extensive discussion held in late 1976 between CINB Chairman
Roger Anderson and a number of bank stock analysts, Anderson was quoted as saying
that Continental was trying "very carefully not to become enamored with a numbers
game, so that we don't wake up five years from now and find we haven't the staff to
handle the increased volume of business that we have, and which will be developing."

As is now known, Penn Square demonstrated that CINB emphasized cost
control in its staffing priorities rather than concern for maintaining adequate staff
levels to administer its growing oil and gas portfolio.




116

Market

a/ialysts

ol

the

day

were

generally

uniform

in

their

praise

of

Continental's 1976-1977 policy of maintaining a strong reserve (or loan losses. Much
of

that condition was due to the Bank's relatively large exposure to the then-

troubled reaJ estate investment trust field. The following table depicts the loss
reserve/loan ratio maintained by the 10 largest bank holding companies, as of
September 30, 1976.

Loss Reserve/Loan Ratio
10 Largest Bank Holding Companies 9/30/76

Continental Illinois

1.40%

Western Bancorporation

1.18%

Chase Manhattan

1.17

J.P. Morgan

1.12

First Chicago

1.00

Chemical

0.98

Manufacturers Hanover

0.93

Bankers Trust

0.91

Citicorp

0.84

BankAmerica

0.81

(Source; Morgan Stanley, Nov. 23, 1976)

By mid?1978, Continental was being praised as a bank destined to rank among tlie
moat profitable very large banks in the U.S. with a rate of earnings growth projected to
increase to about 13% - up from 9% achieved in 1976-1977. For 1979, profit gain was
being projected between 12% and 18%, with the result that Continental stock was being
given a very strong "buy" recommendations. One analyst noted the following:

Our confidence in a strong two-year earnings outlook tor Continental is
buttressed by the Company's well-defined strategies and documented
progress in raising its basic profitability. In particular, we believe
Continental will achieve further ROA and ROE improvement in 1978 and 1979,
partially as a result of continuing managerial emphasis on four areas:
the improvement of its relative position in various commercial lending markets;




Ihe expeditious cleanup of re/ruining problem real estale jsseis; Hie more efficient
control of nonlnterest operating expensesi and asset liability management geared
toward minimi/log the e f f e c t s of fluctuating interest rates and sector credit
demands on the bottom line. (Morgan Stanley, June 2, 1978)

Some of this optimism was based in part on early analyst acceptance of the
ambitious corporate goal of

annual growth for CINB, outlined by George It. liakor

(CINB executive vice president) at a November 1977 meeting of the New York Society
of Security Analysts. At that meeting, Baker cited CINB lending to energy-related
industries and multinational companies as among those expected to produce the highest
rates of return to the bank. Energy-related industries such as mining, petroleum, gas,
and public utilities, underscored Continental's increasingly strong position in the
energy-lending business — an activity dating back to the mid-i9)0's, and one which
had achieved substantia! investor recognition as the bank moved aggressively into these
fields. Continental's expertise was then viewed as very broad, and as having been
developed in a gradual, careful manner characteristic of most of the Company's
significant undertakings.

A distinguishing mark regarding Continental's growing preeminence in the lending
field was its opting for more and better customer service - or so the impression was made
upon various analysts. The bank's announced goal of adding )00 people to its staff, over
the three year period of 1978-1980, primarily in the lending area, was met with glowing
comment:

How

has

Continental

achieved

the

competitive

edge

in

personnel quality implied by recent independent surveys of
large corporate borrowers?

On a recent

headquarters, we asked several
answer

to

this question.

top-level

Two basic

visit to Chicago
o f f i c e r s for

factors

the

consistently

emerged in their explanations: a strong dedication to training
and

development

and

delegation

of

responsibility.

The

commerical lending department's training program has been
established since the Forties and has received
support of top management.

the strong

Continental's strategy has been

to satisfy Its people needs through recruitment and Internal
development,

offering

very

coinpetitve

compensation

obtain highly qualified university graduates. As a rule, the




to

118
Bank

ukes

a

long-term

view

of

individual

Specifically, individuals are generally

given

performance.
three

to

five

years to learn the Bank's operating and lending philosophies
and develop as credit o f f i c e r s .

The development of Instant

successes it neither sought nor encouraged.
which promotes

the

growth

and

The other factor

retention

of

good

loan

o f f i c e r s is the Company's policy of delegating a relatively
high (based on industry standards) degree of credit authority
to junior o f f i c e r s by eliminating the committee process of
decision making on all but the most significant credits.
(Ibid.)

Some of the ramifications stemming from the bank's policy of delegating a
relatively high degree of credit authority to "junior" loan o f f i c e r s were to result in
the

Penn

Square

mishap.

Had

lower

authorized

levels of

credit

maintained, some set of checks or balances might have emerged.

action

been

Given the choice.

Continental felt it more justified to eliminate the bureaucracy it believed dominant
in large organizations. This may have led to retention of personnel, but it must also
be recognized, however, that this degree of delegation clearly led to some of the
more irregular aspects of CINB's relationship to Penn Square, and In turn, may also
have led to the downfall of the management of Continental following the collapse of
the bank's financial base In I98<».

There was little visible disagreement among market analysts, regarding the
attractiveness of Continental stock.
during 1979.

Continental

appreciation potential was of paramount interest.
one of

was held in fairly high regard

As an issue especially suited to investors to whom long-term capital
E.F.

Hutton rated the stock as

two new "Buy" recommendations added to its list.

The bank was seen

paralleling the growth and development record of Citicorp, and making a major push
domestically to build its consumer lending (at that time comprising only 3% of the
loan portfolio).

Hutton's November

1979 staff

notes stressed that bank market

strategy of the day was being set in anticipation of "sharply higher consumer-related
earnings in coming years, when interest rates and loan loss levels are expected to
recede." (Hutton, November 1979)




The

analysts

continued

to

hold

Continental

up as a well-managed

unit

throughout 1980, pointing out that charge-offs in 1980-1981 were more or less a
reflection of the recession, and that loss provisions were likely to Increase due In
part to the continuing expansion of

the loan portfolio. (Mutton, May

13, 1980)

Throughout 1981, Continental continued to be viewed as a stock for the conservative
investor, interested

In the preservation

of

capital, high current

income,

and

moderate growth in value, and was seen as one of the steadiest performers among
wholesale banks, with earnings growing at an average annual rate of a little over
11%.

The following comment by Bache on, May 7, 1981 reflected overall industry

sentiment at that timet

Continental Illinois continues to excel in gaining market share and presflge in
domestic corporate lending.

Their momentum has taken them to a position

among the top three U.S. banks in polls of corporate treasurers, surpassing in
the process several larger and better known banks. Chairman Roger Anderson
has done a superb job of increasing market penetration without commensurate
increase In loan losses.

Then came 1982, and with it, the hints of trouble.

On February

17, 1982,

Hutton wired the following observations to its subscribers:

Continental Illinois
(C1L-30K)

ALL WIRES #I0<»
FEBRUARY 17, 1982

There was an article in this morning's paper about Continental Illinois'
rise in non-performing loans which indicated that Continental's non-per(orming
loans increased $100 million from the third quarter and now equal
outstanding loans.

A few remarks are in order:

oi

The article pointed out that

non-performing loans peaked during the last economic cycle at 3.8% of loans,
so Continental Is about a ihird of where it was then. Continental has been one
of the more aggressive commercial lenders particularly since its




120
primary competitor, Fint Chicago was burdened by Internal turmoil and was
essentially out ol the market for some while.
more

I believe Continental will get

than Its share of non-performing loans and charge oils due to its

aggressive lending policies. In terms of an industry perspective we are at the
point now where non-performing loans and charge-offs will be Increasing.

I

think they will be manageable but could exert a negative elfect on the prices
of bank stocks.

As far as Continental Is concerned, I think there may be

more risk in its earnings due to credit problems than say, First Chicago, but
not of sufficient magnitude to cause major earnings problems. I think there
is a better opportunity to make money with First Chicago, however, since
FNB has started from a modest base and should improve while oil may have
more pressure to maintain at least an excellent record. This is a good swap
idea.

Additional information is available upon request. End.

By mid 1982, Hut ton's analyst was moved to observe the following, including a
warning that all energy lending is not bad (alluding to Penn Square), but there are
some questionable characters in the field:

INVESTMEhfT SUMMARY

July 16, 1982

Continental Illinois ( C l l - 2 0 ) / Chase Manhattan (CMB-39) (7/7) Harold Levine

Lowering 1982 estimates for Continental Illinois and Chase Manhattan in
connection with loan participations with former Penn Square Bank. Assuming,
at this point, roughly 20% of these loans will be charged o f f . Based on Its $1.2
billion exposure, believe Continental's potential losses are $2<*Q million which,
assuming management will make provision for this amount, will contribute to
an after-tax loss of $6) million or $1.60 per share.
estimated

at

$3.80-$<i.00 per

share

versus prior

Full year earnings now
$6.80 projection.

For

1983,lowering estimate $0.10 to $7,30. Using same charge-off assumptions for




Chase, Its $230 million exposure would result In after-tax charge of roughly
$0.30 per share. This brings second quarter loss to $1.00 and full year
estimate down to $8.70 from $9.20. Changing Chase Investment rating from
4-2 to 4-3. Continental rating now 4-3 versus prior 2-2 rating. Each stock
certainty capable of snapping back a few points from here, but would avoid
this strategy except for traders with strong hearts.

In Its July 16, 1982 Invesunent summary, E.F. Hutton toted up the bad news,
regarding bank stocks, (that week had witnessed a 3.9% decline by the group, while
the market rose 1.3% overall) ruminating that "the pen is mightier than the sword,"
and In this case various "Penns" had done much more damage to bank stock investors
than any sword might have wrought. The reference, of course, was to Penn Central,
First Pennsylvania Bank, arid as of mid-1982, Penn Square. The 1982 default of the
Orysdale Government Securities Corporation had not helped matters at all either.
The Drysdaie collapse led to money center bank writeoffs (as clearing houses for
Orysdale

transactions) of

Manufacturers Hanover.

at

least

$270 million by Chase and $20 million by

The Treasury losses in taxes paid to the U.S. Treasury was

estimated to be $133 million.

Hutton apparently saw an unfortunate parallel between Drysdaie and Penn
Square, but, at the same time, one viewed as isolated and disconnected.
links In a "chain ol financial disasters." The parallel was explained this way:

In each

case,

the

underlying

securities

trading

ignoble.

However,

imprudently.

or

energy
the

activity,
lending,

operators

in

I.e.,

is not
each

government
particularly
case

acted

The "unfortunate parallel" is that a particular

bank in each Instance failed to curb or control adequately its
dealings with these operators.

The problems were avoidable

as they related to Chase and Continental Illinois.

If there

had not been an undue concentration of business by these two
banks, the failures of Orysdale and Penn Square would not
have caused the stirs they did.
(Hutton, Investment Summary, July 16, 1982, p. 24)




And not

1411

By now, market perceptions held by the stock analyst were becoming more
than clear.

They were blunt.

questionable

characters

"All energy lending is not bad, but there are some

in the

field."

(Ibid. p.

19)

In one rather

glaring

understatement, the Hutton analyst was prompted to conclude that he doubted
Continental had inis|udged the value ol oil and gas reserves in the Penn Square case.
Rather, he was of the opinion the adequacy of oil reserves was really a matter o(
documentation, and that Penn Square had obviously gained a great deal of collateral
mileage out of the same oil and gas reserves.

A foreboding sense of disaster was finally emerging.
C,

The Examiner's Perception of Continental

In a recent study touching on deposit insurance in a changing society, the FOIC
concluded that improved disclosure of bank financial and operating information
(would) help focus stronger market discipline on risk taking by banks.

The FDIC

categorized such discipline as an "Important supplement to the lederal regulation
a/>d supervision of institutions."

(Deposit Insurance in a Changing Environment,

FDIC, April 1983, p. IV-I)

The potential for such disclosure is all the more obvious when viewed through
the spectrum of contrasting views of Continental over the period of 1976 through
1981-82, held by the examiners who were most responsible for advising the top level
Federal regulators, and those most actively involved in advising the investor in bank
stocks.
In 1976, when Continental began its move to become one of the three top U.S.
banks, the bank's starting point was not the strongest.
classified assets

to gross capital

funds was

Continental's ratio of

121%, and was being viewed by

examiners as troublesomely high, meaning that the volume of CINB loans classified
as "substandard," "doubtful," or "loss," was well over the loss absorption ability of
the bank. In fact, three months before CINB announced (July 1976) OCC examiners
had rated the Bank's condition as only Fair, and cited a number of matters as
requiring attention:

Classified assets amount to $1.2 billion which is 121% of gross capital
funds versus 109% at the tune of the previous examination.




Gross capital funds amount to

of total resource:*, down from b. I'i»

last examination.
The bank continues to rely heavily on purchased funds to carry its assets.
As of the examination date,

of net assets, as compared to <*9% last

examination, were supported by funds whose cost was a money market
rate.

This matter and the related issue of liquidity are of continuing

concern.

When matched against the Morgan Stanley appraisal offered in February, 1976,
the starkness of contrast can easily be seen (see p. 1 !<»).

In the confidential section of

the report the OCC examiner went on to

characterize CINB's capital position as follows!

Inadequate.

Gross

capital

funds are

unchanged from last examination.

loaned

10.5 tunes

which is

However, the volume of classified

continues high as 121% versus 109% last examination.

Management is

seriously considering going to the capital market before year end but
nothing is definite at this tnne.
(Confidential Memorandum to the Comptroller of the Currency, Report
of Examination, April 1976, p. D~c)
The commentary of OCC examiners regarding the loan administration and
credit quality systems adopted by CINB are especially significant, and again, for
what they might have spelled out to the investment advisor had he or she had access
to their content.

CINB's decentralized, growth-oriented loan managinent system

gave individual loan officers a great deal more independent lending authority than
was the norm in other money center banks.

If a loan developed "prQblerns", it was

the responsibility of the CINB loan officer to put it on a "watch" list.

If he/she

chose not to do so, senior management had no way of knowing the loan was in
trouble until It was independently reviewed and rated by the Loan Review Division
of Continental. That could be quite late in the process. By 1981, the ratio of




1411

problem

loans to capital

was noticeably

on the rise.

More important,

loan

managment review by OCC examiners produced the following assessment of CINB
practices:

A review ot these internal reports for domestic credits only
reflects a significant increase in old-rated credits from last
examination.

In analyzing this report, it was determined that

approximately 373 credits, aggregating $2.4 billion had not
been reviewed

within one

year, with fifty-five of

credits not reviewed within two years.

these

This compares to

approximately 270 credits over one year, totalling $1.6 billion
in June, 1980, with twenty-five credits not rated within two
years. Responsibility currently rests solely with the divisions
to provide information for re-review. However, it is evident
that no one b monitoring this situation to ensure that all
credits are receiving

timely

reviews, as required by the

corporate o f f i c e .

An even more harsh assessment of CINB loan management practices can be
gleaned from an internal memorandum prepared by Kathleen Kenefick, a loan
officer in the oil and gas division of CINB. It will be recalled that a large portion of
CINB loan activity was being handled through this division of the bank.
made the following assessment in July 1981:
Tlie status of

the Oklahoma

accounts (particularly

Penn

Square Bank) is a cause tor concern and corrective action
should be instigated quickly to stem any future deterioration.
Potential

credit problems could be going unnoticed, thus

possibly mbsing opportunities to improve our position and/or
prevent some losses. Management of credit relationships has
not consistently taken place, with minimal forward planning
of CINB and/or customer actions occuring. In some cases the
initial credit writeup had customer information missing, out
of date or incorrect; in other cases there has not been a
credit writup.

Follow up and accountability have been rare.

Thorough monitoring is hindered when both strengths and




Kenefick

weaknesses of the customer are not discussed.

Housekeeping

problems (missing notesheets and approvals, documentation
errors and omissions, past due principal and Interest, etc.)
compound the situation. All of this may result in delayed or
possibly

lost

Income

opportunities both (or

to

the

bank.

Potentially

future business and (or

missed

correcting

possible problems are the result when "reaction" is all we can
handle.

The Oklahoma calling personnel continually fight to

keep their heads above water, with tune spent putting out
fires, and therefore falling further behind.
(Memorandum of Kathleen Kenefick, July 29, 1931, p. 1)

A year later the financial dimensions of CINB loan management and credit quality
problems in the oil and gas division were clear. From $8? million In 1981, their classified
level had risen to $649 by 1982.

Whether making this type of information available to the stock market analyst
would be a helpful addition to his/her analysis deserves serious review. Certainly it seeins
logical to believe that it might have been as persuasive in providing evidence tor assessing
Continental as those given earlier by Dun's Review in 1978 when the bank's aggressive
approach to growth and expansion warranted it being characterized as one of America's
five-best managed companies.
Continental Illinois has achieved one of the best and most
consistent performance records in the industry over the past
five years. ... Most important to Continental has been the
growing impact of its loan business, which soared from $2.6
billion in 197 3 to $1.9 billion at the end of 1977.

And its

domestic loan business was up 19% over a year earlier at the
end of I978's third quarter.
("The

Five

Best-Managed

December 1978, p. <*2)




Companies,"

Dun's

Review,

12(i

D.

Tl>e Rating Agency's Perception of Continental
Rating agency perceptions of Continental are reflected largely through the issuance

of credit watch statements such as those published by Standard and Poor's industry
outlook studies as well as the issuance of securities ratings prepared by Moody's and other
rating organizations. These efforts are aimed at providing potential and existing Investors
with a fairly

uncomplicated

system of

investment in the bank can be weighed.

grading so that the prospective

quality

of

Moody's, for example, maintains throughout the

rating process that the rating itself should be used in conjunction with descriptions and
statistics carried in their Manual (an annual compilation).*

They also maintain that their

ratings are not commercial credit ratings, and in no case is default or receivership to be
imputed unless expressly so stated in their Manual.

SAP operates in much the same

manner. • •

Moody's amended their generic rating categories (aaa, aa, a, baa, etc.) by including
>

numerical modifiers (i.e. I, 2, 3 meaning from highest to lowest within the rating scale)
and apply them to preferred stock issues offered by banks.* (The modification was
completed on May 3, 1982, and is noted below).
*Moody's preferred slock rating symbols and their definitions are as follows:
"aaa"
An issue which is rated "aaa" is considered to be a topquality preferred stock.
This rating indicates good asset
protection and the least risk of dividend impairment within
the universe of preferred stocks.

An issue which is rated "aa" is comidered a high-grade
preferred stock.
This rating indicates that there is
reasonable assurance that earnings and asset protection will
remain relatively well maintained in the forseeable future.
"a"
An issue which is rated "a" is considered to be an uppermedium grade preferred stock. While risks are judged to be
somewhat greater than in the "aaa" and "aa" classifications,
earnings and asset protection are, nevertheless, expected to
be maintained at adequate level.




Y£l

"baa"
An Issue which Is rated "baa" is considered to be
medium grade, neither highly protected nor poorly secured.
Earnings and asset protection appear adequate at present but
may be questionable over any great length of time.
"ba"
An issue which is rate "ba" is considered to have
speculative elements and its future cannot be considered well
assured. Earnings and asset protection may be very moderate
and not well safeguarded during adverse periods. Uncertainty
of position characterizes preferred stocks in this class.
"b"
An Issue which is rate "b" generally lacks the
characteristics of a desirable investment.
Assurance of
dividend payments and maintenance of other terms of the
issue over any long period of time may be small.
"caa"
An issue which is rated NcaaM is likely to be in arrears
on dividend payments.
This rating designation does not
purport to indicate the future status of payments.
"ca"
An Issue which is rated *ca* is speculative in a high
degree and is likely to be in arrears on dividends with little
likelihood of eventual payment.
This is the lowest rated class of preferred or preference
stock. Issues so rated can be regarded as having extremely
poor prospects of ever attaining any real investment
standing.
• • Rating agencies are also very careful to explain that bank rating factors are
very different from criteria used for other industries, and that it is less the
quantifiable or

qualitative

factor

than the so-called

external

factor

that

is

distinctive and that must be weighed accordingiy(emphasis added). Because of this,
items

such as financial

statement

analysis (quantitative) and location, public

confidence, and market position (qualitative) may be weighted differently when
compared or contrasted with what is actually happening in the area of the bank's
regulatory, legal, or economic environment.




1411

Evidence of

a push to qualify analyses on what is asset protection can be

drawn from Moody's March 19, 1982 action to lower its ratings on the senior long
term debt of moat ol the nation's largest bank holding companies (see below, listing
of corporations a f f e c t e d by the action)

Bank America Corporation...
Chase Manhattan Corporation
Chemical New York Corporation
Continental Illinois Corporation
First Bank System, Inc.
Manufacturers Hanover Corp.
Mellon National Corporation
National Ciry Corporation
Northwest Bancorporation

To
Aa
Aa
Aa
Aa
Aa
Aa
Aa
Aa
Aa

From
Aaa
Aaa
Aaa
Aaa
Aaa
Aaa
Aaa
Aaa
Aaa

Moody's noted that other aspects of the BHC's outstanding commercial paper,
such as their ratings, subordinated debt ratings and preferred stock ratings, as well
as their bond ratings on securities supported by letters of credit of their subsidiary
banks, were also reviewed but were unchanged. (Moody's Bond Survey, March 22,
1982)

What these changes In senior long term debt were meant to r e f l e c t was that
Moody's intended thereafter "to give greater emphasis to that degree of

indirect

subordination of these securities as holding company obligations, in their claim on
the assets and earnings of the underlying banks." (Ibid.)

They went on to note that

up to that time, they had been wiling to believe that in rating debt of the BHC, the
"industry's strengths "had o f f s e t this factor, even though BHC bonds were clearly
subordinate in their claim on the assets and earnings of the banks.

What prompted this shift in viewpoint?

Most of the answer can be found in

statements of the rating agency upon the occasion of lowering the senior long-term
debt of the major BHC'ss

The

effects

of

fifteen

years of

inflation on

the banking

customers, compounded by regulatory changes and the

sector

emergence

and
of

its
3trong

alternative intermediary markets have permanently altered the competitive
environment of the (banking) industry. (Ibid.)




(( the climax of events reached in 1982 prompted such an assesment (regarding
the competitive environment of banking), other happenings in the period between
1978 and 1982 seemed to reinforce the more conventional view that Continental was
quite satisfactory as an outlet for high-grade investment. Certainly that would have
appeared the case to the investor had he or she relied on the recommendation
conferred through the rating agency's offering of its Aaa rating on $100 million in
Continental notes because the bank showed a "continuing high-level of profitability,
including

the improved performance

diversification of

of

nonbank

subsidiaries, the quality

and

the loan and investment portfolios, the corporation's strong

worldwide funds gathering capability and our (Moody's) evaluation of management
and Its Information systems..." (Moody's Bond Survey, April 17, 1978) Three and a
halt years later, in October 1981, the rating agency would again bestow its highest
rating on Continental, this time singling out bank action as having achieved rising
earnings

in

recent

years

and

"...maintained

profitability

and

capitalization

relationships In line with those of its peers." (Moody's Bond Survey, October 12,
1981)

Indeed, the agency went on to stress that "...sound asset portfolios are

supported by a well-diversified liability structure. Management information systems
permit careful monitoring of

the bank's worldwide operations."

(Ibid.)

This

viewpoint seems to contrast sharply with some opinions that the information system
of Continental was less than effective when needed most.

Earlier, In June 1981, and again in September 1981, Moody's stated the opinion
that Continental deserved Aaa ratings on a $200 million bond offering, and $100
million of money market notes, because of "...the parent's status as a profitable,
soundly managed, world-class institution..." even though the parent's "historically
strong capitalization and profitability have come under increasing pressure because
of the accelerated growth of the asset base realized in recent years. (Moody's Bond
Survey, September 1981).

With regard to money market notes, the rating agency

concluded that the corporations strong financial condition and performance as a
major money center operations, its informed and competent management (emphasis
added), and its adaptability to changing market conditions, among other factors,
warranted the Aaa rating of the agency. And then came 1982 and with it, numerous
changes in ratings and what they were intended to reflect.

The perceptions of rating agencies are also reflected through the issuance of




1411

credit

watch statements

such as those r e g u l a r l y published by S A P .

In I98<», S A P

issued the f o l l o w i n g c o m m e n t a r y on C o n t i n e n t a l :

A complex and comprehensive financial assistance package
tor Continental has been arranged with the Federal Deposit
Insurance Corporation (FDIC).
assistance

include

The key components of the

the purchase of

$3.5 billion

of

non-

performing loans, the recapitalization of Continental Illinois
Corporation with $1 billion of preferred stock owned by the
FDIC, and a program of continued liquidity assistance from
the Federal Reserve Bank of Chicago...
If

the recapitalization plan Is implemented, the resulting

bank will have improved financial characteristics. Major loan
problems

are

borrowers.
including

sovereign
Other

all of

exposures

problem

the

loans

to

Latin

totalling

American

$3.5

billion

Penn Square loans, troubled energy

credits, and problem real estate loans will be removed.
bank and corporation

The

will by very well capitalized with

primary capital to assets exceeding 79b.
(SAP, Credit Watch, August 6, I98d, p. 1095)
SAP warned the less wary, however, that management had to continue to
actively "address overhead expenses In order to improve earnings."

Such remedial

gestures would position the bank for recovery, but did not and would not assure
successful revival of the bank. That, in the words of SAP, will "come only it senior
management

rebuilds

the

staff

relationships." (ibid., p. 1095)




and re-establishes

both

lending

and

funding

lal

it is clear that by 1984, the "go-go" atmosphere in which banking appeared to
operate in the 1970's and early 1980's had taken its toll on rating agency perception
of

banks.

SAP reflected on the situation and concluded that the "risks and

uncertainties facing the banking industry are heightened to the point where their
effect on credit quality is not temporary or limited, but instead is deemed to be
material and of a lasting nature." (SAP, Credit Perspective, January 23, 1984, p. ))
How would these higher risks manifest themselves?

According to SJtP they

could appear in a variety of forms, ( I ) An increased difficulty for banks to maintain
earnings power in terms ol return on assets on traditional lines ol business and
earnings on new business. (2) Greater volatility and declines in predictability of
earnings In a less protected and more openly competitive environment. (3)

Lesser

regulatory protection, both implicit and explicit, of banks as depositories and on
non-depository financial Institution functions. (4) An increased willingness by banks
to undertake market-driven,

yet

risk oriented

alternatives are the risks of doing too little. (3)

business

strategies

where

the

Increased pressures to utilize

financial leverage capacity during a period when the need to strengthen primary
capital positions will increase. (6) Asset portfolios which will not improve materially
or rapidly in credit quality, relating to expectations that international lending
problems will persist, while asset quality in several major industrial sectors will only
Improve gradually. (Ibid., p. 3)

Given these benchmarks by which to measure safety and soundness, S<VPs bank
analysis for Continental traceable from July 1982 to November 1984 was as follows
(See table on next page.)




KiZ

TABLE b
CMANCHS IN S T A N D A R D A N D POOH HAHNC.S O f
C O N T I N E N T A L ILLINOIS C O R P O I l A T u V ^ r c i c T A N D
C O N T I N E N T A L ILLINOIS NATIONAL B A N M C I N B ] r
HdtlMR*
Issue
1.
2.
3.
d.

Date

i.
2.
3.
d.
3.

Letters ol Credit
Commercial Paper
Senior Debt
Subordinated Debt
Preferred Stock

Sept., 1982

1. Letters of Credit
2. Commercial Paper
3. Senior Debt
k. Subordinated Debt
3. Preferred Stock

April, 1983

1. Letters of Credit
2. Commercial Paper
3. Senior Debt
k. Subordinated Debt
3. Preferred Stock

May, 198<i

1. Letters of Credit
2. Commercial Paper
3. Senior Debt
k. Subordinated Debt
3. Preferred Stock

June, 198V

1. Letters of Credit
2. Commercial Paper
3. Senior Debt
k. Subordinated Debt
3. Preferred Stock

From

July, 1982

y

Letters ol Credit
Commercial Paper
Senior Debt
Subordinated Debt
Preferred Stock

CINB

CIC
From

Aug., I98<»

NOTE: N C = No Change




Alt
AAA
AA*
BBBt

NC
AA
AANC

Ah
AA
AA
NC

Al
At
A

Al
A»
A
NC

NC
A-

AA
NC

AA
Alt

At
Al

At
Al

ANC

AA1

BBB
A2

m\s.

Al
ABBBt
BUB*

A2
BBB
BBBBB

A2
BBB
BBBBB

B
BB
BUB»

NC
NC

NC
NC

NC
NC
NC
Bt

To

AAA
Alt

C

1411

E.

Disclosure

This

discussion

has

centered

on

the

presumption

that

with

regard

to

Continental, the eye and mind ol the regulator, the investment counselor, and the
rating

agency

analyst

may

have

been

influenced by

a market

perception

ol

Continental that had its origins just beyond the reach of modern memory—perhaps
as far back as the 193Q's and I940's.

Part of the solution yet untested, regarding

Continental or any other large financial institutions facing financial ruin, is knowing
whether or not additional disclosure of financial and related operational information
at an earlier time (to the regulator and the public) could help avert such crises and
disasters.

If this is shaped in the form of a policy question, the answer seems most

often to be:

" Y e s , but..."

A proper response also deserves some understanding of

what is meant by disclosure and what are its limitations.

Disclosure has been defined as the "process by which information concerning a
bank's financial conditions and performance, its management, and its policies md
philosophies is made known to the public at large." (Deposit Insurance in a Changing
Environment, FDIC, April

13, 1983, pp. IV-2)

The idea ol increasing disclosure

provisions, concerning any financial and operation information, has been gaining
ground — especially as a suggested technique by which to add stronger "market
discipline" to the bank industry. The element of discipline would apply essentially to
the risk taking element, and would, in the judgment of its advocates, supply an
important degree of meaning to tlie functions of regulation and supervision by such
organizations as the FDIC.

There are a number of caveats that might be noted, if added emphasis is to be
given to increased disclosure provisions.

First, there is general agreement among those most involved in investment
counselling, rating agency activity and the like, that the already extensive amount
ol bank financial data ts overwhelming in volume and depth.
have chosen to describe it, is not one of insufficient data.
fundamentally related to how existing data are manipulated.




The problem, as they

Rather, the problem is

liH

Second, the general view ol these same personnel was that improved disclosure
would be helpful, particularly if that included greater access to Reports of
Condition and Income (Call Reports). Several people interviewed urged the
FDIC proceed in its current e f f o r t to revise the content of the Call Reports,
noting that the market's perception of Continental rested heavily upon
information available through management narratives, i.e. CEO letters to
stockholders, annual reports etc., and that it was probable that aspects ol
future content of Call Reports would be a very important part of their
operations/financial analyses. In this respect, the February 11, 1985
announcement of the FDIC enforcement actions against banks can be taken as
a significant step toward increasing the prospects (or e f f e c t i v e discipline. The
FDIC has indicated that additional disclosure would include the agency's
possible intention to terminate bank insurance, to suspend or remove o f f i c e r s
or directors, to get a cease-and-desist order against the bank if further action
appeared to be heading the bank toward insolvency, and to levy fines or order
increased capitalization within a specified time. If taken, all such steps would
increase public awareness of possible bad management or mat ginal operation
of the bank, and thus ensure that remedial steps would be taken to restore
stability to a more normal pace.

Finally,

it

sliould

be apparent

that

despite

the plethora

of

information

concerning capital adequacy, asset quality, management, liquidity position, earnings
capacity and the like, neither bank debt rating companies, nor security analysts had
a clear, accurate understanding of Continental's true portfolio condition.

There is,

of course, serious question as to whether the Bank's repeated statements about its
commitment

to asset

quality

were borne out

in actual, day

to day

practice.

Nevertheless, outside experts were and continue to be quite dependent upon this
type of information when rendering investment advice.

The fable of the blind men

being asked to describe an elephant after having touched its tail, its ear, and its
trunk, should not be dismissed.

Much of what is rendered as investment

advice

concerning bank stocks would seem to depend very heavily on that part of
industry the advisor has in mind.




the

C H A P T E R VII
PENN SQUARE LENDING AND LENN SQUARE NATIONAL BANK

A popular theory about why CINB encountered the difficulties it did in 1984 is that a
small group of CINB employees lured the Bank into an extraordinarily targe relationship
with Penn Square Bank, N.A. of Oklahoma City. When Penn Square (ailed on July

1982,

the theory goes, the billion dollar relationship between the banks collapsed and the losses
Incurred by CINB shook investor confidence to a degree that CINB never fully recovered.
While CINB's Penn Square-related losses were factors In the Bank's subsequent
problems, It Is simplistic to assign so much weight to that one relationship in analyzing
what went wrong at CINB.

This section of the report discusses CINB's energy lending

generally, its activities involving Penn Square Bank, and why the problems at Penn Square
were not discovered earlier by CINB.
A.

History of CINB Energy Lending

When CINB began to establish its relationship with Penn Square In the late 1970s, the
Bank was by no means a novice in the field of energy lending. As the former President of
CINB, John Perkins, testified before the Banking Committee in September 1982, CINB had
been, since 1934, a "leader among banks in financing the development of this country's oil
and gas resources and lending to established and emerging businesses directly engaged in
or providing services to the oil and gas industry."
energy lending became even more pronounced.

In the 1970s, the Bank's aHmity (or
In its 1973 annual report, the Bank

explained why this was occurring:
Growth in the Special Industries Divisions, which number petroleum
and other energy-related industries among their clients, will stein from the
necessity for the country to attain self-sufficiency in this area. But it
will rely heavily on the special expertise of the staff that has been
developed tlirough the years in anticipation of increasing emphasis on the
market. (1973 Annual Report, p. 9)
Unmentloned In this brief excerpt was the obvious profit potential in a growing
energy industry. But even in 1973, the caveat existed in the Bank's plans that growth in
the energy area could only occur if highly qualified staff were available.




(135)

lau
Already in 1976, the Bank began to see results from this new emphasis.

Its annual

report said:
Gains in energy-related industries -- mining, petroleum, natural gas,
and public utilities — contributed significantly to the year's results. These
continue to grow at substantial rates and Continental assists that growth
through the professional approaches of its banking and engineering specialists
and innovative project financing. (1976 Annual Report, p. 6)
The 1976 annual report (p. 7) also noted that during 1977, intensified emphasis would
be placed on better market coverage, with Commercial banking Divisions concentrating
on, among other things, specific industries such as oil and gas. Clearly, CINB was putting
energy at the top of its priorities.

The Comptroller of the Currency, In examining CINB in 1976, found nothing to
criticize In the Bank's energy loans. While criticized loans overall at CINB were running
at 121% ol gross capital funds in that year, a level OCC expressed concern about, the bulk
of the problems were in the real estate area, where CINB was trying to work out its
involvement

in real estate Investment

trusts (REITs).

No energy-related loan was

mentioned for criticism by OCC in the 1976 exam.

The next

year, CINB again trumpeted the significant growth in its domestic

commercial loans, citing energy-related businesses and industries — mining, petroleum,
natural gas, and public utilities — as "a primary factor in loan growth." The importance
ol staff was again emphasized in the annual report:

The varied and escalating needs of those customers were matched by
the financial skills and geographic deployment of our banker-engineers in
financing projects that range from coal mining and power generation
to the offshore search for oil. (1977 Annual Report, p. 5)




1411

Immediately

following thai paragraph, tlie Bank discussed, in one sentence, a

development that was to be an important factor in the energy area.
larger

corporations

increasingly

It said, "Although

used the commercial paper market

lor

short-term

borrowings that formerly took place under bank lines ol credit, a substantial volume of
additional loans was generated." While it is not clear to whom these additional loans were
extended, in part at least tlie Bank turned more and more to the funding of smaller
companies that could not take advantage of the commercial paper market.

In 1978 and

after, Penn Square became an important source for lending to these relatively small,
Independent energy operators in the Oklahoma area.

The Comptroller in 1977, again noting that real estate was the major problem area
for Continental, cited |ust one oil and gas loan for criticism, and even that criticism was
In the least serious category. Clearly, the Bank seemed to be doing inost things right in
the energy area.
I97S marked an Important year lor CINB In energy lending, II only because It marked
the beginning ol the Bank's relationship with Penn Square.

Breaking its precedent of

several years, the Bank's annual report did not mention energy lending as a growth area,
nor did the Comptroller perforin an examination in that year.

The 1979 information from the Bank and OCC shows that CINB continued to be
active in the energy area.

A new office was opened in Denver to serve business in that

region, and a branch ol Its Canadian affiliate, Continental Illinois (Canada) Ltd., opened
in Calgary, Alberta.

The Bank also announced a proposal to set up a Houston-based

subsidiary, Continental Illinois Energy Development Corporation, "to meet the needs ol
smaller independent oil, gas and mining exploration and production companies that might
not quality for conventional bank financing.1' (1979 Annual Report, p. 8).

This 1979 Annual Report contained an interesting follow-on to the comment in the
1977 report about large companies using the commercial paper market.

In the 1979

report's financial section, management included the following paragraph:
A significant portion ol the commercial and industrial loan portfolio
represents credit to prime borrowers. However, middle-market loans provide
a larger proportion of this segment of the loan portfolio than in the early




1411

1970s. Tins market may be subject to a higher incidence of loss in an
economic downturn, but any increase in credit losses related to these loans is not
expected to be substantial. (1979 Annual Report, p. 26).
The caution expressed in that statement relating to the size of Institutions might
also apply to concentrations of credit in particular industries that are subject to severe
downturns.

Yet at the time, energy was not an industry suffering from those problems.

As noted elsewhere In the annual report, world oil prices more than doubled In 1979,
fueling inflation but also making energy lending an attractive proposition.

The Comptroller's examination in 1979 continued to find the energy portfolio In
generally good condition. Credits to only a handful of borrowers were criticized (virtually
all ot it classified substandard).

This represented about 4% of the total amount ot

outstanding loans and unused commitments for domestic oil and gas lending in the Bank's
commercial lending department.

Nevertheless, one disturbing statistic surfaced In this

examination report for the first time.

In the Concentrations section of the examination

report, the total exposure to domestic oil and gas borrowers was listed as $2,162 billion,
$1,473 billion of which was in outstanding credits and $6S9 million in unused commitments.
This meant that credits to domestic oil and gas borrowers amounted to 173% of the Bank's
total capital funds.

Other industry concentrations included minerals (38%); finance

companies (independents) (49%); shipping (46%); and securities and commodities dealers
(213%, of which over two-thirds was in unused commitments).

Oil and gas had clearly

become an area of significant exposure for CINB, more so than virtually any other
industry.

In 1980, energy remained at the forefront of CINB's expansion.

Gone from the

annual report was the concern for the country's energy self-sufficiency that had been
reflected in the report 3 years earlier.
for CINB.

Now the emphasis was on efficiency and profits

In a section of the report entitled "Allocating Critical Resources," CINB

discussed how it needed to make choices on the markets it would enter based on
opportunities and competitive realities.

Resource allocation was the key, and several

industries warranted increased attention:
Businesses believed to have the greatest long-term potential to contribute to prolits
obviously warrant added emphasis. Our objective in these areas is to increase
market share or service levels through appropriately high levels of investment in
manpower and capital equipment. Some examples include the Oil and Gas Division
of Special Industries Services, Systems and the Treasury. (1980 Annual Report, p.
14).




1411

The Comptroller's examination, reflecting data as of June 10, 1980, showed a
continued major expansion in the oil and gas portfolio. Concentrations in that portfolio
now totaled 393% of total capital funds, with more than a doubling of the dollar value of
oil and gas exposure from the pievlous year, to $3,708 billion.
concentrations were more modest:

In contrast, other

minerals (76%), securities and commodities dealers

(179%); shipping (73%) and automobile manufacturers (48%). Despite the volume ol oil and
gas loans, as yet the quality had not deteriorated markedly.

Total criticized oil and gas

loans were under $30 million, and at least half were carry-over credits from the previous
year.

By 1981, CINB's posture as a preeminent commercial lender among U.S. banks had

been widely recognized. There was clearly no doubt In the Bank's mind at least, what had
helped fuel that rise to prominence in the commercial arena:

A primary commitment to wholesale banking, a leading position in key areas such as
energy lending, and an aggressive push into attractive markets across the U.S. have
made Continental one of the nation's top commercial and industrial lenders as well
as the nation's sixth largest bank holding company. (1981 Annual Repot t, p. 8)
By the fact of its being mentioned in this context, it is apparent that energy lending
was a critically important factor in CINB's growth, in dollars and In prestige. The Energy
Development Corporation was also mentioned in the same report as being a way "to
augment Continental's premier position in the Houston energy market."

(1981 Annual

Report, p. 9)
When the Comptroller examined the Bank, using April 30, 1981 data, the criticized
oil and gas credits still involved only two borrowers, a fact that the OCC examiner in lus
1981 report was careful to point out in a glowing account of CINB's oil and gas
involvement:
One of the primary growth areas within the bank over the past two years is the Oil
and Gas (OdcG) division within the Special Industries Group. Domestic OJtC loan*
now total $2,862 million and represent over 10% of the bank's total loan portfolio.
Significant growth has occurred since early 1979 to date, with O&G loans up 65%
from year-end 1978. CINB is adequately staffed with both sound lending officeis
and scientific (engineers and geologists) personnel to handle current relationships
and meet continued strong growth anticipations. The bank has developed a pretence
in most of the active areas ill the industry through the establishment of regional
offices in Texas (which have generated loans representing 38% of OAG ciedits),
Denver, Colorado and Calgary, Alberta, Canada.
No significant problems ate
evident as noted by the fact that only two O&G credits were classilicd herein.




1411

No concern was expressed about the still-increasing exposure of CINB In the oil and
gas area.
finds.

The dollar exposure had increased to $7,288 billion, or 432% ol total capital

Roughly 58% ol this total was in outstanding loans, and the remainder in unused

commitments. Other concentrations included minerals (83%); securities and commodities
dealers (172%); shipping (81%); and auto manufacturers (33%).
1982 was the year when CINB's strategy of rapidly increasing oil and gas credits
resulted in severe problems for the Bank. By April 30, 1982, the Bank's concentration in
oil and gas had Increased to 632% of total capital funds, or a total availability of $11,741
billion, including $6.66 billion in outstanding loans. When Penn Square Bank failed on July
3, 1982, the shock waves quickly spread to CINB. What the Penn Square failure brought to
light was not only the exposure to the Oklahoma bank and its creditors, totalling about
$1.1 billion, but also the depth of problems In other parts of the Continental portfolio.
While the tendency has been to focus attention on Penn Square credits, or oil and gas
alone, In fact the problems spread even deeper.

In the 1982 OCC examination report,

total criticized assets had reached 262% of gross capital funds, 36% of which represented
credits from oil and gas and real estate. This continued to leave a wide variety of credits
from Oliver areas also subject to criticism.
In terms of CINB's credits actually classified loss that were mentioned In the 1982
OCC examination report, Penn Square loans accounted for nearly 63% of those losses and
non-Penn Square oil and gas added another 17%.

As to the next category, "doubtful"

assets, Penn Square represented 31% of the total, and non-Penn Square oil and gas loans
accounted for an additional 13% of total doubtful assets. In the "substandard" category,
the picture changed considerably.

There, Penn Square loans represented 12% of the

substandard assets, and non-Penn Square oil and gas loans added another 22% in that
category.

The conclusion from these statistics is that, in the Comptroller's view in 1982,

Petut Square was a major contributor to the most severe categories of criticized assets,
but that well over $2 billion of assets rated substandard, doubtful or loss were in tact not
oil and gas-related.
I. The Reasons lor CINB's 1982 Losses
CINB's loan problems that came to light alter the Penn Square lailure have been
analyzed by many people Irom a variety ol different perspectives. Perhaps it is only lair




1411

to begin w i t h the C I N B ' s o w n e x p l a n a t i o n .

In its 1982 annual r e p o r t , the Bank said Ihe

following!

C o i n i n g on top o l the g e n e r a l e c o n o m i c problems in other industries, the
t i m i n g and unique c h a r a c t e r of the Penn Square s i t u a t i o n m a d e our o v e r a l l
credit problems much more severe.
Our strong position in domestic
c o m m e r c i a l and i n d u s t r i a l loans, e s p e c i a l l y our l o n g t i m e leadership in cncigy
c r e d i t s , of course tended to h e i g h t e n our position in areas under pressure.
( 1 9 8 2 A n n u a l R e p o r t , pp. 1 - 5 )

Further, the Bank added the following:
The major credit problems that developed in 1982 in part reflect the prolunged
worldwide recession and Continental's position as a leading lender to U.S.-and
International-based business. (1982 Annual Report, p. 8)
The Comptroller's o f f i c e , in Its 1982 examination report, gave a different view.
While mentioning CINB's policy of aggressively pursuing dominance In domestic corporate
lending, and the decentralized approach to management, OCC's Deputy Comptroller (or
Multinational Banking, William Martin, also pointed out that "Several large lending
relationships raise prudency questions given that one of the most basic fundamentals of
banking Is the diversification of risk."

The Comptroller's examination went on in much

greater detail to describe breakdowns In the internal controls at the Bank, excessive
concern for earnings growth and hence asset growth, and other management weaknesses.
At one point, the report noted that "The Penn Square situation is largely the result ol a
breakdown in controls, but management must be held accountable lor not detecting the
situation, and reacting, sooner." Further on, the examination report states:

The problems in these (Penn Square Oil and Gas) loans are economy-related, but are
also the result of improper supervision, as discussed fully elsewhere in this
commentary.
The most detailed discussion by OCC was in the following quote:
As reflected in the previous examination, the primary growth area in the bank
over the past several years has been the Oil and Gas (O «V G) divisions within
the Special Industries Group. From <•-30-81 to <»-)0-82, outstandings (or this
group increased Irom $2.8 billion to $3.2 billion and now represent over 13% of
the bank's total loan portfolio. Throughout 1981, the oil and gas industry
exhibited strong growth overall. Lending by numerous linancial institutions to
this industry continued to be strong, with the apparent belief that this industry




1411
was recession-proof. However, reduced demand lot oil products, reductions in
oil prices, over-expansion in various segments ol ihe industry, and the effects
of high interest rates on this capital-intense industry have seriously affected
cash flows and also the viability ol many firms, both large and small. As a
result, total criticisms at CINB have increased from $85 million at the prior
examination to $1.2 billion, or approximately 30% ol the O & G portfolio net
ol the Penn Square credits.
A lew common threads run through these various explanations of what happened to
CINB. It is apparent that the Bank had become overexposed in the energy area, not only
in Penn Square but in other energy lending as well. This caused the Bank to be vulnerable
to changes in the economic picture overall and to fluctuations In energy prices in
particular.

One central question is how specifically CINB's exposure to the oil and gas

industry, and particularly through Penn Square, came to be. For this, it Is useful to look
into the corporate structure in CINB as it related to energy lending, and then to describe
the evolution of its relationship with Penn Square.
2.

The CINB Structure for Oil and Gas Lending

The organization of oil and gas lending within CINB prior to July 1982 is rellected in
the two organizational charts on the pages that follow. General Banking Services, which
was headed during that

tune by Executive

Vice

President

George

R.

Baker, had

responsibility for all the Bank's wholesale lending except for that relating to real estate.
Baker reported to Roger Anderson, Chairman of CINB's Board.

Under Baker, Executive

Vice President Gerald Bergman headed the Special Industries Department, which In turn
was divided into groups organized generally along industry lines. The Oil and Gas Group,
headed by Senior Vice President John Redding, was divided geographically, and included
the Mid-Continent Division under Vice President Jotm Lytic that was the source lor the
lending relationship with Penn Square.

Also under Bergman organizationally was the

Continental Illinois Energy Development Corporation, a subsidiary created in 1980 and
headed by E. G. Jackson, Jr.




HcJ

Although this precise organizational arrangement was not in effect during the entire
period from the mid-1970s onward, it did operate during the lime that the dramatic
increase in oil and gas lending was taking place in the late 1970s and early 1980s. In
particular, a significant position relating to Penn Square lending, head ol the MidContinent Division, was held by John Lytic from August 1980 until just prior to Penn
Square's failure on July 5, 1982. Prior to Lytle's occupying that office, he had served as a
loan officer in that Division responsible for independent oil companies.

The mechanism by which this relationship between Penn Square and CINB was
carried out was the participation, a device whereby a lead bank (in this case Penn Square)
would arrange with a borrower for financing, to be jointly funded by the lead bank and one
or more participating banks.

With respect to Penn Square, CINB not only served as a

participating bank but also in at least one case (Michigan National Bank) encouraged otlier
banks to join in participations Involving Penn Square.
It is important to clarify the role that a participating bank plays and the degree of
its involvement in the details of participation loans. When a loan is arranged on a direct
basis by a bank with a borrower, without other banks participating, the lending bank's loan
officers, engineers and other personnel have direct contact with the borrower, the bank's
lawyers draft and review contractual documents, and all documentation is processed and
kept at the lending bank.

Responsibility (or the loan rests directly with the employees

and the lending processes in the lending bank.
In a participation, that responsibility is more diffused. There is no set model for the
degree of involvement ol a participating bank in such a loan.

Who holds the collateral

documentation, or the collateral itself; whose lawyers review the contractual documents;
whose engineers examine the proposed collateral for sufficiency; wlio actually receives
the borrower's payments uider the loan — these are all issues that in e f f e c t distinguish
direct loans from participations, but as to which there is some fluidity in actual practice.
It is certainly fair to say, however, that to the degree a participating bank grants its lead
bank discretion to do all or part of these tasks, the participating bank remains responsible
for knowing that the lead bank is in fact doing an adequate job on its behalf.

When

warning signs arise that there are problems in the lead bank's actions, a participating bank
is obliged to take prompt steps to protect itself.

Whether CINB did that in the case of

Penn Square is the issue to which this report next turns.




1411

B. Tlte E v o l u t i o n of the Penn Square R e l a t i o n s h i p

From relatively modest beginnings in the mid-1970's, the relationship between CINB
and Penn Squat e Bank and its holding company grew to be a significant part of CINB's
energy-re la ted acti/ities by the early |980's. The bulk of the CINB dollar exposure came
in the form of CINB participations in loans originated by Penn Square Bank, a rapidly
growing, aggressive energy lender in Oklahoma City, Oklahoma.

From a small shopping

center bank, Penn Square grew in a matter of a few years in the late I970's and early
I980*s into a major actor in the energy lending field in the Southwest, focusing primarily in
Oklahoma's oil- and gas-rich Anadarko Basin. In its meteoric rise and fall, Penn Square
grew to be a bank with more than $300 million in assets, but perhaps more significantly
for this report, became the source of over $1.1 billion in energy loans sold upstream to
CINB.

This represented loans to a few borrowers, many of them small, independent oil

and gas operators in the Oklahoma oil patch.
The relationship between CINB and Penn Square began in 1978. According to Lytle,
Ite was introduced to Penn Square Vice President Bill Patterson by Dennis Winget, then
head of CINB's Oklahoma section in the Mid-Continent Division and later an employee of
Penn Square. The relationship began relatively modestly, starting in 1978 and growing to
approximately $3(X-$33 million in early to inid-1980; to $200 million by December 31, 1980;
to $600 million by September 30, 1981; to $900 million by December 31, 1981; and to $13
billion by 3une 30, 1982, just days before Penn Square failed.
Aside from the dollars and cents value that Penn Square's and gas loans

had for

CINB, there is no question that some of the colorful characters at the Oklahoma bank
intrigued tt>e Chicago-based CINB bankers.

Episodes involving Bill Patterson, Penn

Square's Executive Vice President in charge of oil and gas lending, have been widely
reported in the press, but other instances of interesting behavior were described in reports
by CINB personnel. In one case in May 1979, in a notesheet relating to a CINB loan to




Penn Square's holding company, CINtVs loan ollicer in the Southwest Division reported the
following:
Jennings (Penn Square's Chairman) in his own inimitable fashion has devised a rather
ingenious scheme lor landing new deposits at Penn Square. The bank is ottering a
1979 Silver Shadow Rolls Royce in return for the deposit ol $1 million for six months.
One Rolls has already been taken with a second prospect likely.
In February 1982, George Gronskls, a member of the operations staff in CINtVs
General Banking Services who visited Penn Square to look into operations problems
between the banks said, In a memo to his superiors, "Pi>lJ cooperated fully In not only
providing all that we had asked of thein, but also showing us what Oklahoma hospitality is
all about on two occasions."

Clearly, there was a little bit of excitement associated with this bank that operated
In a very dilferent environment from the more staid Chicago banking community.
Aside from this major relationship as a participant in energy loans from Penn
Square, CINB also had another type of banking relationship with Penn Square's holding
company,

First Penn Corporation.

In 1980 and 1981, CINB provided a line of credit to

First Penn, beginning at $1 million and peaking at $10 million (of which $J million was
participated out to another bank), the proceeds of which the holding copany used to
augment the bank's capital.
In fact, the financial relationship between CINB and First Penn began even earlier
than l980.Accordlng to CINB notesheets, First Penn had had an account with CINB since
1976. The formal loan relationship between the two banks, which increased periodically up
to the $10 million level in September 1981, began in January 1980.

At that time, CINB

participated, in the amount of $1 million, in a $4 million term loan to First Penn agented
by Fidelity Bank of Oklahoma City. CINB's participation increased to $ ) million in June
1980, to $4.5 million In December 1980, and finally to $7 million In September 1981 when
CINB replaced Fidelity as agent for the loan.

Following a First Penn payment In early

1982, CINB's exposure under the loan was reduced to $6,823 million, the level at which it
remained until Penn Square lailed in mid-1982.




Mb

Each of

these C I N B

loans to F i r s t

i n j e c t i o n of c a p i t a l to the b a n k .

Penn was d o w n s t i e a r n e d to Penn Square as a n

These i n j e c t i o n s w e r e genciall-y in response to c r i t i c i s m s

by the C o m p t r o l l e r of the C u r r e n c y r e l a t i n g to Perm Square's i n a d e q u a t e c a p i t a l p o s i t i o n .
To some d e g r e e in this p e r i o d , Penn Square also Increased lis c a p i t a l by selling new stock
and e n h a n c i n g r e t a i n e d e a r n i n g s .

Y e t , it is c e r t a i n l y true that C I N B p l a y e d an I m p o r t a n t

r o l e in 1980 and 1981 in helping Penn Square respond to serious p r o b l e m s w i t h its c a p i t a l .

1. Warnings from the First Penn Relationship
Apparently the earliest indications of serious problems at Penn Square began to
surface in connection with its lending to First Penn Corporation, rather than through its
purchase of participations in Penn Square's energy loans. As early as April 1980, CINB was
aware of many of the problems Penn Square had had with the Comptroller of the Currency
and the bank's external auditor.

Beginning in 1980, CINB began to lend to First Penn Corporation, the parent
company ol Penn Square Bank.

Whenever borrowings were proposed, notesheets were

prepared by loan officers in the CINB Dallas regional office describing the financial and
operating condition of Penn Square.

Those notesheets indicate that CINB personnel had

full knowledge of the results of Comptroller examinations and customer-specific data
from Penn Square.
Notesheets relating to proposed loans from CINB to First Penn Corporation, as early
as April l<», 1980, reflected an awareness ol Penn Square's dilliculties. The April Id, 1980
notesheet discussed a dramatic increase in criticized loans at Penn Square found during a
Comptroller's examination.

CINB asked Penn Square to provide a list of accounts that

were classified to help CINB monitor Penn Square's progress in resolving the problem.
(The list was received at a June 27, 1980 meeting.) An April 25, 1980 notesheet indicated
that CINB would not provide additional funding until it had access to the results of the
soon-to-be completed Comptroller's examination of Penn Square.




14 I

In June 1980, another notesheet proposing a $2 million increase in CINIVs loan to
First Penn described the Comptroller's concerns about c.ipital adequacy and classified
loans at Penn Square, and noted that a team Irom CINb would be going to Perm Square in
June

to

discuss

the

Comptroller's

examination

with

Penn

Square

management.

Specifically, the Comptroller was requiring that Penn Square Increase Its capital to 7.2 8% by year-end 1980, which was a justification in part for the increased assistance from
CINb to the holding company. The notesheet pointed out that an official at Fidelity bank
(then the agent bank on the loan to Penn Square) was supporting the proposed increase in
the loan because he believed that the Comptroller was putting considerable pressure on
Penn Square to Increase equity and that this pressure by the banks and the Comptroller
was sufficient to make Penn Square "work to maintain reasonable fundamentals at the
bank."

Even at this early stage of its relationship with Penn Square, CINb had developed a
somewhat avuncular attitude toward the Oklahoma bank. In tlie June 20, 1980 notesheet,
In a section called "Forward Planning," CINb's loan officer wrote the lollowing;
First Penn has rapidly outstripped the internal ability of its staff to plan for
the near and intermediate term future of this fast growing aggressive bank. As a
result, it has been proposed that Continental provide its expertise in the areas of
Financial Advisory Services and Corporate Finance to provide a structure within
which to grow over the next 1-5 years.
Jennings (Penn Square's Chairman), having already agreed to talk to Corporate
Finance, received the suggestion enthusiastically with an initial meeting planned to
lay the groundwork.
Clearly, CINb was (tot only willing to provide financial help to enable Penn Square*
to deal with its regulatory problems, but it also perceived some significant management
deficiencies and was willing to provide help in those areas as well.
In June 1981, when CINb's exposure to First Penn was at $4.5 million, a CINb
notesheet discussed the Arthur Young qualified audit of Penn Square for 1980.

Arthur

Young had said it could not accurately assess the adequacy of Penn Square's reserves do«;
to a lack of sufficient documentation to enable a judgment to be made about the quality
of a number of reviewed accounts. Hie CINb notesheet acknowledged that documentation
exceptions had been the subject of criticism by Comptroller examiners, and said that Penn




1411

Square management attributed the problem to "an acute shortfall of support personnel and
adequate internal controls."

The note sheet pointed out that Penn Square had been

recruiting senior administrators from other banks to deal with this, and concluded that
"This area is expected to remain a primary focus of attention of First Penn management
and of regulators and First Penn creditors." This final category presumably included CINB
itself. In summary, the notesheet said that Penn Square was continuing "to take a very
aggressive position in energy-related lending In Oklahoma," that its "rapid growth" was
requiring "a stepping up in the staffing of loan production and documentation positions and
other support and control functions," and that "the Comptroller of the Currency's office
"was continuing to monitor Penn Square closely."
This mid-1981 time period was a critical one for CINB's relationship with Penn
Square. At that point, CINB had something over $200 million in participations with Penn
Square, meaning that the vast bulk of the loans purchased (reaching a total as high as $1.1
billion) came on CINB's book in the year after these comments were written.

Therefore,

it is important to see what improvements in Penn Square's operations were noted by CINB
to justify the rapid increase in the two banks' relationship in late 1981 and early 1982.

A September 14, 1981 notesheet, supporting a proposed increase in CINB's lending
from $4.3 million to $7 million, discussed at some length the results of Penn Square's early
1981 Comptroller's examination. After meeting with Penn Square's management, the CINB
loan officer concluded:
(Penn Square) was severely criticized in the bank examiner's I Q 81 report. Principal
areas of concern were poor documentation and loan procedures, high level of
classified assets ($16.6 million, 77% of gross capital funds at I2/3I/80), high rate
sensitive funding sources and insufficient equity.
The notesheet went on to say that hiring new managers and certain other actions had gone
a long way to resolving the criticisms in the examination and in the August 1980 written
agreement

with the Comptroller's office.

The bank was also working on reducing

problems with certain oil and gas loans that were Inadequately documented and with
insider loans, notably to director Carl Swan, the notesheet said.




1411
One area where the bank was continuing to have problems was in reaching the
Comptroller's required capital adequacy level, and, to help deal with that, $2.3 million In
additional funding was requested and granted by CINB.

Thus CINB was continuing to

perforin a major service for Penn Square in assisting the smaller bank in meeting its
requirements imposed by the Comptroller.
A January 3, 1982 notesheet discussed the Comptroller's interim examination, in late
1981, which required Penn Square to charge off significant numbers of loans, alttiough not
primarily in the oil and gas area.

Later that month, on January 20, another CINB memo

described the CINB loan olficer's meeting with John Baldwin, head of the loan teview
function at Penn Square. Baldwin had organized a complete review and rating system lor
Penn Square's portfolio, and was planning to get to the oil and gas portfolio in the second
quarter of 1982, after reviewing the commercial and real estate portfolios.

CINB took

some comfort In tlie fact that, although classified loans remained high at Penn Square, a
more effective loan review process was underway.
On March H, 1982, the CINB loan officer met with Chairman Jennings and President
Beller of Penn Square to discuss more fully the Comptroller's interim examination of late
1981.

Progress had been made in certain areas, and the loan review

function was

particularly commended. But the notesheet said that areas identified by the Comptroller
as needing additional work included improper structuring of certain loans and out-of-town
lending practices.

In summary, the notesheet said that the tenor ol the Comptroller's

report was similar to what CINB had been told by Penn Square manaagement, "which wa>
that serious ellorts were being made to Install those Internal systems that had been
neglected or did not exist, and that, given the bank's tremendous growth, were now very
much required. Clearly, however, much additional progress needs to be made." The aura,
then, is that CINB lound some hopelul signs but was not at all convinced all was well by
any means.

A lurtiter visit with Penn Square officials occurred on March 18, 1982, and the ftr*t
real glimmer of concern about the oil and gas portlollo specifically is rellected in thi>
notesheet.

While recognizing that the internal loan review of non-oil and gas loans was

complete, the notesheet commented, "We are, however, more interested at this time in




ir>o

determining the results of lialdwin's review of the oil and gas portfolio which has only just
begun and is due to be completed in the middle of the third quarter."

The notesheet also

says that CINB's oil and gas group indicated CINB had about IdO letter of credit deals
involving Penn Square with a median loan amount of about $1 million.

The CINB oil and

gas group had visited with Seattle First National Bank, another upstream bank lor Penn
Square. SeaFirst was planning on reducing some of the

million in overlines it had

with Penn Square. According to the notesheet, SeaFirst's loans involved a certain number
of rig loans and undeveloped lease acreage lines of credit such that the overall credit
quality was not apparently as high as CINB's loans.
In view of the general uncertainty, CINB decided not to meet Penn Square's request
to establish a secured liquidity line to make up lor timing differences between the holding
company's placement of CD's in the bank and their sale of shorter term commercial paper.
Clearly, at this point, CINB had adopted a wait and see attitude about further help to
Penn Square.
Peat Mar wick's unqualified audit of Penn Square lor 1981 led to another notesheet
being prepared on April 2<», 1982. While still noting that the oil and gas portfolio was yet
to be reviewed internally, and that the quality of that portfolio depended on the effects of
ll»e slowdown in the oil patch, the notesheet found that progress was being made to
address many of the Comptroller's concerns.

Perhaps more importantly, the notesheet

states that CINB had "conducted a collateral review of our participated loans and
confirmed that the underlying collateral appears adequate and in line with overall lending
policies." Thus, despite the overall uncertainty, CINB apparently felt It had some security
in its position.

Alter this notesheet, two other memos appear in the files. On May 17, 1982, Penn
Square's access to the $<i million Fed funds line that CINB provided was made subject to
prior approval by one of two CINB officers. Then, on June 25, 1982, the Fed funds line to
Penn Square was canceled. These were two ominous signals that things had gone seriously
awry at Penn Square. By July 5, Penn Square had failed.




1411

11 1981, the Mid-Continent Division, in which the Penn Squaie loans were booked,
1
began to show up on CINIVs internal reports, indicating
with documentation exceptions and past due loans.

that that Division had piobleius
Lytle, the head of that Division,

blamed the situation on errors in CINb's Loan Operations office, which was troubled by an
outmoded computer system, rather than on any failings of the Mid-Continent Division. To
the extent these exceptions and past due reports were an early indication of the problems
to be encountered with Penn Square credits, their credibility was undercut by arguments
relating to the inadequacy of the operational office, and a valuable signal may therefore
have been overlooked. Indeed, according to the Special Litigation Committee report

2. Signals from the Oil and Gas Relationship
Even aside from the warnings being picked up in the Southwest Division, indications
were emerging Iroin the Mid-Continent Division that there were problems at Penn Square.
In 1981, the Mid-Continent Division, in which the Penn Square oil and gas participation
loans were booked, began to show up on CINB's internal reports, indicating that that
Division had problems with documentation exceptions and past due loans. John Lytle, the
head of that Division, blamed the situation on errors in CINB's Loan Operations office,
which was troubled by an outmoded computer system, rather than on any failings of the
Mid-Continent Division.

To the extent these exceptions and past due reports were an

early Indication of the problems to be encountered with Penn Square credits, their
credibility was undercut by arguments relating to the Inadequacy of the operational
office, and a valuable signal inay there tore have been overlooked. Indeed, according to
the Special Litigation Committee report prepared by CINB, the Bank's own audit of the
Loan Operations function confirmed the accuracy of those documentation exception
reports. Nevertheless, in mid-1981 the debate about the validity of those reports seems to
have deflected concern from the real issue of the underlying quality of the loan in the
Mid-Continent Division. Since these debates were occurring at meetings in the presence
of George Baker, head of General Banking Services, they could have served as an early
warning to very senior management of problems to come.

At roughly the same time as these debates were hastening, a loan officer in the
Oklahoma section of the Mid-Continent Division, Kathleen Kenefick, prepaicd a memo
criticizing documentation and other procedures relating to Penn Square and expressing




1411

concern iKat some potential credit problems might be overlooked.

In particular, her

memo, typed on July 29, 1981, criticized the lack of management of credit relationships;
poor credit write-ups; lack of

follow-up on accounts; housekeeping problems such as

missing notesheets, documentation

errors, and past-due principal and interest; and

overworked CINB staff. She attributed the difficulties to a series of causes:

The explosive growth in the number of relationships, combined wit(i personnel
shortages and the organizational structure followed, are the perceived primary
causes. In addition, however, the short term transaction philosophy (put the
loan on lor 30-90 days with either a strategy or more information to follow)
adds to the problem. This builds the workload and potentially limits options.
Pie standards of acceptability of work, both here at CINB and from Penn
Square Bank, are other causes of the problem. The lack of control exerted
over Penn Square Bank "after the fact" is another source ol concern as the
situation may change without our being aware ol it. (Hearings, House Banking
Committee)
George Baker was given a copy of this memo in September 1981 and retained it for
about eight months, ir*Jicating that senior management was aware of internal criticisms
about Penn Square nearly a year before that bank failed.
There is substantial dispute over exactly what liappened late in 1981 regarding CINB's
relationship with Penn Square.

George Baker recalls having told Bergman to make all

existing Penn Square credits into direct loans, rather than participations, and to make all
new credits on a direct basis.

This order was given, according to Baker, because of the

"unreasonable concentration" of loans emanating from a small bank like Penn Square, as
well as the fact that his subordinates, Bergman and Redding, did not seem to be aware of
the dollar level of participations CINB had with Penn Square.

Those subordinates,

Bergman and Redding, do not recall a general order to convert to direct credits, but do
recall a desire to switch to direct funding for major credits.

Lytle only recalls that he

was "encouraged" by Redding to make direct loans lor credits over $3 million.
Litigation Committee Report, pp. 33-36).

(Special

An internal CINB notesheet dated January 6,

1982 indicated that Oil and Gas would be "converting the larger borrowers to CINB's own
notes where possible as relationships came up lor renewal or renegotiation."
Why was it critical whetlier the Penn Square loans were done directly or through
participations, and why did George Baker think that lending on a direct basis would
prevent

occurrences of

the problems

then becoming apparent?

explanation came from Continental's employees themselves.




Perhaps the best

In testimony, John Lytle noted that "Significantly, in the case of participation loans,
tlie loan documentation was initiated and held by Penn Square Bank."
Banking Committee, September 29, 1982, p. )).

(Hearings, House

This gave Penn Square control over the

(low of information to its participating banks, and Penn Square tailed, in at least some
instances, to provide needed documentation to CINB. In addition, as Lytle also explained,
control of the original documentation gave Penn Square, as lead bank, the chance to
provide

CINB with documentation of

collateral

in photostat and then release

the

collateral without CINB's knowledge (Id., p. 40).
Kathleen Kenefick alluded to a similar problem in her July 1981 memo, when she
said, "The lack of control exerted over Penn Square Bank 'after the fact' is another source
of concern as the situation may change without our being aware of it."
The Continental internal auditors who visited Penn Square In late 1981 also found
coordination problems brought about by the participation relationship. In many cases, the
auditors found, Continental's loan and collateral documentation did not agree with Penn
Square's; interest billings and payments were inaccurate; and collateral positions were not
adequately protected.

Furthermore, CINB had on 12 occasions purchased a participation

that was greater than the outstanding balance booked by Penn Square.

To some degree,

the CINB auditors cited procedures at CINB as contributing to these problems, but many
of the basic (laws seemed to reside in Penn Square.

Perhaps the most curious thing to

consider, however, is tliat in most of the loans purchased by CINB as of September 30,
1981, Penn Square retained only a very small portion, if any, of the actual dollar exposure
on the loan. For over two-thirds of these loans, CINB had purchased 93% or more ol the
dollar value of the loan.

Looked at another way, CINB's purchased participation* Irom

Penn Square amounted to 134% of Penn Square's total net loans (i.e., not just those in
which CINB participated but all of Penn Square's net loans), and those par notations
bought by CINB amounted to over 20 times Penn Square's total equity. Since Penn Square
was not a significant sharer of the credit risk on most loans, the value of its activities for
CINB seem to have been as a loan originator, giving greater entree to the Oklahoma
market, and as a document processor.

As the auditors sltowed, however, the document

situation at Penn Square was Itardly exemplary.




1411

Aitotlker employee of Continental confirmed the problems at Penn Square.

G. A.

Gronskis, from the CINB operations office, found, in a February 1982 report, numerous
areas

to

criticize

documentation.

in

Penn

Square's

control,

production

and

interpretation

of

Gronskis made the following general observation about Penn Square's

operations!
Responsibilities (or the preparation of notes and participation certificates,
note booking and exception reporting appears to be overly fragmented so that
no department has a final document review responsibility. This results in a
number of questionable participation certificates sent to and accepted by us,
which do not reflect the conditions stated in the note. Additionally, since a
very superficial review of the note instrument exists .... numerous notes have
severe deficiencies in the signature area and in the rate firucture clause.
(Gronskis memo, p. <f.)
Gronskis' observations concerning CINB, and particularly its Loan Division, were
also revealing;

While PSB (Penn Square Bank) personnel are willing to act in an agent
capacity, they have not, to date, learned the intricate method of volume
business as well is we, and to that end, we should develop a more helpful
attitude towards the operating unit of PSB as opposed to a critical and
demanding one. Because of our large investment in their total loan portfolio
(almost H0%), CINB should with their sophistication, carry the brunt of followup until such time as PSB matures and gathers experience as a volume agent
bank. (Gronskis memo, p. 6.)
At the time, CINB's exposure to Penn Square participations was $887 million,
according to Gronskis.

This degree of involvement makes the somewhat paternalistic

attitude reflected in this quote all the more startling. Again, one must question precisely
what it was that CINB felt it was getting from Penn Square and why it felt sufficiently
confident to expose itself to the degree it did given the problems discovered in Penn
Square's operations.
What emerges clearly from all these descriptions is that a participation relationship
raises particular problems that are not encountered when credits are handled directly by a
bank's staff.

The question of how much confidence one bank can vest in another bank's

documentation capacity is certainly raised by the experience between the two banks, and
it would be hard to argue that Penn Square's track record was one meriting much




confidence by CINb.

An even inore significant question is whcthci CINB was allowing

Penn Square to substitute its credit judgment for that of CINb in making loans. There has
been testimony

to the effect

that CINB's credit

judgment remained in full force

throughout its relationship with Penn Square. Nevertheless, some factors tend 10 indicate
that CINb would have had some dilliculty doing so. Hor example, documentation was in
some cases in disarray on the Penn Square-related credits) many ol those credits were
stale-rated or not rated at all; the relationship with Penn Square had led to a sigiulicant
concentration from that one correspondent bank and had increased substantially in sue
during the last quarter of 1981 and the lirst hall of 1982; there were indications that stall
was being squeezed in its ability to cope with the volume ol Penn Square credits

— all

these lactors suggest that significant pressures were being put on CINb to ensure that its
credit judgment was still intact.
It is simply not enough to say that the downturn in the energy market led to the
Penn Square debacle and the resulting problems at CINb.

The issue really is whether

CINb sliould have gambled so much on a particular economic sector and on a single bank
to service it in that sector, and done so without the greatest of caution.

CINb has countered

with

the

statement

that

the Oklahoma

independent

oil

producers it sought "tended to deal primarily with Oklahoma-based financial institutions."
(Hearings, House Banking Committee, Sept. 29, 1982, p. 69).

Thus the entree into that

market would be more rapid and more effective through a Penn Square.

Nevertheless,

CINB was already established in the market lor lending to independent oil producers,
including in Oklahoma (Id.), so that the market sought was one ot expanded market share
in a market already serviced and, as it turns out, increased lending to insiders and trtends
of officials at Penn Square.

CINB's internal auditors found in October I'i&l that

ot

the participations purchased by CINB at that time, amounting to over $93 million, were to
individuals (Chairman of the Board or Director),

their companies, or partnerships which

had a Close relationship to Penn Square or its holding company. Again, the question about
credit judgment and the purpose ot CINb's involvement in this type ol energy lending has
to be raised.




X

Vm I W

Unique 7

Tcfttimony has Indicated that CINB maintained no other participation relationship
wiih OIIMT correspondent banks that was anywhere close to the magnitude ol that
maintain*! with Penn Square. While CINB had been active in correspondent banking lor
many y«*rs, the participations with other banks tended to be in the $20 million to $25
million f*nft, rather than the hundreds ol millions as with Penn Square, (Testimony ol
Jot« Perkins, Hearings, House Banking Committee, September 29, 1982, p. 75).

This

admission cuts both ways. On the one hand, it may say that CINB acted responsibly by
limiting lU participation exposure to very small amounts as a general rule. On the other
hand, It raises the question why CINB was not more aware ol its increasing exposure
through Penn Square.
CINb Apparently

was not

lully

aware lor

some time that Its participation

relationship with Penn Square had increased so dramatically.

No regular report to top

management disclosed the source ol credits on a correspondent bank basis.

Thus, the

credits were listed by borrower, rather than by the lead bank in the participation.

This

kind of reporting makes sense so long as the Bank made independent evaluations of each
credit to ensure that it met CINB's credit standards. II there were a breakdown In that
system such that a correspondent bank would play a more decisive rote in committing
CINb to the credit, the reporting system that existed was inadequate to protect CINb.
Perhaps in the end, the only real proof whether the Penn Square relationship was
uniquely damaging to CINB would be to analyze the criticized asset portfolio to see
whether Penn Square-related oil and gas loans were more harshly criticized than other oil
and gas loans. The data show that substantial volumes of oil and gas credits that were not
Penn-Square related were criticized, but that the bulk of credits most heavily criticized
were Penn Square-related.

Over $1.2 billion in non-Penn Square energy credits were

criticized in 1982, while over $820 million in Penn Square-re la ted credits were criticized.
Of

these

totals,

the OAEM (Other

Assets Especially

Mentioned) and Substandard

categories, the two categories of mildest criticism, contained over twice as many nonPenn Square oil and gas credits as Penn Square credits by dollar volume. On the other
hand, more than twice as many Penn Square as non-Penn Square oil and gas credits were




in the "doubtful" category, and Pent) Square had nearly lour tunes us many loans in tlie
"loss" category.

On a percentage basis, the Penn Square predominant e was even more

striking, since Penn Square represented about 20% of all oil and gas out standings, but over
40% of the criticized oil and gas loans (and much higher percentages HI Hie two categories
of strong criticism, "doubtful" and "loss").

In and ol themselves, the volume of criticisms of non-Penn Square oil and gas loans
would have been a cause for serious concern lor CINB, but the e f l e c t of that problem was
magnified greatly by the more Immediately serious problems in Penn Square.

Some have argued that, even had CINB missed most of the signals that something
was ainiss at Penn Square, there were two instances that should have elicited greater
vigilance from the Bank. The first of these was the personal loans thai Penn Square hank
made to John Lytle of CINB's Mid-Continent Division.
by CINB

to First

Penn

Corporation,

Penn

Square's

Pie other instance, the loans made
holding company,

is discussed

Immediately following this section.

The Loans from Pnm Square to John Lytle

Prior to becoming head ol the Mid-Continent Division in August 19110, John Lytle had
been an account o f f i c e r in that division.

It was in the latter capacity that he first came

in contact with Penn Square. Beginning in June or July 1980, Lytle began to borrow money
from Penn Square, first in the amount ot $20,000 and increasing over the next year and a
half until the final figure ot $363,000 was reached.

Originally, the reason lor this

borrowing was listed as home improvements at Lytle's house; later amounts were justified
in Penn Square loan papers as being for stock purchases by Lytle. Lytle has admitted that
he told no one at CINB ot this loan relationship because he did not consider it a conflict ol
interest.

Lytle contends that

he was not an executive

officer ol

CINB; such a

relationship with a correspondent bank was common practice in Oklahoma; and he (elt his
borrowing at Penn Square was good business for Penn Square since he was a solid creditor.
Thus Lytle's borrowing from Perm Square was, in Lytle's eyes, good lor CINB, since it
cemented even further tlie Bank's relationship with a valued correspondent, Penn Square.




1411

Interestingly, It was from Penn Square, rather than from CINB, that the first hint of
concern over Lytle's personal borrowings apparently arose. On October 2), 1981, the Penn
Square Credit Policy Committee met to consider a loan consolidating Lytle's other
borrowings

into a $513,000, 1 % fixed rate
1

amortization, plus 1% fee.

loan

for

a three-year

term,

30-year

The Committee approved the loan, but the minutes of the

meeting included the following comment;
Rick Dunn (Penn Square Executive Vice President, Loan Administration Division)
informed the (Penn Square Credit Policy) Committee and the Loan Officer that
according to general counsel, due to the relationship with Continental Illinois
National Bank and Mr. Lytle's position with Continental, we should obtain from the
Chairman, President or Secretary of Continental, a letter certifying;
A.
B.

Mr. Lytic is not a director, executive olficer or principal shareholder of
Continental Illinois National Bank, and
They are aware of the terms of this loan and do not object to same.
Bill Patterson agreed and said he would personally see that this is done.

There is no indication that Patterson ever notified CINb, prior to CINB's becoming
aware of the loan in December 1981. Perhaps the most telling aspect of this, however, is
that notwithstanding Penn Square's reputation as a "go-go bank", the senior officers of
Penn Square on the credit policy committee were troubled enough by the implications of
the Lytle loan to want CINB's agreement to it.

When it did find out about Lytle's relationship, CINB acted as though It were
tortured by the thought of having to deal with it. The loan first came to CINB's attention,
as best it can be determined, in early December 1981, when CINB internal auditors Minnier
and Kaar discovered it on their second trip to Penn Square.

Word was passed quickly to

Bank auditor Edwin Hlavka, and in turn to George Baker (in some detail) and Roger
Anderson (apparently in general terms). From December 1981 until April 1982, a scries of
staff level meetings were held to decide what was to be done about Lytle. Several CINB
officials took the position that Lytle should be lired, while others suggested less onerous
sanctions such as reassignment.

Meanwhile, during those months Lytle remained in his

position and the level of CINB exposure to Penn Square borrowers continued to Increase
significantly.

In the first quarter of 1982, while CINB was considering what to do about

Lytle, Penn Square-re la ted exposures increased by more than $250 million.

It was not

until May 17, 1982, fully six months after the Lytle situation apparently first came to light




ii/j
at CINB, that the decision was made by Koger Anderson not to iire Lytic but instead
remove hun from the Oil and Cas Group and give him no salary increase or incentive
compensation lor two years.
There is a real question whether the Bank took strong action early enough to deal
with the Lytic issue.

The Bank's auditor, liiavka, determined quickly llie sue ol Lytle's

loan ($565,000) and that Lytic was living beyond his means. Yet other than telling Lytic
that his loans should be taken out ol Penn Square, no other actions apparently were taken
against Lytle.

(As it turned out, Lytic complied by relocating his loans, with help Irom

top otlicials at Penn Square, to one ol

Penn Square's correspondent banks, with a

guarantee irom Penn Square to back up the transfer, thereby retaining a rather significant
level ol involvement by Penn Square in the loans). Thus, a lending official who had gottcr.
himself overextended with a major correspondent bank in a relationship that certainly
raised serious conflict of interest questions was, (or six months, permitted by CINB to
continue operating much as before.

Even conceding that Lytle was a 23-year veteran ol

the Bank and deserved some due process, and that it is easier m hindsight (alter July 5,
1982) to judge just how bad the relationship with Penn Square was, nevertheless there were
abundant signals that things were amiss at Penn Square. The lact that two auditing teams
and a loan operations team had to be dispatched to clean things up at Penn Square, that
the relationship with Penn Square-re la ted borrowers was growing very quickly in a lending
sector in which CINB was already significantly concentrated in mtd-|9&|; that orders had
already gone Irom George Baker to change at least some o( these Penn Square-related
credits from participations to direct credits; that internal sources within the MidContinent Division were criticizing the operations in that Division; that exception reports
and stale-rated credits were unusually htgh--cach of these alone may not have been a
sufficient signal, but cumulatively they pointed to tile need lor more decisive action than
in (act occurred.

This is not to argue that CINB would have escaped its problems with Penn Square il
Lytle had been lired in early 1982. Even by that time CINB had a >igm(icant number of
loans on the books and probably could not have extricated itself before Penn bquai e
failed. Yet a fuller investigation and awareness ot Penn Square earlier in 1982 might have
helped CINB deal more effectively and with less trauma with the situation that eventually
developed when Penn Square tailed.




It is dear Irom this chronological summary ol CINb noteshccts in the Southwest
Division and Irom warning signals relating to the Mid-Continent Division, that CINb was
aware Irom the start ol the serious problems Penn Square was lacing. Tire inadequacies in
capital, asset quality, management, and internal controls identified by the Comptroller
were fully documented and noted by CINb olficlals.

And yet, m testimony before the

House banking Committee, CINb President Jotm Perkins said;
It is true that Penn Square had had prior auditing problems and bank
examination criticisms, which were
However, the qualified
auditors' letter regarding Penn Square's l98tTaudit, which was received in
the spring of 1981, appeared to relate primarily to housekeeping matters.
The same was true ol criticisms made during early 1981 by the national
bank^examiners. (Hearings,llousc Banking Committee, Sept. Zfr, M 2 , p.

Three points should be made about this statement. Hirst, there Is a clear admission
that the tacts abaout Penn Square were known by CINb.

Second, as is clear Irom the

CINB noteslttets, the OCC examiner's report on Penn Square, issued in early 1981,
contained criticisms ol far more than "housekeeping" matters.

The Comptroller described

the report In these words:
It disclosed further deterioration in the bank's overall condition. Major
concerns continued to be inadequate capital, poor asset quality,
ineffective loan administration, inadequate staffing and policy
development, weak internal controls, and deficient liquidity, asset, and
liability management practices. During 1980, the bank had more than
doubled in size. Most of this growth continued to be concentrated in the
energy-related businesses. Additionally, violations ol banking laws and
of the formal Agreement were cited in the report. (Testimony of C.
Todd Conover, Comptroller of the Currency, Hearings, House Banking
Committee, July 15, 1982, p. II.)
Third, to the extent CINB

took solace in the fact that Penn Square liad made

ellorts to clean up these so-called "housekeeping" problems, it was apparent in CINB's
own audits in late 1981 and early 1982 that Penn Square was still not a reliable provider ol
documentation (or its credits.

Therefore, it seems apparent that CINB largely ignored

some important warning signals about Penn Square from both OCC and Penn Square's
independent auditors, downplaying tlte significance ol those problems and feeling they had
been cleared up. In making those mistakes, however, CINb may not have been any more
in error than P e w Square's auditor, Peal Marwick, or its regulators in finding that Penn
Square was making substantial progress in improving itself in late 1981 and early 1982.




C.

Continental's Other titergy-Related Activities
In addition to the energy lending llut went on within CINI1, a separate subsidiary ol

CINB's holding company also engaged in lending to oil and gas borroweis. The Continental
Illinois Energy Development Corporation ("CIUDC") was lormcd in February I'J&O and was
designed to meet the needs ol smaller, independent oil, gas and mining exploration and
production companies thai inlght not quality lor conventional bank financing. Ul>/V CIC
Annual Report, p. 8). It was recognized Irom the outset that this type ol lending held the
possibility ol greater risk than lending to more established and larger borrowers.

CII.OC's

authority included lending and the purchase ol voting and nonvoting equity mteiesu in
these companies.
were directed

According to Federal Reserve examiners, CIEDC's original activities

toward purchasing participation

interests in loans advanced by Amex

Mineral, N.V., an energy lending subsidiary ol American Express, whose assets were
eventually

purchased by Driltainex, Inc.

Later, Continental Illinois Corporation got

Federal Reserve approval to acquire the Ainex assets Irom Dritlamex, in August 1981.
Thereupon, CIEDC began to rapidly expand its energy lending portfolio.

To be sure, the volume of

CIEDC's energy portlolio

compared with that of the bank itself.

was never

suable

when

As of the 1981 Federal Reserve inspection, CILDC

had total loans and investments of less than $26 million, compared with the bank's overall
exposure to the oil and gas industry of over $7 billion, as found by the OCC examiners In
1981.

Even then, the Federal Reserve was warning about the Corporation's rapid asset

growth and pressure on equity capital, cautioning that if earnings did not keep pace,
additional equity capital might be required,

by I982's Inspection, CIEDC total assets had

risen to $9<i.8 million, with classified assets totalling

million, slightly over hall of

which was rated substandard and the remainder, rated doubtlul and loss, being almost
totally involved with a credit to one borrower.

These figures dwarled CIEDC's total

equity of $1.1166 million, and its valuation reserve of $922,000.

One offshoot of the purchase of the assets of Amex Mineral, N.V. was that two
officials of that company, Edwin G.

Jackson, Jr. and Jolui Oliver, became President and

Vice President, respectively, of CIEDC.

both were given special incentive contracts

allowing them to acquire equity interests in and receive royalty rights from customers of
CIEDC, subject to certain contractual limitations. In Jackson's ca-^e, this contract was a




continuation of the contract he hud with Amex.

These provisions were cited as being

needed to attract and retain high quality executives at CIEDC, but they also had the
effect of causing or contributing to certain violations of law by CIEDC. In two instances,
once in August 1981 and again in 1982, CIEDC acquired voting shares of common stock in
companies that exceeded the

limitation in the bank Holding Company Act.

Mr.

Jackson also purchased shares in those companies, which had the effect of increasing the
prohibited exposure in those companies.

The Federal Reserve concluded that "while

neither violation is considered willful, management is requested to notify this Reserve
Bank of

their

actions taken which reduces Energy's voting ownership of (the |wo

companies) to the limitations set by Section 4(c)(6) of the ISank Holding Company Act, as
amended."
It is interesting that Mr. Jackson's relationship with companies that did business
with CIEDC was encouraged, as an Incentive for Mr. Jackson to stay with the Corporation
(and presumably reap additional personal financial rewards). His situation was presumably
much dilferent from Mr. Lytle's, in that Lytle was a debtor to his correspondence bonk,
while Jackson was a creditor.

Nevertheless, there are questions that arise about the

evenhandedness of credit and investment decisions in a situation where officers of the
lender deal, as individuals, with a borrower. Both aspects ot this issue that are raised in
the Continental case should receive continued consideration.




"Chapter VIII
FEDERAL ASSISTANCE

A.

Clironology of Assistance l"Iai) Development

Tl»e first sign of real trouble at Continental began with the (ailore ol Penn
Square bank on 3uly 5, 1982.1
debacle, as a supplier

of

Continental's extensive involvement In the l*enn Square

funds and participant

documented elsewhere in this report.

in energy-related loans, has been

For a two-year period following the Penn Square

failure, conditions at Continental continued to deteriorate.

Loans purchased from Penn

Square proved to be worse than was originally anticipated, and other problems at CINb
began to surface, particularly in the Sptfcial Industries Division.

CINb's funding grew

more volatile, with the bank having to purchase each day approximately $8 billion, or
about 20 percent of its total funding.
Although some management changes were made in an ellort to tighten controls,
changes at top level management did not take place for nearly two years following the
Penn Square failure; and when changes were linally made, replacements were made Irom
inside tlie organization.
Testimony received by the Subcommittee indicates that the bank's loan chargeofl
policy was not sufficiently aggressive, and its dividend was not reduced.

In addition, the

sale of the bank's profitable credit card operation was perceived by many as a "despeiate
attempt to raise funds to support the dividend, to the long-range detriment ol the b.mk."^
A crisis in confidence in the bank occurred in May,

when ruinois began

circulating that the bank was near insolvency. It lost $9 billion in lunding and there were
estimates that it could lose as much as $15 to $20 billion in a short tune. Additionally, the
funding problem began to affect tlie markets generally, and the regulators knew that
something had to be done quickly to stabilize the situation.
1 Statement of Win. M. Isaac, Chairman, FDIC, on Federal Assistance
to CIC and CINb before tl»e House hanking Committee's Subcommittee
on Financial Institutions, October
1982.
2 Statement of Win. M. Isaac, p. 2.




( I "I)

1411

In hi* appearance before the Subcommittee, Mr. Isaac stated that there were (our
option* available to the regulators:

(1) close the bank and pay oil insured depositors) (2)

arrange a merger on an open- or closed-bank basis; (3) grant permanent assistance; or, (4)
provide temporary direct assistance to halt the deposit outflows and provide time to
salvage the situation and, if necessary, develop a permanent assistance program.

The

regulators chose the latter.
Option (I) was not adopted because Continental, although it

ad severe confidence

and liquidity problems, was not perceived to be insolvent in that the value ol its liabilities
were less than the regulators' valuation ol its assets. Also, according to Mr. Isaac, closing
the bank would have had "catastrophic consequences for other banks and the entire
economy."
Option (2) was not viable, since arranging a merger involving a bank ol Continental's
size within the limited time available was virtually impossible and extremely expensive to
the FDIC. Granting permanent assistance, Option 3, was rejected at the time because not
enough was known about the bank and its needs. Moreover,

in addition to the legal and

accounting complexities, the regulators believed that every effort should be made to find
a private sector solution belore resorting to direct assistance.
The regulators, therefore, decided initially on a temporary assistance program which
they announced on May 17, 1984. This was followed two months later by the announcement
of the permanent assistance program on July 26, 1984.

I- Temporary Assistance Plan
A financial assistance program, called the "Temporary

Assistance

Plan," was

announced on May 17, 1984. The participants included the FDIC, Federal Reserve, OCC
and a group of leading banks.

The plan was designed, according to the participating

agencies, to "provide assurance of the capital resources, the liquidity, and the time
needed to resolve in an orderly and permanent way the bank's problems." It provided a $2
billion loan in tike lorm of a demand subordinated note ($1.3 billion was provided by the




I

bo

FDIC with the balance provided by a group of major U.S. banks).

In addition to funds

made available by the Federal Reserve through its "discount window," a consortium ol 28
banks made available to the bank a standby line o( credit ol $3.) billion. Throughout this
period, the FDIC assured the public that "in any arrangements that may be necessary to
achieve a permanent solution, all depositors and other general creditors ol the bank will
be fully protected and service to the bank's customers will not be interrupted."

Between the interim assistance plan and the announcement ol the permanent
package, the FDIC and Continental permitted a number oI potential acquirors ot CINB to
come into the bank and review its records and documents to decide whether they might be
Interested in bidding on the bank.

Several banks, including Chemical Bank, Citicorp and

First Chicago, did so, and In some cases devoted substantial personnel resources to
examining Continental's condition to see whether it was a possible acquisition target.
None of these Inquiries by other banks or other overtures Involving private parties such as
the Bass Family resulted in formal negotiations working toward an agreement to acquire
the bank.

Some of the banks that looked at Continental discussed with the FDIC the

possibility of assisting FDIC (through fee-generating services) in finding a possible
resolution of

the Continental

problem, but none of

these discussions led to tiny

arrangements with these banks.
Concluding that the only practicable solution to the problem was to have the CINB
continue as an Independent institution, the Federal bunking agencies In a joint press
release on July 26, 1984 announced

a multibilllon dollar permanent assistance plan to

rehabilitate CINB and restore it to financial health. The release stated:
"Alter careful evaluation of all the alternatives, the agencies have
decided that the best solution is to provide sufficient permanent capital and
other direct assistance to enable the bank to restore its position as a viable,
self-financing entity.
Factors considered in reaching this determination
included the cost to the FDIC, competitive consequences, and the bunking
needs of the public (emphasis added).
The major components of the permanent assistance program included installation ol
a new management team, removal of $4.) billion in problem loans, infusion ot $ billion in
1
new capital, and a continuation of ongoing lines of credit from the Federal Reserve and a
group of major U.S. banks.




1411

2.

P e r m a n e n t Assistance P r o g r a m

The permanent assistance program (the "Plan") which was approved by the Federal
banking agencies on July 26, |98<» and which later was favorably voted on and adopted at a
special meeting of Continental Illinois Corporation's (CIC) stockholders on September 26,
198<i consists of the following elements;
Loan Purchase. Since CINB had a substantial volume of troubled loans, it was
decided that the first order of business was to remove most ol those loans from the bank.
Accordingly, the first major element in the assistance plan provided for the FDIC to
purchase troubled loans with a book value of approximately $<*.5 billion.

Initially, loans

with a May 31, I98<* book value of $3 billion are to be purchased by the FDIC for $2 billion
with the bank absorbing a $1 billion chargeoff. Thereafter, the bank may sell to the FDIC
for a three-year period additional loans outstanding on May 31, 198<«. These loans, having a
book value of $1.3 billion, would be sold to the FDIC for $1.3 billion.
The FDIC will pay the $3.3 billion lor the purchased loans by paying off the $3.3
billion indebtedness CINB has incurred to the Federal Reserve Bank of Chicago.

The

Federal Reserve borrowings assumed by the FDIC have a five-year maturity, bearing
interest on the first $2 billion indebtedness at 23 basis points over the three-month U.S.
Treasury bill rate as established at the beginning of each quarter. The rate of interest on
the remaining $1.3 biJIion of indebtedness will be the same as the rate charged to the bank
by the Federal Reserve of Chicago. The FDIC will repay the Federal Reserve borrowings
by making quarterly remittances on the troubled loans; and if at the end of the five-year
period there is a shortfall, the FDIC will make up the deficiency from its own funds.
The loans will be managed for the FDIC by CINB pursuant to a servicing contract.
Either party may terminate the servicing arrangement. The FDIC may do so at any tune
and the bank may terminate the arrangement upon six months' notice.
The FDIC Option.

To replenish the $1 billion chargeoff

and in further

consideration of FDIC's assumption of the bank's $3.3 billion debt to the Federal Reserve
Bank, the plan provides for the FDIC to acquire prelerred stock in

CINB's parent, the

Continental Illinois Corporation (CIC) for $1 billion. This capital infusion, which must be




l()7

downstreamed to the bank in the torm of equity, will be divided into (wo permanent
nonvoting preferred stock issues:

the first issue, in the amount of $720 million, is 32

million shares of a new class of junior convertible preferred stock. Pus issue will pay no
dividends except to the extent that dividends are paid on the common stock; the second
issue, in the amount of $280 million, will be an adjustable-rate, cumulative prelened in
which a dividend will be determined by the highest of three Treasury rates as published by
the Federal Reserve.

As to the first issue the FDIC is given the option to convert the

preferred stock into 160 million shares of newly authorized common stock (which would
approximate 80 percent of CIC's common stock). This is to compensate the FDIC lor any
losses it may incur on the troubled loans it has acquired.

The e f f e c t of this option, if

exercised by the FDIC, may be to wipe out the 40 million shares of common stock owned
by the current stockholders and which constitute approximately 20 percent of the equity
ol CIC.

Under the plan, at the end of five years, an estimate of the losses, il any,

incurred by the FDIC in the purchase of the troubled loans and assumption of debt to the
Federal Reserve

will be made.

The estimates will be made by tltree referees, one

appointed by the FDIC, one by CIC, and the third appointed by the two referees.

If the

FDIC suffers arty losses, it will be compensated for by exercising Its option to acquire
common stock in CIC held by the new corporation.
at

May

31, 1984 amounted to $800 million, after

Since the shareholders' equity in CIC
taking into account the $1 billion

chargeofl, a deficiency or loss to the FDIC of that amount would permit the FDIC the
option to acquire all ol the shares ofcominon stock of CIC as held by the current
shareholders, resulting in the complete elimination ol their equity interest.
other hand,

If, on the

the FDIC docs not suffer any losses, all remaining loans and other assets

acquired under transferred loan arrangement will be returned to the bank.

Rights Offering. The current holders ol CIC common stock were given a right to
acquire, on a pro rata basis, approximately 40 million shares of common stock at $4.30 per
share lor 60 days Irom the Rights Record Date and at $6.00 thereafter for (he subsequent
22 months.

The equity raised in this offering is to be downstreamed to the bank and the

shares it represents are not subject to the "make whole" arrangement under the I DIC
option.




Iti8

Interim Assistance Program and Continuing Funding.

Pursuant to the terms of the

interim assistance program, the $2 billion subordinated loan to the bank from the FDIC
and a group of U.S.

banks has been repaid.

Tlie Fed continues to meet the liquidity

requirements of the bank and the $3.3 billion funding facility provided by major U.S. banks
continues to exist.
Assignment of Claims to the FDIC.

CIC and CINB have assigned to the FDIC all

claims arising out of events occurring on or before

September 26, 1984 which either

entity may have against any of its present or former officers, directors, employees, bond
or other insurance carriers, and others

whose conduct may have contributed to any loss

incurred in connection with troubled loans purchased by the FDIC.

Any recoveries

obtained from such claims are to be applied toward payment of the FDIC obligations to
the Chicago Federal Reserve Bank.

Management Changes.

The boards of CIC and CINB named two new executive

officers: John E. Swearingen, as Chairman of the Board and Chief Executive Officer of
CIC, and William S. Ogden, as Chairman of the Board and Chief Executive Officer of
CINB. Both individuals will serve on both boards ot directors.
Day-to-Day

Operations.

Although certain agreements give

the FDIC

basic

protections as a major investor, the FDIC will not be involved with the bank's day-to-day
operations, or participate In the normal business decisions, i.e., hiring or compensation of
officers, lending or investment policies.

Further, it is the intention of the FDIC to

dispose of its stock interest in Continental as soon as practicable, possibly through a sale
to a private investor group, to one or more banking organizations, or to the public in an
unwritten offering.

B,

Concerns About the Assistance Plan

The permanent assistance plan may be an expensive one for the Federal Treasury.
Estimates prepared by Congressional budget experts indicate that the cost to the Treasury
could reach $3.8 billion, depending on the types of economic and interest rate assumptions




11>J

one makes (or future years.

This estimate, however, dues not lake into juuuni the

potential cost of FDIC's assurance that "if, for any reason, the permanent financial
assistance package proves to be insufficient, the FDIC will commit additional capital or
other tonus ot assistance as may be required."

The extent of this liability is completely

speculative.
In contrast to a significant potential loss to the Treasury, the Federal regulators
have taken pains to assure the financial community that all depositors and general
creditors of Continental would be fully protected.

A lively debate occurred within the government about whether FDIC's proposal to
channel the assistance through the holding company, rather than through the Bank itsell,
was lawful under section 13(c) of the Federal Deposit Insurance Act.

The Treasury

Department took the position that amendments to that section adopted In the Carn-bt
Germain Act had not given FDIC the authority to use the holding company lor assistance
payments, unless the case involved incrger-related assistance, which the Continental case
did not. As the Treasury's Acting General Counsel said;
"In my opinion, using the holding company as the vehicle lor assistance to the
Bank substantially increases the likelihood ot litigation and the risk that a
challenge will be successful. I strongly recommend against the choice ol the
FDIC's proposal, in light of the availability of other alternatives, which arc
clearly legal."
The FDIC argued that section 13(c), as amended, gave thein great latitude to
structure an assistance package, a position with which the Federal Reserve Board agreed.
Both agencies relied heavily on the doctrine that it the plan were challenged, a court
would give substantial deference to the interpretation of

the administrative

agency

charged with carrying out the Act.
Because of the controversy, Treasury asked the Justice Department tor an opinion
on FDIC's approach. While generally upholding that approach, Justice hinted strongly that
It was uncomfortable with the supporlability of holding company assistance:

"At the same tune, however, we caution that neither the opei alive
statute nor its legislative history is entirely clear on this issue. Assistance
through the vehicle of the Bank's holding company, rather than diiectly to the




1Iu

bank, manifestly increases Ihe risk that a court would conclude that the
FDIC had exceeded its statutory authority. Moreover, even if the statute
docs not categorically preclude such assistance, it is possible that a court
might conclude that the FDIC had abused its discretion if, lor example, the
circumstances indicated that it has based its determination to provide
assistance in this manner for reasons that were demonstrably inconsistent
with its statutory authority, such as a desire to protect existing management,
stockholders, or creditors. Channeling FDIC funds to the Bank through its
holding company, if there Is an equally feasible alternative involving
assistance directly to the Bank, simply invites litigation and judicial
scrutiny... Notwithstanding some reservations and our preference for a more
fully developed analysis of the FDIC explanation for its approach, in light of
the broad latitude given the FDIC by the text of the statute, the deference
given by the courts to an agency's interpretation of its own statute, the
responsibility of the courts to construe the provisions of the statute liberally
in light of its purpose, and on the record presented to us in the short time
available, we conclude that the transaction contemplated probably would not
be held to exceed the FDIC's statutory authority."
The plan could be subject to legal challenge and prolonged litigation, certainly an
unsettling prospect for a company like Continental that is seeking to regain public
confidence.
While the FDIC has resisted calling Continental a nationalized bank, there Is clearly
a new competitive reality created by the assistance package.

The approach taken in

Continental is not one that historically has been taken in cases involving troubled small or
even regional banks. If the message of Continental is that a certain class of very large,
money center banks cannot be allowed to fail, the handwriting may be on the wall for
smaller banks that don't have that assurance.

Smaller banks, at the slightest hint of

trouble, may find their more volatile funds fleeing to havens in the "fail-safe" big banks.
This has enormous implications tor the entire banking system in this country, and the
regulators must be called to account on the question.
For example, one of the more serious concerns to be addressed is the FDIC's lack of
administrative capacity to do a payoff involving a bank the size of Continental, even
though under some circumstances, the FDIC in its wisdom may decide that such action is
not in the best interests of ail concerned.

Mr. Isaac testified that it would have taken

about a month or more to pay off the 8)0,000 insured depositors at Continental; and that
is simply too long. In contrast, the FDIC could handle over the weekend the processing of




checks in a small bank that has perhaps IO,GO(J accounts.

So theie presently exists an

unfair policy which favors banks "too big to fall," simply because the FDIC lacks tlie
administrative capacity to handle such a situation.

What is ol even greater l o i ^ c m ,

however, is the ripple effect ol losses to the uninsured depositors and general creditors in
a large bank payofl. In Continental, there would have been "uninsured creditors holding
$30 billion in claims that they wouldn't collect on lor years and years
Again, because ol its size, the FDIC current policy would lend to favor large banks
over small banks. This one-sided approach to resolving problems sends the wrong signals
to management and depositors alike. This "failsafe" policy not only is unfair; but it gives
the FDIC an unusual amount of supervisory discretion to determine which institutions are
"failsafe" and, most importantly, raises serious concerns about the safety and soundness of
this nation's banking system.
I. Assistance Under Section 13(c) ol the Federal Deposit Insurance Act (FDIA)
Section

13(c) ol

the

Federal

Deposit

Insurance

Act

(FDIA)

authorizes

the

Corporation, in its sole discretion, and upon terms and conditions as its Board of Directors
may prescribe, to provide assistance to insured banks that are encountering financial
difficulty. Specifically, under Section l3(cXl), the FDIC is authorized "to make loans to,
to make deposits in, to purchase the assets ol or securities ol, to assume the liabilities of,
or make contributions to, any insured bank" in order to prevent (I) its closing, or (2) to
restore a closed bank to normal operation, or (3) to lessen the risk to the FDIC "when
severe financial conditions exist which threaten the stability ol a significant number of
insured banks or ot insured banks possessing significant financial resources."

Under Section 13(cX4KA), the assistance provided to a troubled bank cannot exceed
the cost of liquidation, including paying tlte insured accounts, unless the FDIC determines
that the "continued operation ol such insured bank is essential to provide adequate
banking services in its community."

I Testimony of Chairman Isaac, pp. 231-232 ol transcript.




VIZ

Originally enacted as pari ol the banking Act of 19)3 which amended the Federal
Reserve Act of 1913, the Federal Deposit Insurance Act became a separate law in 1950. It
was at this time that 13(c) was added.

Although, as originally enacted, 13(c) did not

contain any limitation on the amount ol assistance the FDIC could provide to a troubled
insured bank (i.e., one that was closed or in danger of closing), it did require the Board of
Directors ol the FDIC, in its discretion, to find that the continued operation of such bank
be "essential

to provide adequate banking services in the community" before any

assistance could be provided.

The essentiality test was not included in the bill as

introduced in the 81st Congress; and there appears to be no mention of It during hearings
held before the Senate Banking Committee.

It was later added, however, to the Senate

version ol the bill, according to a study by Ann Cooper Penning,!

as a result ol the

Federal Reserve's concern about the possibility ol Iree-wheeling aid.

The issue was briefly discussed in the House Banking hearings and the House report
lavored omitting the essentiality test on the ground that to do so would be "ol particular
benefit to mutual savings banks as these banks cannot be merged or consolidated with
commercial banks, and there is only one mutual savings bank in the community."
Nevertlteless, the Senate version was adopted in conference without any further discussion
of tlie issue in eitlier the conference report or during the lloor debates.

Accordingly,

irom 1950 to 1982, 13(c) ol the FDIA required the FDIC to lind a troubled bank to be
"essential" to the community belore it was permitted to grant any assistance.

2* Amendment ol 13(c) under Garn-St Germain
Tlte economic environment in the early 1980's to the present, especially during 1981
and 1982, was and is characterized by high and variable interest rates, rapidly increasing
the cost ol lunds and causing severe linancial problems for many depository institutions.
Thrilt institutions were especially hard hit.

Mutual savings banks and savings and loan

associations, burdened by low-yielding mortgages and having to purchase lunds at high
rates ol interest, sullered substantial losses and severe declines In their net worth.
I Penning, Ann Cooper, Aid to Distressed Banks - Yesterday and Today:
A/i Historical SurveYo/ Federal Assistance to Distressed Banks (2 vols., 1968),
at 5 (unpublished; available at Amer. Bankers Asso. Library, Washington,
1




m

The Congress responded to the needs ol depository institutions, especially those
financial institutions which were or close to falling, by passing the Garn-bt Germain
Depository Institutions Act ol 1982 ("The Act"). For two years prior to the passage ol the
Act both the Mouse Banking and Senate Banking Committee* conducted extensive heatings
on the financial problems of depository institutions, especially the thrills.
Noting tlie loss experience of, especially, mutual savings banks insured by the l-DIC
at that time, the House Committee on Banking in its report accompanying H.K. 4603 (the
predecessor to H.K. 6267 and which became Title I ol the Garn-St Germain Act of 1982)
said:
"FDIC's primary concern at present is the current loss
experience of mutual savings banks insured by the
Corporation.
Mutual savings banks' net deposits, not
including credited interest, declined $9.4 billion through
August 1981 from approximately $131.1 billion in January 1981.
For the first six months of the calendar year, FDIC insured
mutual savings banks incurred operating losses of $590
million.
Seventy-nine FDIC Insured savings banks with
deposits of $100 million or more held over 75 percent of all
mutual savings banks' deposits.
Assuming continuation ol
present interest rate levels, FDIC staff estimates that the
net worth of at least 12 ol these institutions holding assets of
$25.9 billion will decline below 1 percent ol total assets in the
next 13 months.
(H.R. Rep. No. 97-272
at 13.)
Summing up the regulators' case requesting thai more flexible authority be provided
under Section 13(c), former Federal Deposit Insurance Corporation Chairman, Irvine
Sprague, saidi

"We have proposed to the Congress and solicit your active and
aggressive support lor legislation ... to modify the statutory Section
13(c) test to enable us to make capital inlusions more easily,
particularly In the New York thrifts, and to permit FDIC as a Ueceivei
of a large failed FDIC-insured bank to arrange a Section 13(c) puchase
and assumption transaction with an out-of-state institution
We are
talking i°day about emergency legislation to meet a specific need.
(Emphasis added!
(H.R. Report 97-272 at 18-19)




1411

Finally, Paul Volcker, Chairman of the Board ol Governors ol the Federal Reserve
System, who served as the regulators' coordinator during the months preceding the
introduction of H.R. 460), urged its immediate adoption. Me said: "In my judgment, the
legislation belore you, limited in objective, modest in scope, and temporary in duration, is
needed now, but in no way should prejudice your further examination ol more fundamental
issues."
(H.R. Rep. No. 97-272 at 19)
Again pressing the case for the regulators in testimony before the House Banking
Committee, Chairman Volcker said:
"I also want to emphasize at the outset that I consider the acute
problems of the thrift industry to be transitional in nature .... The bill
before you .... simply provides the FDIC and FSLIC, under specified
conditions, with more flexibility either to provide transitional
assistance to thrift Institutions that can survive during a period ot
financial stress or to broader merger possibilities.... The past record
and interest ot the supervisory agencies seems to me to provide
assurances that this additional margin of flexibility will be utilized with
great care and prudence, and with appropriate safeguards to the public
interest; it is not a generalized "bail-out" and should not be viewed as
such
The assistance would be provided only in circumstances in
which it would, in fact, avoid large potential drains on the insurance
funds themselves that would arise in the event otherwise sound
institutions needed to be merged or liquidated."
(H.R. Rep. No. 97-272 at II)
Responding to the volatile economic environment and to the pleas of the Federal
banking reguldtors lor help, the House passed H.R. 4603 (the Deposit Insurance Flexibility
Act), and the Senate, S. 2879.

As reported, both bills included the substance of the

amendment to 13(c) that was added to H.R. 6267 (tlie Net Worth Guarantee Act) and
enacted as Title I of the Garn-St Germain Depository Institutions Act ol 1982 (P.L. 97320).




1411

Section 13(c) ol the Federal Deposit Insurance Act (FDIA) was amended to give the
FDIC additional options to provide assistance to institutions within its jurisdiction to
include purchasing securities ot and making contributions to insured banks.
In addition to providing assistance to prevent the closing ol or to restore to normal
operations an insured bank, the Garn-St Germain Act amended 13(c) to provide assistance
"II, when severe financial conditions exist which threaten the stability of a significant
number of insured banks or of insured banks possessing significant financial resources,
such action is taken in order to lessen the risk to the Corporation posed by such insured
bank under such threat of instability."
The 1982 amendment also permitted

the FDIC, for the first time, to provide

assistance to an insured bank having financial difficulty, without first having to make a
determination that such institution was essential to the banking needs in the community.
A limitation, however, was imposed, which provided that such assistance could not exceed
the cost of liquidation, including the paying off of insured deposit accounts. If, however,
the FDIC, in its determination, makes a finding that a bank is essential to provide
adequate banking services in its community, no limitation on the amount of assistance is
provided.

Although commercial banks were obviously going through a most stressful period
(from 1981 to 1983, lor example, the FDIC handled over 100 bank failures, including 18 ot
the largest 23 in its history), it is fair to say that the primary focus of attention, as
evidenced by the testimony aforementioned, was on providing emergency help to savings
and loan associations and the mutual savings banks.

No one, including the regulators,

appeared to have considered providing expanded or more flexible autltority, on the
possibility that 13(c) would be used to provide assistance to the failure of one ol the top
ten largest commercial banks in the United btates —assistance which could possibly dwarf
In magnitude the cost to the FDIC of all the bank failures that agency has handled in us
fifty-year history.




i

3.

/b

A p p l i c a t i o n of 13(c) Assistance to C I N b

As noted earlier, the regulators decided on May 17, 1984 to provide CINb with
temporary assistance under Section 13(c) ol FDIA.

The purpose of this assistance was In

part to stabilize the rapidly deteriorating lundlng problem at the bank and to give the
regulators additional time to find a permanent solution.

The permanent assistance plan,

announced two months later on July 26, 1984, also derived its authority pursuant to 13(c)
assistance.
One week before the announcement of the temporary assistance plan, in a highly
unusual press release dated May 10, 1984, the Comptroller of the Currency publicly denied
rumors that CINb was in serious trouble and that regulators were searching lor a lirin to
take over the bank. The press statement said;
"A number ol recent rumors concerning Continental Illinois National
bank and Trust Company have caused some concern in the linancial
markets.
The Comptroller's Office is not aware of any significant
changes in the bank's operations, as reflected in its published financial
statements, that would serve as a basis for these rumors."
Yet, despite these assurances, the Comptroller knew, according to the FDIC, as
early as April 2, 1984, if not before, that with the exception of the Federal Reserve
board's Discount

Window, the CINb had no significant additional domestic

liquidity

available at the current pricing premium levels and that major sources of international
funding were drying up.l

This information, in fact, led the Comptroller to write the FDIC

on May 17, just seven days after

his press release, urging that agency to provide 13(c)

assistance to CINb because the OCC had determined that the CINb might not be able to
meet its obligations as they became due. Mr. Conover saidi
"On March 14, 1983, the bank entered into a formal agreement wih the
O f f i c e . However, the bank's condition has continued to deteriorate. An
examination as of January 31, 1984, revealed that non-performing assets
had reached approximately $2,300,000,000. Although the bank's capital
structure appears sufficient to absorb ihe probable losses in its
portfolio, rumors and speculation regarding the bank's condition have
received prominent coverage in ihe news media. As a result, the bank
lias experienced increasing problems in meeting its short tenn funding
needs. Reflecting this fact, the bank's borrowings from the Federal
Reserve System have increased from $850,000,000 on May 9, 1984, to
$4,700,000,000 on May 16, 1984. If the bank's ability to obtain funding
continues to deteriorate, the bank may become unable to meet its
obligations as they become due."
1

Memorandum to the Board ol Directors of the FDIC from Robert V. Shumway,
Director, Div. of bank Supervision: "Continental Illinois National bank and
Trust Company ol Chicago Assistance - Sec. 13(c)(2)," dated May 17, 1982.




i I

i

It was this letter and another irom the Comptroller dated July 25,

together

with other documentation, that the FDIC used to support its findings as required under
13(c) that assistance be granted to prevent the closing ot the bank.
In its decision

on the

Permanent

Assistance

Plan, the

FDIC

also

reviewed

memoranda prepared by FDIC staff, one ol which was submitted for the FDIC (Ward's
meeting on July 25, I98W by Robert V.

Shumway, Director, Division ol bank Snpei vision

for the Federal Deposit Insurance Corporation (similar to an earlier memorandum ol May
17, I9tt<t), which concluded that Continental is essential to provide adequate banking
services in its community and that the FDIC provide Section 13(c) assistance. It found:
that CINB was continuing to experience severe funding difficulties; that in
addition to the $2 billion ol subordinated notes purchased by the FDIC with
participation

of

large

commercial

banks

(pursuant

to

the

Temporary

Assistance Plan ol May 17, I9&<t), borrowings from the Federal Reserve of
Chicago continued to increase at a substantial level;
that CINB had utilized $<1.13 of the $4.5 billion line of credit that the bank had
established with 2& large commercial banks; and
that the Comptroller of the Currency in letters to the FDIC of May 1 and July
7
25, 1984, as noted above, urged that assistance under 13(c) be provided.
The reasons given for concluding that Continental was "essential" included the
followingi
—

It is one of the ten largest banks in the United States, with $34 billion in
assets, 57 offices in 14 states and 29 toreign countries stalled by several
thousands of people.
It provides a full range of commercial, individual and trust services throughout
tike midwest.

—

It has a major correspondent

relationship with hundreds of

downstream

correspondent banks which rely on Continental for check clearing and other




1411
vttal banking services.
—

These downstream correspondent banks and a number ol major banks have
provided Significant funding to Continental, and the potential adverse impact
on

the

liquidity

and capital

position of

these

funding banks could be

significantly disruptive to the U.S. banking industry.
—

Its failure would cause the domestic and international money markets to be
severely disrupted, resulting in an increase in the cost of funds which would
affect a broad spectrum of financial institutions.

—

Its many corporate customers which maintain deposit relationships at and have
other vital services performed by Continental would be severely harmed.
These commercial, industrial and institutional customers would have difficulty
reestablishing banking relationships; and, finally, a significant number of Cook
County consumer depositors would be left without deposit services uuil new
arrangements could be made.

Thus, the FDIC, for only the sixth time in its 30-year history, made a determination
under Section 13(c) that a bank was "essential" to provide banking services to the
community.
a. The Essentiality Test
The FDIC, in its application of 13(c), has no set formula as to what factors it uses to
determine whether a bank is "essential." In the five previous applications, however, it has
relied on a number of factors such as the number of depositors and the relative size of the
bank,! the location ol offices,2 whether the bank Is a signilicant provider of services
(including check clearing and other vital banking services tor other banks),3 and the
impact on the economy.^

1 First Pennsylvania bank
2

bank of the Commonwealth; First Pennsylvania bank

3 bank of Commonwealth
** First Pennsylvania Bank and Farmers Bank of the State of Delaware




i7J

P*e FDIC, however, is not limited to the>e factors.

A v oiding to a memorandum

prepared by the Acting General Counsel ol the FDIC to the Ikiaid ol Directois regarding
the legal authority lor Section 13(c) assistance to Continental, the board may conshlci
"such (actors as how the (allure ol one significant bank could a i l e d other banks and how
the resulting economic and social tremors would undermine conltdence in our country's
banking system."

The memorandum also takes a rather

expansive

view

ol

what

constitutes a "community" as that term is used in Section 13(c). Pie "community," the
memorandum states, "is the trade area it serves, plus the regional and national banking
community."

Taking its cue liom Corpus Juris Secundum

I which says the term

"community" is a flexible one, taking color from the context in which it appears, the
memorandum states that "it can be the trade or service area to be served by the bank, and
can extend beyond the geographic limits in which the olltces ol the bank are located."
The broadness of the definition of "community" as applied by the FDIC in the Continental
situation clearly raises the possibility that any bank with a significant level of business
lending, a retail deposit base, correspondent relationships and a lair amount ot lending
abroad, would be "essential," meaning cost would be irrelevant.

Although the statute

apparently does not require any cost estimate to be made when there has been a
determination that a bank is essential to the "community" prudence would dictate that
some cost analysis be prepared by the FDIC.

Despite the scarcity ot legislative history or other congressional guidance on what
the definition ot "community" is, it is doubtful that the Congress meant to include the
possibility that such term could be interpreted as encompassing the globe.

To provide

some parameters or guidance tor the federal regulators, tlic term community needs
statutory clarification.
b* The Cost of l*roviding Section l)(c) Assistance by FDIC to
Continental
Altliough the total FDIC cash outlay under the permanent financial assistance
plan will be $1 billion, ultimately the gain or loss to the FDIC depends on any losses it may
incur under the loan purchase arrangement and the price it gets on its sale ot CIC stock.

I 13 A C.3.S.




1411

lite possibility that the FDIC may have a harder time collecting on the troubled loans (and
thereby costing tliat agency more tha/i It may have earlier anticipated) was made evident
recently by Continental in a IO-Q ltlmg with the Securities and Exchange Commission lor
the third quarter, 1984. It saldt
"because of the mix, type, and volume of the transferred loans in
particular and economic conditions In general, recoveries may well be
worse than the bank's experience prior to transferring the loan"
(emphasis added).
According

to the filings, between

Duly 26 and September

experienced losses of $28 million on its $3.) billion loan portfolio.

25, 1984, FDIC

At this rate over a

five-year period, the losses would exceed the $800 million equity currently held by
Continental's shareholders. If the losses continue at this rate, the FDIC option to convert
its preferred stock to shares of CIC common stock under the assistance plan would be
exercised, thus wiping out all the current shareholders' stake in Continental. AltlWugh the
success of the assistance plan depends on the overall performance of the transferred loans
over the next five years, the general condition of the overall economy, and a number of
other factors, the FDIC is prepared, it says, to commit additional capital or other forms
of assistance should the permanent financial plan prove to be insufficient. The ultimate
cost to the FDIC and the U. S. Government, therefore, continues to be unknown.

(I) CbQ's Analysis of the Federal budget Impact ot Assistance to CINB
At the request of Chairman St Germain, the Congressional Budget Office prepared
an analysis of the estimated federal budget impact of the assistance provided CINB.l

A

single joint estimate of the budgetary effects of the assistance plan was not feasible due
to much uncertainty about key factors in the analysis—especially the value of loans
transferred to the FDIC and the future value of stock of the bank's parent, Continental
Illinois Corporation.
based on three scenarios developed by CbO, estimates of net federal outlays over
the 1981-1990 period varied between -$0.2 billion and $3.8 billion.

'

"Analysis of the Federal Budget Impact of Assistance to Continental Illinois
National Bank and Trust Company," Congressional Budget Office, October 3,
1984.




Although the Federal Reserve and the Comptroller of the Currency played a role in
developing the assistance plan, the significant budget impact derives from and is related
to the activities of the FDIC. The CliO also concluded that the assistance plan could also
affect the American and international financial systems and the U. S. economy, although
"the budgetary effects are highly uncertain, and there is no reliable way to predict the
nature of magnitude ot possible secondary elfects."
The value of the troubled loans acquired by the FDIC is the major uncertainty in lite
cost of the plan to the FDIC. As noted earlier, many of the loans are energy-related, real
estate, or shipping and are of poor quality. To reflect this uncertainty, CbO's analysis is
based on three alternative scenarios;

—

an optimistic assumption — that the FDIC will collect $4.0 billion of
principal

and

interest

on

tlie

$3.3

billion

in

transferred

loans.

(Continental's recent 10-Q filing would seem to dispel any likeliltood that
this assumption will become a reality);
—

a pessimistic assumption — that the FDIC will collect $2.0 billion of
principal and interest on the $3.3 billion in transferred loans; and

—

a midpoint assumption — that the FDIC will collect about $3.0 billion ot
principal and interest on the $3.3 billion in transferred loans.

Taking the value of the troubled loans as indicated in each scenario and adding the
CbO's assumptions on FDIC's receipts from sale of the convertible preferred and common
stock using optimistic, pessimistic, and midpoint assumptions, with prices of $7.00, $1.00,
and $4.00, respectively, per share of common stock, and including dividend income and
loss of Interest in the FDIC portfolio, the CbO projected the net effect on FDIC outlays
from 1983-1990 to range from -$0.2 billion (using optimistic stock price and loan collection
assumptions) to $3.8 billion (using pessimistic assumptions), with a midpoint estim tie of
$1.8 billion.




As indicated in the CbO analyst, if the FDIC incurs losses in the amounts suggested
in il»e pessimistic and midpoint assumptions, tlie agency

would reduce or eliminate

insurance rebates that might otherwise be made. Even without considering the effect of
Continental, because of the rise in the number of bank failures, a rebate to banks on their
1985 insurance assessments is not expected.

These costs are ultimately passed on to

depositors, borrowers, and/or stockholders.
What was even harder lor CbO to assess was the potential budget impact of the
alternatives available to the FDIC.

For example, had the bank been closed, the FDIC

would have been named receiver of the bank's assets. Insured deposits were only a little
more than $3 billion. Alter paying off these depositors, the FDIC would begin paying off
creditors and others as necessary from liquidation of the bank's assets. Once the FDIC
had agreed to guarantee all deposits and general creditors, as Mr. Isaac so announced on
May 17, 1984, FDIC's direct liability would have been about $38 billion in the event the
CINb failed, aittiough its net liability after recoveries would have been considerably less.
Nonetheless, the CbO concluded that "... The failure ol a bank of CI's magnitude might
have caused a general loss of confidence in American banking institutions, and the longterm budgetary and economic impact, although impossible to measure, could have been
enormous."
(2) FDIC's Cost Analysis
Although the Subcommittee eventually had the benefit of the CbO analysis, the
Subcommittee was unable to obtain comprehensive and meaningful financial data which it
presumed the regulators (particularly the FDIC) had prepared in their effort to arrive at
an appropriate decision as to what to do in Continental.
One of the major controversies that erupted during the Committee's inquiry was
whether a cost analysis was prepared by the regulators to determine whether indeed the
program finally agreed upon would not only help the depositors at Continental, but
whether the decision would work well for the U. S. banking system at large and, indeed,
whether it was in the best interest of




the taxpayers of this country. The Comptroller ol

ibJ

lite Currency insisted that a cost analysis was done (although the OCC did not have the
information). He said it was available:
"I think what we are talking about are analyses of the impact on the
FDIC ol alternative ways of handling Continental in terms of a payoll,
in terms of the merger analyses with other banks, in terms of the final
solution that was put in place."
It is not clear to what analysis Mr. Conover was referring, but there was an FDIC
memorandum dated June 19, 1984, prepared at Chairman Isaac's request, titled "Exposure
ol Downstream Correspondent banks to Continental Illinois."

In that memorandum the

FDIC stall identified 2,299 banks which had deposits or funds invested in CINb. Ol these,
976 banks had an exposure in excess ol $100,000.

The amount of this exposure was

calculated as a percent ol the correspondent bank's equity.
adjustments for

deposit

Insurance coverage

for

Although the stall made no

the deposits of

the 976 banks or

anticipated recovery on CINb's liquidation, they concluded that 66 banks had an exposuie
to CINb In excess of 100 percent ol their capital and another ID banks had an exposure to
CINb between 50 and 100 percent of their capital.
Although the FDIC memorandum docs not say so, Mr. Conover, In testimony before
the Financial Institutions Subcommittee on September 19, 1984, without identifying his
source of information, concluded!
"If Continental had failed and had been treated as a pay oil,
certainly those 66 banks would have failed and probably a goodly
number ot the other 11) would have failed, if not immediately
thereafter, certainly within some timeframe afterwards. So let us say
that we could easily have seen another hundred banking failures."
In contrast, Chairman Isaac, when testifying before tlie Subcommittee on October
1984, vehemently dented ever predicting the number ot failures that would have occurred
if a deposit payoff had been made in Continental:

"We have never predicted, I have never predicted, this agency has
never predicted the number of banks that would have failed as a result
of a deposit payoll in Continental.... My point is, Mr. Chairman, the
FDIC has never represented that any portion ol those 2,300 banks
would have failed. We have never slated how many of those 2,1UU
banks would have failed.... I would be willing to tell you fewer than l'>
would have (ailed in the first round...."




1411

Adding further to the already confusing state of affairs, Mr. Isaac was asked by
Chairman St Germain to produce the analyses that Mr. Isaac had stated were done in June
and July. Mr. Isaac replied, "...there are no written analyses."
Further testimony followsi
"Chairman St Germain. It was all mental?
"Mr. Isaac. That is correct. Estimates.
"Chairman St Germain. Estimates. Mental estimates?
"Mr. Isaac. That is correct.
"Chairman St Germain. In other words, guesses.
"Mr. Isaac. That is what this business—
"Chairman St Germain. Educated guesses?
"Mr. Isaac. That is what this business is, educated guesses.
"Mr. Isaac.
question.

At the point when we were doing this it was a totally moot

Continental had already been taken care ol on May 7.

We had

decided that tlte bank would not be permitted to fad on May 17th. "Anything
we did in June or July—
"Chairman St Germain.

Oh, so you made a decision without ever having any

written analyses, right?
"Mr. Isaac. Pardon?
"Chairman St Germain. You made that decision without having ever run these
numbers?
"Mr. Isaac. I didn't tell you that. I told—
"Chairman St Germain. That is what you just said. It would have been
moot because you said a decision was made on May 17.
"Mr. Isaac. I told you. I told you, Mr. Chairman, that I had some rough
numbers that I was given at that time.

We could not come up with

better numbers. We did not have time.
"Chairman St Germain. You said you got those numbers In June or July.
"Mr. Isaac. No. I got tlte first numbers in May.




"Chairman St Germain. In May?
"Mr. Isaac. Yes.
"Chairman St Germain. Those are just rough numbers, right?
"Mr. Isaac. Very rough."
Hie colloquy recounted above may reliect the imprecise statutory language tound in
Section 13(c).

It may be that In Its attempt to provide wide latitude and give greater

flexibility to the regulators in such emergency situations, Congress may have sacrificed,
to some degree, the accountability that such regulators should be called upon to provide.
Admittedly, the Congress linds itself

on the horns of a dilemma;

It is absolutely

necessary that lite banking regulators be given certain powers (in some instances,
extraordinary) not given to other governmental agencies, to provide immediate and broad
assistance to troubled financial institutions, which if not piovided, could have farreaching and disastrous consequences lor our national economy.

However, these powers

must in some way be offset by or balanced with equally necessary precautions which
absolutely insure that such regulators are accountable lor their actions and are subject to
intensive Congressional review.
accomplish this necessity.

There are no adequate procedures, at present,

to

Hence, the decision by tlie regulators to provide 13(c)

assistance, to declare that the CINB was essential to provide the banking needs in the
community in this case, and to do so without having done, apparently, a comprehensive
cost analysis or evaluation, and without having to confer with any other authorities, raises
substantial questions as to whether the regulators should continue to have such absolute
authority and whether such a momentous decision should be left to their "sole discretion."
Perhaps, Section 13(c) should be lelt alone. Perhaps not. At the minimum, however, 13(c)
should receive a thorough Congressional review.

The issue is whether, in light ol

Continental, Section 13(c) assistance as it is now written is the most appropriate means to
handle all sizes of troubled banks, whether the remedies provided therein arc appropriate,
whether

they truly serve the public interest, and whether, in its desire to provide

flexibility,

Congress

may

have

also,

Inadvertently,

relieved

accountability for their actions, or whether, unwittingly, it may have

the

regulators

C a s t its

ot

blessings on

banks "too big to tail," to the prejudice and detriment ot smaller institutions.

In support of Its deliberations and findings (and in addition to the Comptroller's
letters), the Board ol Directors ol tlie FDIC reviewed two memoranda, each ol which was
submitted to the Board at its meetings on May 17 and July 2), I9H4, respectively, by




12(i

Robert V. Shumway, Director, Division oi bank Supervision lor the Federal Deposit
Insurance

Corporation.

Tl»e

memoranda

concluded

that

"continued

operation

ot

Continental is essential to provide adequate banking services in its community and that
tt>e FDIC provide appropriate assistance pursuant to Section iMc) ol the FDI Act to
prevent the closing o! the bank."
In support

thereol, both memoranda, which are similar

in content, stated in

substance the following:
—

that CINb was continuing to experience severe funding difficulties; that
in addition to the $2 billion ol subordinated notes purchased by the
FDIC with participation oi large commercial banks (pursuant to the
Temporary

Assistance Plan ol

May 17, 1984), borrowings Iroin

the

Federal Reserve of Chicago continued to increase at a substantial level;
—

that CINB had utilized $4.13 of the $4.) billion line ol credit that the
bank had established with 28 large commercial banks; and

—

that the Comptroller of the Currency in letters to the FDIC of May 1
7
and July 25, 1984, as noted above, urged that assistance under 13(c) be
provided.

Mr. Shumway not only concluded that 13(c) assistance should be provided because
there were sufficient facts which indicated tliat CINB was m danger of closing, he also
addressed

the

issue of

the

amount of

assistance

to be provided

in the

May 17

memorandum, saying that "(w)e have determined that the amount of assistance required
to facilitate a merger, consolidation or the sale of assets and assumption of the liabilities
of Continental is an amount in excess of that amount reasonably necessary to save the
cost of liquidating, including paying

insured accounts, ot Continental.

However, we

bebeve that the continued operatioq o| Continental is essential to provide adequate
banking services to its community."




His memorandum of July 25, 1984 advised that

Continental's financial condition had woisened, but again confirmed that Continental w
"essential." Reasons given for concluding that Continental was "essential" were staled
the memorandum, dated July 2), 1^84:

"Continental is one of the ten largest banks in the United States, with
$34 billion in assets, 57 o f f i c e s in 1 stales and 29 foreign countries stalled
4
by several thousands of people.
It provides a full range of commercial,
individual and
trust
services
throughout
the midwest, has ma|or
correspondent relationships throughout the world.
Por these reasons ami
others listed below DliS continues to believe that Ihe continued operation of
Continental is essential to provide adequate banking services in its
communities.
Continental has a major correspondent relationship with hundreds
of downstream correspondent banks.
These banks rely on
Continental (or check clearing and other vital banking services.
It would be extremely disruptive to these banks and their
customers should these services be interrupted. It also would be
very difficult to reestablish such a large number of correspondent
relationships in a short tune.
"—

Many downstream correspondent banks and a number of major
banks have provided significant funding to Continental through
deposit balances (domestic or oflsliore) and Fed Funds sold. The
potential adverse impact on the liquidity and capital position of
these funding banks could be sigmficonily disroptive to the U.S.
banking industry.

"--

A failure
domestic
investors
premium
adversely

"—

Many corporate relationships would be severely disjointed it
Continental were to fail.
It lias domestic commercial and
industrial loans of about >13 billion (and financing commitments of
about $15 billion). Many of these entities also maintain de|>osit
relationships and have additional vital services such as payroll,
performed by Continental.
Additionally Continental handles
clearing accounts of major commodities exchanges.
An
interruption of (unctions provided to commercial customers would
severely disrupt the operation of commodity exchanges and harm
the commercial, industrial and institutional customers because of
tlte difficulty
(or
these
entities
to reestablish
banking
relationships.

"—

A significant portion ol consumer deposits in Cook County ai e
held by Continental; if Continental were to fail, these dc|K>sitors
would be left without dej>ostt services until new relalionshij)s
could be established."




of Continental would severely disrupt international and
money markets. It would cause foreign and domestic
to avoid bank CD's in general or demand a large
for litem.
This increase in the cost of funds would
a f f e c t a broad spectrum of financial institutions.

1411

c. Resignation oi Continental's Top Three Executives
Despite the (act that tike management decisions ol CINB's top executives directly
contributed to the enormous problems at that institution (as is documented In Chapter II
of this report), its board ol directors, nevertheless, decided to give very handsome
separation packages to its three top executives, Messrs. Anderson, Miller, and Perkins, all
o( wtkjm agreed to early retirement effective April 30, 1984.

Although the termination

agreements may not be characterized, by some, as "golden parachutes," In the sense that
such packages are normally reserved to protect key executives in a company which may
be subject to a hostile tender offer—which is clearly not the Continental case—these
particular executives did fairly well by any standards.

In addition to other benefits, Mr. Anderson received a one-tlrne lump sum pension
supplement of nearly $270,000, a monthly consulting fee of over $12,000 through 3uly 1986,
a cash payment of $77,000 reflecting the value of forfeited shares of restricted stock due
him had he retired at age 63, certain financial advisory services, and payment of dues for
certain

clubs.

Messrs.

Perkins

and

Miller

also

received

handsome

termination

agreements.*

An OCC legal memorandum dated July 3, 1984, titled, "possible OCC Action Against
'Golden Parachutes' at Continental Illinois" concluded that the Comptroller might have
difficulty enforcing any action against Continental or the three executives given the
difficulty of proving that the termination agreements constituted an unsafe or unsound
banking practice considering the bank's size, financial condition, and industry practices
regarding termination agreements. However, it cited another internal memorandum from
the Assistant Director of Litigation to the Deputy Chief Counsel, which concluded that
"... it might be advisable for the FDIC, considering the leverage it now has over

I Hearings, pp. 176 and 188-189




lb'J

C o n t i n e n t a l , to 'suggest' t h a t these c o n t r a c t s be r e s c i n d e d as they are not in the bank's

best interest."

2

Tlus conclusion was further supported by Mr. Conovei during his appeal ance before
the Subcommittee oil Its Inquiry into Continental on September It*, I'Jttt. Me saidj
"I have talked both to the subsequent management of the bank and the
FDIC, about this subject. 1 believe the FDIC is at least considering taking,
and probably will take, some action regarding those contracts... I think the
Important point is that either the bank, itself, or the FDIC is In a better
position to do something about this pioblein than we are. I think they ought
to go ahead and do it."3
Recently, the FDIC initiated actiou to rescind the termination agreements.

As a practical matter, It is unlikely that separation packages would ever adversely
affect the safety and soundness of an institution the sUe of Continental.

More to the

point, however, such packages as agreed to in the Continental situation could threaten the
loss of public confidence in the entire banking industry.

In light of the FDIC's apparent

difficulty In resolving this issue, the Committee may want to consider a legislative
remedy.

2 Hearings, p. 187
* Hearings, p. 377




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Hcgioital Adoi ni at r a t'




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H D L K A L IO:i>tKV£ D A N K Ol C H I C A G O
1)0 SOUTH LA SALIC
UUtl
CHICAGO IIJINOIS SOtVO

(111) }li Mil

February 20, l^dL

Hr.

Donald

Vict

C.

Continent*)
231

Miller

Chairman
S.

Illinois

Corporation

LaSallc

Chicago,

Illinois

Dear

Milleri

Kr.

60693

Enclosed
Condition
prepared
examiner.

The

1980,

11,

ia

requested

at

its

next

and

that

of

Inspection

Illinoia

to

natters

vaa

the

Meeting

Upon
and

Report

ioapection

Attached

form

a

of

Corporation,

b f ^ y ^ Q E Q w U Q f l • adoinistrative

August

related

ia

ofContinrotil

it

and
are

be

auch

of

this

this

1930,

be

by

1,

report,

Reserve

please

truly

Board

ol

Regional

•a i»»




Governors
Administrator

ol

National

banks

It
Directora

ainutea.

correspondence

sign

yours,

AKbicja
-

the

of

consents.
the

("CIC"),

company
on

I960.

BoarJ

cxamner'a

laclosuree

cc

in

office.
Very

holding

26,

and

llliooia

comaeneed

the

noteJ

FcJeral
page

bank

September

reviewed

of
on

30,

on

review

copica

discussed

to

of^ Jun<

report

receipt

return

as

coapleted

Operations
Chicago,

attached

zoo
FEDERAL

RESERVE B A N K

OF

CHICAGO

2>0 SOUTH LA SAIXf rTUEET
CHICAGO, ILLINOIS 6O&V0
()I2) | 1 M » »

October

M r . John B .
President

13,

1981

Parkins

Cootioeotftl I l U o o i i
Corporation
231 S o u t h L a S s l l s
Chicago, I l l i n o i s
60693
Dsar

Nr.

r«rkinsi

l o c l o s s d i t a l a p o r t of
Condition o f C o n t l n e n t a l I l l i n o i s
p r e p a r e d by | U U U H B I t t | f l D i '

I n s p e c t i o n o f O p e r a t i o n s and
Corporation* Chicago, I l l i n o i s ,
f o l d i n g company • s a a i o c r .

The l n s p e c t i o o a> O F . A g r . f l 30 f 1961, C O W I D C C D oo J u l y 6 , 1901»
and v a a c o m p l e t e d on A u g u s t 2 ) . 1 9 * ] .
I t is requested that
t h e r a p o r t b t r s v i t w e d by t h « Board o f D i r e c t o r s s t i t s n s » t
M e e t i n g and such r s v i e v b t n o t e d i n tha m l n u t s s .

for*

and

Upon r e c e i p t o f t h i s r s p o r t ,
return i t to this o f f i c e .
Very

plssss

truly

yours^

KJBidap
cc

-

Board o f
Bagioosl

• s I S3




Covcraori
Adatoistrstor

of

Rations!

sign

Banks

the

attached

FEDERAL RESERVE D A N K Oh C H I C A G O
:»« soi I N LA SAIL* s m i I
CHK AGO. ILLINOIS 606V0

( M2) >21
December 10, I9t)2

Board

of

Directora

c/o Roger I . Anderson
Chairman

of

ihe

Continental
231

S.

Board

Illinois

LaSalla

Chicago,

Corporation

Street

Illinois

60693

Gent leneni
Enclosed
o f C o n i mental
H H M ^ m
August
Chat
the

examiner.
2,

the

1982,

next

ainty
It

be

is

the

Che

eenior

to

by

Chat

at

to

of

this

30,

6,

1982.

be

noted

the

aa

the

arrange

for

report,

pleaae

a mutually
sign

-

Clearing

Unit

(2

copies)

OCC
FDIC
Field

copy

COPY
•a i » >




the

office.

" S i

requested

a,

within

Co a d d r e s a
of

variou

However,
problem

raise

other

committee.

y
Very ^ ^ j j ^ y o u r

cc

level
and

jSftl

on

minutes.

eourcee

concerns

audit

ia

attps

high

b v IT?

a netting

expansion.

from mjtket

these

at
the

taken

arreat

unuaually

funds
of

has

to

in

Condition

couutenced

It

Directors

and

prepared

1982,

of

discuss

memtera

322-5889 'to

receipt

thie

and

April

Board

well

procuring

opportunity

of

management

with

of

aa

Operationa

Illinois,

review

auch

that

ol

Chicago,

on O c t o b e r

the

aasociated

management

Upoo
it

and

cost

undersigned

return

coapleted

aa

ramifications
the

lnapection

was

dcficicnciea

the

related

of

inapection,

recognised

control

request

Report

Corporation,

reviewed

daya

and
with

a

The

and

report

internal

We

is

Illinois

mattere

Please

agreeable
attached

loans

concerns.
contact

tioie.
furm

and

1411

F E D E R A L R E S E R V E B A N K OF C H I C A G O
} H «OJTH LA WU I r rr*£TT

OUCAOO
mm
(312) 3 2-3322
2

February 10, 19B4

Kr. Roger E . Anderson,
Chairman of the Board
and Chief Eiecutlve Officer
Continental Illinois Corporation
231 S. taSalle
Chicago, Illinois B0693
Dear K r . Anderson:
Enclosed 1s a Report of Inspection of Operations and Condition of
Continental Illinois Corporation. Chicago, Illinois, prepared b y ^ K t B
W K K B X txtmSntr. The Inspection as c ' September 30 1963. commenced on
October 31, 1983, and was completed on December 30, 1 9 8 3 . I t 1s requested
that the report be reviewed by the Board of Directors and such review be noted
1n the minutes.
As detailed 1n the accompanying report, the holding company's
financial condition Is regarded as unsatisfactory. This assessment Is
reflective of the problems presently confronting U s principal bank subsidiary
which constitutes the vast majority of Its assets. These problems are set
forth 1n the examination report covering the lead bank prepared as of June 30,
1983, and have been further covered with you 1n your meetings with
representatives of the Office of'the Comptroller of the Currency, tour
attention 1s directed to pages 1 and 5 of the enclosed report for a discussion
of the overall condition of the Corporation and certain policy matters which
we believe should be considered. We will be 1n contact with you with regard
tc a possible meeting with the Audit Committee or other tpproprlate body.
As you know, we have had the opportunity to review your 1984
operating plan with your staff. While we are not 1n position tc make a
Judgment concerning the achlevablllty of this plan, we would comment that It
does not appear to provide for much flexibility. Clearly, the performance of
the Corporation over the next several months 1s critical. Consequently, we
w H l closely follow Its progress In meeting Its plan objectives and maintain
our dialogue with your staff.
Very trujy yours

cc: Board of Covaraors (2 copies)
Comptroller oI Um Currency
£t*te Banking Departnent
Federal Deposit Insurance Corporation




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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102