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INQUIRY INTO CONTINENTAL ILLINOIS CORP. AND CONTINENTAL ILLINOIS NATIONAL BANK HEARINGS BEFORE THE SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE OF THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIES HOUSE OF EEPEESENTATIVES NINETY-EIGHTH CONGRESS SECOND SESSION SEPTEMBER 18, 19 AND OCTOBER 4, 1984 Serial No. 98-111 Printed for the use of the Committee on Banking, Finance and Urban Affairs INQUIRY INTO CONTINENTAL ILLINOIS CORP. AND CONTINENTAL ILLINOIS NATIONAL BANK HEARINGS BEFORE THE SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE OF THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS HOUSE OF REPRESENTATIVES NINETY-EIGHTH CONGRESS SECOND SESSION SEPTEMBER 18, 19 AND OCTOBER 4, 1984 Serial No. 98-111 Printed for the use of the Committee on Banking, Finance and Urban Affairs U.S. GOVERNMENT PRINTING OFFICE 39-133 O WASHINGTON : 1984 HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS FERNAND J. ST GERMAIN, Rhode Island, Chairman CHALMERS P. WYLIE, Ohio HENRY B. GONZALEZ, Texas STEWART B. McKINNEY, Connecticut JOSEPH G. MINISH, New Jersey GEORGE HANSEN, Idaho FRANK ANNUNZIO, Illinois J I M LEACH, Iowa PARREN J. MITCHELL, Maryland RON PAUL, Texas WALTER E. FAUNTROY, District of ED BETHUNE, Arkansas Columbia NORMAN D. SHUMWAY, California STEPHEN L. NEAL, North Carolina STAN PARRIS, Virginia JERRY M. PATTERSON, California BILL McCOLLUM, Florida CARROLL HUBBARD, J R . , Kentucky GEORGE C. WORTLEY, New York J O H N J. L A F A L C E , New York MARGE ROUKEMA, New Jersey NORMAN E. D'AMOURS, New Hampshire BILL LOWERY, California STAN LUNDINE, New York DOUG S. BEREUTER, Nebraska MARY ROSE OAKAR, Ohio DAVID DREIER, California BRUCE F. VENTO, Minnesota J O H N HILER, Indiana DOUG BARNARD, J R . , Georgia THOMAS J. RIDGE, Pennsylvania ROBERT GARCIA, New York STEVE BARTLETT, Texas MIKE LOWRY, Washington JACK EDWARDS, Alabama CHARLES E. SCHUMER, New York BARNEY FRANK, Massachusetts BILL PATMAN, Texas WILLIAM J. COYNE, Pennsylvania BUDDY ROEMER, Louisiana RICHARD H. LEHMAN, California BRUCE A. MORRISON, Connecticut J I M COOPER, Tennessee MARCY KAPTUR, Ohio BEN ERDREICH, Alabama SANDER M. LEVIN, Michigan THOMAS R. CARPER, Delaware ESTEBAN E. TORRES, California GERALD D. KLECZKA, Wisconsin SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE FERNAND J. ST GERMAIN, Rhode Island, Chairman CHALMERS P. WYLIE, Ohio FRANK ANNUNZIO, Illinois GEORGE HANSEN, Idaho CARROLL HUBBARD, J R . , Kentucky JIM LEACH, Iowa NORMAN E. D'AMOURS, New Hampshire ED BETHUNE, Arkansas DOUG BARNARD, J R . , Georgia STEWART B. McKINNEY, Connecticut J O H N J. L A F A L C E , New York NORMAN D. SHUMWAY, California MARY ROSE OAKAR, Ohio BILL McCOLLUM, Florida BRUCE F. VENTO, Minnesota BILL LOWERY, California ROBERT GARCIA, New York GEORGE C. WORTLEY, New York CHARLES E. SCHUMER, New York BILL PATMAN, Texas DAVID DREIER, California STEPHEN L. NEAL, North Carolina BARNEY FRANK, Massachusetts RICHARD H. LEHMAN, California J I M COOPER, Tennessee BEN ERDREICH, Alabama THOMAS R. CARPER, Delaware RICHARD L. STILL, Subcommittee ill) Staff Director CONTENTS Hearings held on: September 18, 1984 September 19, 1984 October 4, 1984 The Financial Performance of Continental Illinois National Bank: "A Chronology and Peer Group Comparison," staff report dated September 17, 1984. Page 1 169 395 7 TESTIMONY OF TUESDAY, SEPTEMBER 18, 1984 Kenefick, Kathleen, former employee, Continental Illinois National Bank Kovarik, Richard, senior national bank examiner, Office of the Comptroller of the Currency McCarte, Allan, former national bank examiner, Office of the Comptroller of the Currency Meade, John, senior national bank examiner, Office of the Comptroller of the Currency WEDNESDAY, SEPTEMBER 19, 107 108 106 1984 Conover, Hon. C.T., Comptroller of the Currency THURSDAY, OCTOBER 4, 95 172 1984 Dugger, Robert H., Subcommittee Deputy Staff Director; accompanied by Gary Bowser, senior auditor, General Accounting Office Isaac, Hon. William M., Chairman, Federal Deposit Insurance Corporation 413 456 ADDITIONAL INFORMATION AND PREPARED STATEMENTS SUBMITTED FOR INCLUSION IN THE RECORD Continental Illinois Corp.'s proxy statement dated August 24, 1984 Annunzio, Hon. Frank, a Representative in Congress from the State of Illinois, news release containing copy of letter sent to FDIC Chairman Isaac asking him to clarify FDIC policy in the future regarding guarantee insurance for losses suffered by depositors "Central Bankers Have a Hot Line Too/' article from Fortune magazine of October 1, 1984 Congressional Budget Office: "Analysis of the Federal Budget Impact of Assistance to the Continental Illinois National Bank and Trust Company," report dated October 3, 1984 Letter from Rudolph G. Penner, Director, dated October 3, 1984 Conover, Hon. C.T.: Letter to FDIC Chairman William M. Isaac, dated May 17, 1984 Prepared statement with attached appendix Press Release dated May 10, 1984, regarding Continental Illinois National Bank Response to questions of: Chairman St Germain 310, Hon. Carroll Hubbard, J r Hon. B i l l P a t m a n Hon. George C. Wortley Hon. Chalmers P. Wylie din 188 82 379 401 400 286 194 285 364 297 375 356 294 IV Continental Illinois National Bank Failure and Its Potential Impact on Correspondent Banks," staff report dated October 4, 1984 "FDIC Reform in the Light of the Continental Illinois Experience: A Statement of Views, With Policy Recommendations," by Albert Gailord Hart, professor emeritus of economics, Columbia University, dated September 8, 1984 General Accounting Office, statement by the Comptroller General of the United States Isaac, Hon. William M., prepared statement on behalf of the Federal Deposit Insurance Corporation (FDIC) Kenefick, Kathleen, memorandum dated July 1982 to J.R. Lytle, division manager, midcontinent division of the oil and gas groups, Continental Illinois National Bank Kovarik, Richard, memorandum dated November 15, 1982 to William E. Martin, Deputy Comptroller for Multinational Banking Lane Banking Group, Chicago IL, letter with attached statement dated October 19, 1984, from William N. Lane III, chairman of the board Leach, Hon. Jim, a Representative in Congress from the State of Iowa, opening statement Letters of invitation requesting witnesses to appear at subcommittee hearings held on: September 18, 1984 September 19, 1984 "Minimum Capital Ratios; Issuance of Directives," excerpt from the Federal Register of September 4, 1984, regarding Comptroller of the Currency's proposed rule Office of the Comptroller of the Currency (OCC), memorandum dated J u n e 3, 1984, on the subject of "Possible OCC Action Against 'Golden Parachutes' at Continental Illinois" St Germain, Chairman Fernand J.: Memorandums submitted by Robert V. Shumway, Director of Bank Supervision, Federal Deposit Insurance Corporation, regarding Continental Illinois National Bank dated: J u n e 6, 1984 J u n e 20, 1984 J u n e 22, 1984 Quotation from Fortune magazine of October 1, 1984 Shumway, Hon. Norman D., a Representative in Congress from the State of California, opening statement Vento, Hon. Bruce F., a Representative in Congress from the State of Minnesota: Documents regarding FDIC CAMEL rating of Continental Illinois National Bank Letters from the Deputy Comptroller for Multinational Banks pertaining to OCC examination reports transmitted to the Continental Illinois Bank board of directors with attached replies dated from 1979 to 1982 ... Wortley, Hon. George C , a Representative in Congress from the State of New York, transmittal letters from the Deputy Comptroller for multinational banks pertaining to OCC examination reports to the Continental Illinois Bank board of directors dated 1977 and 1982 Wylie, Hon. Chalmers P., a Representative in Congress from the State of Ohio and ranking minority member of the subcommittee: Correspondence and FDIC Chairman Isaac's response to the committee staff study "Continental Illinois National Bank Failure and Its Potential Impact on Correspondent Banks" "Federal Deposit Insurance Corporation Assistance to an Insured Bank on the Ground t h a t the Bank is Essential in its Community," study by the Congressional Research Service dated October 1, 1984 "Internal Controls" excerpt from the Comptroller of the Currency's report of December 6, 1982 Memoranda regarding the Unity Bank and Trust Co. case, Farmers Bank of the State of Delaware and others dated May 17 and July 25, 1984, with attached material providing a history of essentiality of a bank in the community Opening statements: September 18, 1984 October 4, 1984 Page 418 606 625 457 100 105 618 85 168 392 383 177 598 599 600 376 91 330 313 356 592 492 165 522 76 411 INQUIRY INTO CONTINENTAL ILLINOIS CORP. AND CONTINENTAL ILLINOIS NATIONAL BANK TUESDAY, SEPTEMBER 18, 1984 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON F I N A N CIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE, COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS, Washington, DC. The subcommittee met, pursuant to call, at 10:08 a.m., in room 2128, Rayburn House Office Building, Hon. Fernand J. St Germain (chairman of the subcommittee) presiding. Present: Representatives St Germain, Annunzio, Hubbard, Barnard, Oakar, Vento, Schumer, Patman, Carper, Wylie, Leach, McKinney, Shumway, McCollum, Wortley, and Dreier. Also present: Representatives Mike Lowry and Thomas J. Ridge of the full committee. Chairman S T GERMAIN. The subcommittee will come to order. This morning we open hearings into the problems of Continental Illinois National Bank, an institution t h a t failed to survive without massive, record breaking, infusions of Federal moneys and credit. Deja vu. For a decade and a half, this subcommittee, and the full committee, have probed bank and regulatory failures—U.S. National Bank in San Diego, the Texas Rent-a-Bank scandals, the Bert Lance playpen at Calhoun National Bank in Georgia, the Penn Square circus in Oklahoma City. We've monitored and gathered facts about dozens of lesser cases in all sections of the Nation. In 1977 and 1978, we battled uphill against the combined bank and regulatory lobby to enact an entire set of new and improved supervisory powers—to make certain t h a t no one in the Federal supervisory bureaucracy could claim they lacked the tools. Yet, today, we return to this forum faced with what is, for all practical purposes, the granddaddy of bank failures, a $44 billion money center bank t h a t rolled into the ditch uncontrolled by its $500,000-a-year chairman and the rest of the megabucks management team—or the Federal bank supervisory system. Minus the excitement and the "anything your heart desires" approach to Federal assistance, 56 commercial banks have slipped quietly down the tubes this year—a failure pace rivaled only in the dark days of the Depression. In 1983, the bank tombstones numbered 48, and in 1982, 42. Hardly ringing testimony to the strength of the economy or the supervisory agencies. (1) 2 No one on this committee is foolish enough to suggest that all bank failures could or should be prevented. But it is not unreasonable to expect the regulators to identify the problems early on and, most important, to force remedial steps with vigor and without the long period of handwringing agonizing that allow the problems to fester and become more expensive. When the remedial action isn't forthcoming and when the problems are terminal, it is incumbent on the regulators to concede the fact in a timely fashion and not allow the gap between knowledge and action to dupe and ensnare the public—as we saw so clearly in our Penn Square investigation. The timidity factor in our Federal regulatory system is expensive for the investing public and the Federal Treasury. And it breeds contempt for a regulatory system that consults when it should condemn. In the case of Continental, money managers and the foreign investors—about whom we have heard so much—obviously were knowledgeable and spotted problems at the bank. When the regulators failed to force meaningful change, when there was no public announcement or hint of vigorous action to assure the bank's improvement, the investors moved their money. A group clearly more devoted to definitive timely action than our Federal regulators. In the world of the regulators, secrecy cures all. In my opinion, regulatory secrecy dupes the innocent, the unsophisticted, and doesn't fool, for long, the wise men of international finance. For those of us who have ridden the failed bank circuit, the deja vu qualities of Continental are discouraging. It appears that the only thing the regulators have improved is their ability to make excuses. The list of excuses will be long and varied. Some will tell us the economy did it. I was as concerned as anyone about the recession but it is far too simplistic to let the economic downturn be used to paper over the deficiencies at Continental. We must have a banking system and a regulatory system for all seasons—for good times and bad times. Some will tell us that all would have been well—or at least undetected—had the Arabs just kept the price of oil going upward. True, the best bets about oil and gas supplies and prices missed the mark in the early 1980's. But prudent bankers hedge their bets and diversify the portfolios so that even if the most expert of the experts is wrong, the bank is protected. The proof of this is the fact that most banks, including those heavily committed institutions in the Southwest, did survive the downturns in their oil and gas portfolios without the kind of massive help required by Continental. And if the problems of Continental were simply an unexpected downturn in prices of an otherwise solid oil and gas portfolio, one must again wonder the regulator. Regulators, like prudent bankers, presumably do watch the concentration of assets in a single industry and are in a position to demand the type of diversification that would enable the bank to ride out unforeseen storms. The Office of the Comptroller of the Currency is skilled in is post-failure public relations. Officials of the agency have circulated among the Washington press corps, offering explanations and an occasional plea of mea culpa on some of the issues, reminiscent of the high school student who brings home the failing marks and 3 quickly concedes he was tardy a few times in hopes t h a t his angry parents will be diverted from asking about all those days he played hookey. Before these hearings are completed, I am grateful t h a t we will have been able to sift through these excuses, rationalizations, and wishful thinking. Some of the issues are, indeed, complex and some of the decisions, I will concede, are easier to second-guess t h a n to make firsthand on the firing line. We have an enormous amount of testimony scheduled to be presented to this committee, in coming weeks, but one central theme already stands out in the research. In the late 1970's, the management of the bank made a conscious decision to become more aggressive and to move Continental up in the competition for the top rungs among money center banks. It was a big change for an institution t h a t had a track record of moderate, if not conservative, banking. Little thought apparently went into the consideration of strengthening the bank's internal controls commensurate with the increased loan activity. With the bank's growth shooting up past its peer groups among national banks, it is presumed t h a t the alarm bells—if the system were working—would have sounded within the walls of OCC. It was time to move in, to demand a tough internal system of review, and to make certain t h a t management at all levels could qualify for jet-age banking. It is true t h a t the examiners on the scene did spot troubles in the internal review process in the late 1970's and early 1980's. But, it is not apparent t h a t OCC ever really did anything about the information—anything t h a t might have forced the changes t h a t might have negated the need for these hearings today. In August 1981, the examiner reported the startling information t h a t the internal review process was so badly in disarray t h a t billions in loans had never even reached the review stage within the bank—finding $2.4 billion untouched 1 year, $1.6 billion in another year. "* * * It is evident that no one is monitoring this situation to ensure that all credits are receiving timely review . . . " the examiner stated in his 1981 Examination Report. Clearly, a dangerous situation in a bank now headed pell mell at top speed in the big time arenas of banking. Strangely, this same examiner—after finding this mass of loan paper lying around unchecked—wrote the Continental board of directors this nicely perfumed note: We found it (the internal system) to be functioning well and accurately reporting the more severely rated advances to the Board and senior management. What kind of timid, tip toe through the tulips signal was this supposed to convey to the board of directors? A little more t h a n a year later, another examiner at Continental began to have second thoughts about the OCC's timidity. Noting the aggressive growth policy of the bank and the lack of increased attention to controls, Richard Kovarik wrote in the 1982 examination report: 4 The loan review function at CINB has been the recipient of criticism from the OCC for at least three years. However as it was functioning fairly well, that criticism was not as strong as it now appears it should have been. When we start passing out awards in the Continental case, I want to nominate Mr. Kovarik for the prize for understatement. Yes, Mr. Kovarik, you are right—it does indeed appear that OCC wasn't as strong as it might have been * * * much to the sorrow of this committee, the banking industry, and the American taxpayer. As we proceed in these hearings it is essential that we keep in mind the critical importance of the internal review process in money center banks. The size of these institutions make it impossible for examiners to walk through all the loan documents—as might be possible in a smaller institution—and thus much of the regulatory process hinges on the integrity of internal audits, review and control processes. When internal review is faulty, the burden on the examiners increases dramatically. In the case of Continental, the internal control machinery—the process by which the bank double checked its quality standards on loans—was manned frequently by inexperienced personnel or worse, by people who had made the loans in the first place. In either case, it was unworkable. It is not reasonable to expect a loan officer who has made the judgment to grant the loan to then turn around and conduct a harsh review and give himself or herself a bad mark. That just isn't human nature, and it isn't sound judgment on the part of bank management to allow the review process to be compromised in this fashion. Overall, this case presents an unfortunate combination of aggressive, decentralized management and timid regulatory approaches. There is no more volatile mixture in banking than aggressive management and timid regulation. When we have pursued these banking failures in the past, we have put a heavy emphasis on the safety and soundness of banks, the efficacy of the regulatory process, and the need to maintain banking services in local communities. With Continental, we add a new ingredient—the safety and soundness of the U.S. Treasury. For it is the Federal Government, the American taxpayer and bank customers across the land who will bear much of the burden for the mistakes at Continental. The bailout—the nationalization, assistance package, whatever name fits one's philosophical viewpoint—is enormous by any standard. Combining assistance from FDIC with the high point of the Federal Reserve's discount window operations and the package of loans from other banks, the bailout probably tops $15 billion. FDIC's direct assistance includes the purchase of $4.5 billion of the bank's bad loans and a $1 billion infusion of new capital. In late August, the Federal Reserve's discount window had slipped $7.2 billion into the bank and the commercial banks, at the suggestion of the regulators, had moved more than $4 billion to Chicago. In contrast, the entire package of loans to Lockheed, Chrysler and New York City voted by this committee did not exceed $6 billion combined. More to the point, these instances of corporate assistance were possible only after extended debate, investigations and majority approval of both Houses of Congress, and the President of the United 5 States. Before the Lockheed-Chrysler-New York City packages were approved these recipients had to appear before the Banking Committees of both the House and Senate, to agree to stiff conditions and to subject themselves to ongoing reviews by specially established oversight oversight boards within the Federal Government. In contrast, the bailout of Continental was put together behind closed doors by the three regulators. No public debate. No prior approval by the Congress and the President. Just an announcement of a fait accompli by the regulators. Not even the President of the United States, in the most dire of emergencies, can commit moneys in this magnitude without prior approval and knowledge. Clearly, this kind of unchecked power—and the ability to commit the moneys and credit of the U.S. Government—cries out for the most thorough of reviews. We will explore every aspect of the statutes which the regulators claim gave them the authority to proceed with the Continental bailout. If, indeed, the authority is clear—as the regulators steadfastly contend—then we have a responsibility to review whether or not this power should remain in its unbridled form. Obscured in the smokescreen about insurance premiums, funny money at the Federal Reserve and other suggestions that all this assistance is accomplished by mirrors, the hard cold fact is that it will have a substantial impact on the Federal budget deficit. I have asked the Congressional Budget Office to review the transactions. CBO's final draft is not in hand, but I am sure it will be their approach to give us a range of possible impacts based on various economic conditions and interest rate projections. Using rosecolored glasses, it might be argued that the budget impact could dip to the vicinity of a half billion dollars. Removing those rosy hues, it appears a more realistic range would place the estimate between $2 and $3 billion with some worst case scenarios reaching well beyond. And the estimates may well be only the tip of the iceberg if the FDIC and the Federal Reserve have created—without congressional approval—a brandnew entitlement program for money center banks. If Continental is a precedent, the big bank fail safe security program may, someday, rival defense outlays. For the banking industry, the bailout presents some significant policy questions. If the bailout program is to proceed on the basis on bank size, there may be a substantial impact on the small and medium size institutions across the Nation t h a t have not enjoyed the automatic bailout features incorporated in the Continental case. The fail-safe banks—with the Continental style 100 percent plus insurance of everything—will clearly have a big let up in the market in the competition for funds and investors. Continental presents the greatest multitude of banking question ever to come before this committee. They are of critical importance to the Nation and are at the heart of this Committee's assigned jurisdiction and responsibility. I feel strongly t h a t we must explore every aspect of this case. I deeply appreciate the support that this inquiry has received from the members of this committee on both sides of the aisle. I also want to commend the staff of both the majority and minority who have worked so well together in a tireless effort to compile the data for the Members. These issues which 6 clearly transcend party and philosophical lines and judging from my conversations with Members, I know there is a determined effort to probe the Continental case with vigor and thoroughness. [The staff reports and charts follow:] 7 THE FINANCIAL PERFORMANCE OF CONTINENTAL ILLINOIS NATIONAL BANK; A CHRONOLOGY AND PEER GROUP COMPARISON September 17, 1984 STAFF REPORT TO SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS This report is the result of staff findings to date and does not necessarily reflect the views of the Members of the Subcommittee. 8 EXECUTIVE SUMMARY This report presents information on the financial history of Continental Illinois National Bank and Trust Company of Chicago, discusses significant events which affected the Bank, and compares the performance of the Bank over time to other multinational banks and other Chicago regional banks. The report is divided into three sections. In the first section, we present (1) a chart which provides information on the increasing number of problem and failed banks, (2) a series of charts which highlight ratios related to Continental's performance in comparison with its peers, and (3) the consolidated statements of income and financial position of Continental for the period from 1970 through the first quarter of 1984. The second section presents a comparative financial analysis of the Bank in relation to its peers. The third section discusses the economic environment surrounding the Bank; changes in the Bank's organization and management; and the Bank's financial performance throughout the period from 1970 to date. The section also discusses significant events which contributed to the Bank's failure and subsequent rescue. Continental Illinois Corporation, which commenced operations on April 1, 1969, is dependent primarily upon the financial condition of Continental Bank, accounting for approximately 95 percent of the holding company's consolidated assets. Through a network of subsidiaries, branches, and representative offices, the Bank provides a broad range of banking and related business services worldwide. At its peak in 1981 the Bank was sixth among other multinational banks and the largest domestic commercial and industrial lender, employing more than 12,000 employees. The financial condition of the Corporation through 1981 was achieved primarily as a result of annual growth in assets and loans significantly in excess of its peers. However, by year-end 1982, the Corporation's ability to function as a viable entity was in extreme jeopardy. During 1982 and 1983, the Bank's financial condition deteriorated severly. The Bank's allowance for loan losses, net charge-offs, and nonperforming loans increased dramatically. Among the factors that lead to this situation were the failure of Penn Square Bank, the bankruptcy or depressed condition of Continental's once blue-chip customers, and Continental's dependency on short-term rate-sensitive funds. Significant asset quality problems in the Bank's oil and gas lending department were highlighted by the Penn Square failure in July 1982. At year-end 1982, the provision for loan losses amounted to $492 million, which included a $220 million provision related to Penn Square. But, problems were not limited to just oil and gas lending alone. During 1983 and 1984, the Bank experienced significant credit quality and documentation deficiencies in all aspects of its loan operations. As a result, more and more loans were labeled as nonperforming. By June 30, 1984, nonperforming loans amounted to $2.7 billion. After Penn Square failed, Continental's large uninsured depositors became increasingly concerned about the Bank's inordinately large amount of poor quality loans and its viability in general. By early 1984, cash flow problems had become critical. In May 1984, rumors of a possible failure or takeover circulated in the foreign money markets upon which the Bank had become so dependent. Soon after, major providers of overnight and term funds abandoned the Bank. Continental turned first to borrowing from the Federal Reserve and then from a consortium of other large banks, but it was unable to achieve stability. Consequently, on May 17, 1984, the Federal Deposit Insurance Corporation arranged an interim emergency assistance program and guaranteed all depositors of the Bank. 9 SECTION 1 Statistical Data on Problem and Failed Banks Continental's Performance Ratios in Comparison to its Peers Continental's Consolidated Statements of Income and Financial Position for the Period 1970 Through the First Quarter of 1984 10 SCHEDULE OF PROBLEM AND FAILED BANKS AND INSURED DEPOSITS FROM 1974 TO 1984 Failed Banks Number Insured Insured Deposits (millions) Year Number of Problem Banks 1974 183 4 $1,575.8 1975 349 13 339.6 1976 379 16 864.9 1977 368 6 205.2 1978 342 7 854.2 1979 287 10 110.7 1980 217 10 216.3 1981 223 10 3,826.0 1982 369 42 9,904.5 1983 642 48 5,541.4 1984 745 a/ 55 a/ §./ Information as of September, 1984 hf Not available at time of printing b/ 11 Performance Measures for Continental Illinois Corporation As Compared to Other Multinational Banks From 1976 to 1983 i / 1976 1977 1978 1979 1980 1981 1982 1983 14.00 10.65 14.14 10.94 13.69 12.33 14.37 13.68 14.82 13.54 14.88 12.75 4.56 11.53 5.95 11.15 .58 .46 .55 .45 .54 .50 .55 .52 .54 .52 .54 .51 .18 .49 .26 .52 .62 .11 .45 .56 .32 .46 .29 .38 .28 .46 .29 .41 1.28 .55 1.37 .64 1.27 1.04 1.13 .99 1.01 1.00 .91 1.03 .90 1.01 .89 1.03 1.15 1.08 1.24 1.21 3.1 3.0 2.2 2.2 1.4 1.5 1.3 1.2 1.1 1.0 1.4 1.3 4.6 2.1 4.5 2.3 4.88 4.90 4.54 4.69 4.51 4.57 4.36 4.39 4.17 4.45 4.22 4.63 4.81 4.86 5.17 5.39 4.88 5.67 4.54 5.34 4.51 5.17 4.36 4.98 4.17 4.93 4.22 5.04 5.27 5.70 5.64 6.26 7.13 1.11 6.90 7.43 6.70 7.11 6.05 6.80 5.11 6.88 5.40 6.76 5.26 6.98 6.03 7.62 Profitability/Earnings Return on Equity Continental Peer Group Return on Assets Continental Peer Group Asset Quality Net Charge-offs to Total Loans Continental Peer Group Allowance for Possible Loan Losses to Total Loans Continental Peer Group Non Performing Assets to Total Assets Continental Peers Capital Adequacy Equity Capital to Total Assets Continental Peer Group Equity Capital + Subordinated Notes and Debentures to Total Assets Continental Peer Group Equity Capital to Total Loans Continental Peer Group 12 Performance Measures for Continental Illinois Corporation As Compared to Other Multinational Banks From 1976 to 1983 i ' 1976 1977 1978 1979 1980 1981 1982 1983 58.35 56.19 56.88 56.27 58.93 57.00 62.92 56.74 62.77 57.15 67.40 60.34 75.79 61.53 71.72 62.25 -37.88 -16.75 -38.18 -17.75 -37.09 -21.48 -45.70 -22.30 -46.32 -25.07 -51.85 -31.55 -58.16 -31.51 -52.61 -30.88 N/A N/A 14.44 14.83 24.73 15.83 23.03 15.36 17.32 12.78 19.84 14.59 2.70 9.26 -7.15 5.99 N/A N/A 17.41 14.75 20.38 14.19 15.23 16.09 17.60 11.85 11.60 8.48 -8.67 7.56 -1.87 4.59 N/A N/A 11.80 15.63 17.25 27.16 16.68 24.77 15.39 14.92 12.69 9.73 -69.41 4.19 39.07 10.79 Liquidity Total Loans to Total Assets Continental Peer Group Liquid Assets Volatile Liabilities to Total Assets Continental Peer Group Growth Growth in Loans Continental Peer Group Growth in Assets Continental Peer Group Growth in Earnings Continental Peer Group U More complete information on the composition of the ratios is contained in Section 2. 13 CONSOLIDATED STATEMENT OF INCOME Continental Illinois Corporation and Subsidiaries Year ended 12/31 ($ in thousands) Interest Jc fees on loans Lease financing income Interest on deposits with banks lnt.& dividends on investment securities: Taxable income Income exempt from Fed.inc taxes Trading account interest Int.on Fed.funds sold 6c securities purchased under agreemts to resell Total interest income Interest on deposits Int.on Fed.funds purch'd Jc secur. sold under agreemts to repurchase Interest on other borrowings Interest on long-term debt Total interest expense Net interest income Provision for credit losses Net interest income after provision for credit losses Trust income Secur. trading profits <c commissions S Foreign exchange profits (losses) All other income Total other operating income Net int^Jc other operating income Salaries and wages Pension, profit sharing, other employee benefits Net occupancy expense Eqpt rental$,deprec.& maintenance Other expense Total other operating expense Income before inc.taxes & securities gains or losses Applicable income taxes (credits) Incbefore security gains or losses Secur.gains or (losses) less applicable income taxes 1 Extraordinary item, net of tax Net income Per common share: Income before extraordinary item Extraordinary item Net income Cash dividends declared Average common shares outstanding (in thousands) 1983 1982 1981 1980 303,734 20,979 3,453,274 95,907 214,107 4,683,350 125,073 499,437 4,796,322 90,327 747,149 3,448,973 65,338 658,355 25,323 10,702 9,859 105,316 49,759 29,182 129,565 59,667 34,308 148,910 64,194 34,032 133,215 70,951 29,307 90,149 960.746 29,499 3.977.044 47,876 5.579.276 83,281 5,964,215 65,374 _4_t 472^513 572,309 2,191,239 3,100,409 3,316,677 2,397,443 124,932 79,046 35.219 811.506 512,868 301,163 141.632 3.146.902 1,056,749 400,266 131.252 4.688.676 1,405,311 354,953 30,993 5.158.434 1,048,795 230,884 65,097 J3,742^219 149,240 140.000 830,142 395.000 890,600 492.000 805,781 120,000 730,294 96,000 9.240 15,857 5,318 7,224 72.483 100.S82 110.122 435.142 62,369 19,648 10,587 309.525 402.129 837.271 398.600 60,428 39,882 (1,428) 221.882 320.764 719.364 685.781 53,600 27,888 31,155 209,764 322.407 1,008.188 634,294 44,309 6,122 32,284 160,422 243.637 877,931 80,702 309,639 293,575 265,614 227,758 21,250 20,134 12,475 S3.357 217.918 74,750 87,410 44,918 204.462 721.179 61,071 72,726 41,095 204.727 673.194 74,877 65,747 36,857 180,759 623.854 61,473 53,314 36,801 173,874 558.220 (107,796) (107,796) 116,092 16,174 99,918 46,170 (38,206) 84,376 384,334 124,019 260,315 319,711 95,568 224,143 575 136,628 29.407 1,245 7,156 108.319 (6,489) 1984(3/31) — $ $ $ $ 2.46 0.17 2.63 2.00 40,045 (5,692) — 77.887 $ $ $ $ — 254,623 1.95 $ 6.4* 1.95 2.00 $ 6.<*4 39,777 $ — 1.90 39,537 Gain on sale of charge card operations. Oue to the availability of information, certain line items have been rounded or reasonably approximated. Also, inadequate information has prevented certain tine items from being stated individually. In some cases, totals were used to maintain consistency for comparative purposes. -133 0—84 2 1,798 — ... 225,941 $ $ « • 5.75 -5.75 1.70 39,256 14 CONSOLIDATED STATEMENT OF INCOME Continental Illinois Corporation and Subsidiaries Year ended 12/31 ($ in thousands) 1979 Interest <c fees on loans J Lease financing income Interest on deposits with banks Int.«5c dividends on investment securities: Taxable income Income exempt from Fed.inc.taxes Trading account interest Int.on Fed.f unds sold & securities purchased under agreemts to resell Total interest income 2,437,870 39,190 455,931 1,022,987 29,772 224,991 918,572 24,918 217,617 1,017,596 22,050 152,619 75,955 77,568 19,510 67,970 75,789 12,265 71,628 70,903 11,060 69,116 63,607 10,326 77,397 46,107 13,169 62,103 3,168,127 2,034,208 12,000 1,443,341 1.312,156 1,739,743 1,049,519 696,809 661,192 668,449 806,611 47,920 2,594,274 444,161 33,665 1,527,345 253,530 27,398 23,712 1,001,449 182,784 23,603 12,089 879,668 189,919 14,077 28,309 900,,754 573,853 70,000 506,863 62,500 441,892 53,500 432,488 75,000 435,,184 75,,000 503,853 37,434 15,730 12,583 141,983 207,730 711,583 444,363 34,521 11,255 15,267 105,713 166,756 611,119 388,392 34,082 ' 10,954 15,005 79,395 139,436 527,828 357,488 33,618 17,299 7,152 66,953 125,022 482,510 360,,184 31.,845 ,282 199,501 166,358 145,600 131,937 119,386 51,187 41,401 27,549 144,894 464,532 44,456 33,838 20,889 118,401 383,942 37,180 30,228 18,658 91,231 322,897 32,048 25,509 18,888 85,898 294,280 29,606 25,640 15,347 80,346 270,325 247,051 52,925 194,126 Interest on deposits Int.on Fed.funds purch'd & secur. sold under agreemts to repurchase Interest on other borrowings Interest on long-term debt Total interest expense 1,496,957 34,294 307,933 227,177 58,453 168,724 188,230 57,468 130,762 195,161 76,164 118,997 Net interest income Provision for credit losses Net interest income after provision for credit losses Trust income Secur.trading profits <c commissions J Foreign exchange profits (losses) All other income Total other operating income Net int.& other operating income Salaries and wages Pension, profit sharing, other employee benefits Net occupancy expense Eqpt rentals,deprec.& maintenance Other expense Total other operating expense Income before inc.taxes <c securities J gains or losses Applicable income taxes (credits) Inc.before security gains or losses Secur.gains or (losses) less applicable income taxes Extraordinary item, net of tax Net income Per common share: Income before extraordinary item Extraordinary item Net income Cash dividends declared Average common shares outstanding (in thousands) 1,681 ; ; 204,931 60,727 144,204 (907) -- (1,081) -- 195,807 7,000 (2,958) -- 167,817 39,195 4.49 1.32 37,336 $ $ $ $ 112,890 $ 4.02 1.26 35,537 3.63 1.18 35,130 Due to the availability of information, certain line items have been rounded or reasonably approximated. Also, inadequate information has prevented certain line items from being stated individually. In some cases, totals were used to maintain consistency for comparative purposes. -- 127,804 4.02 $ $ (6,107) -- 143,123 $ $ 5 56 r175 105,r302 ,486 465 $ $ 6.49 2.23 15 CONSOLIDATED STATEMENT OF INCOME Continental Illinois Corporation and Subsidiaries Year ended 12/31 ($ in thousands) Interest Jc fees on loans Lease financing income Interest on deposits with banks Int.ic dividends on investment securities: Taxable income Income exempt from Fed.inc.taxes Trading account interest Int.on Fed.funds sold & securities purchased under agreemts to resell Total interest income Interest on deposits Int.on Fed.funds purch'd & secur. sold under agreemts to repurchase Interest on other borrowings Interest on long-term debt Total interest expense 1,2*9,113 19,000 207,811 716,490 8,000 133,548 356,674 5,000 53,738 318,388 3,000 11,621 373,238 73,816 44,438 25,076 50,515 48,826 14,546 45,295 43,845 6,983 63,059 39,805 10,733 41,837 34,385 34,236 2,395 9,000 16,000 1,635,254 486,091 198,962 538,834 355,517 57,431 9,135 1,337, ,406 189,064 32,461 6,652 767,011 43,019 16,514 6,357 308, ,942 37,305 9,782 99,047 256,026 298.009 297, ,848 32 ,900 219,914 15,300 2 1 1 ,, 5 9 3 12 , 3 5 3 194,580 15,262 188,082 14,221 Trust income Secur.trading profits <c commissions 5 264, ,948 31 , 4 6 5 13 ,246 31,404 9,381 199, ,240 29,' 7 7 3 2,,303 179,318 27,824 4,299 173.861 22,732 Foreign exchange profits (losses) All other income Total other operating income Net int.& other operating income 64 ,000 108,,711 373 1.65?. 304,399 33 ,000 6 5 . ,076 264, ,316 26,000 58,123 237,441 17,563 40,295 214.156 105,924 89,618 77,57k 66,766 24,099 21,009 10,749 61,484 223.265 20,401 17,679 8,652 48,125 184,475 17,669 15,940 6,886 38,823 156.892 15,936 13,276 6,491 35,681 138.150 120.417 150,394 54,488 95,906 119,924 33,619 86,305 107,424 29,294 78,130 99,291 29,493 69,798 93,739 29,394 64,345 Net interest income Provision for credit losses Net interest income alter provision for credit losses S a l a r i e s and w a g e s Pension, profit s h a r i n g , o t h e r employee benefits Net occupancy expense Eqpt rentals,deprec.<5c m a i n t e n a n c e Other expense Total other operating e x p e n s e 74,861 I n c o m e b e f o r e i n c . t a x e s <c s e c u r i t i e s 5 gains or losses Applicable income taxes (credits) I n c b e f o r e s e c u r i t y g a i n s or losses S e c u r . g a i n s or (losses) less applicable income taxes E x t r a o r d i n a r y i t e m , n e t of t a x Net income Per c o m m o n s h a r e : Income before extraordinary item Extraordinary item — Cash dividends declared $ 5.51 $ Average common shares outstanding (in thousands) (835) (226) -5.51 1.10 265 -- 85.470 95.680 $ $ $ 4.94 --9 4 4. .97 _ 576 — 70,374 $ 4.55 $ $ 4.55 .92 — (6,815) -- 78.395 $ $ $ 4.11 —1 4.1 .88 34,264 Due to the availability of information, certain line items have been rounded or reasonably approximated. Also, inadequate information has prevented certain line items from being stated individually. In some cases, totals were used to maintain consistency for comparative purposes. 45,556 — 57,530 $ $ $ 3.38 —8 3.3 .82 16 CONSOLIDATED STATEMENT OF CONDITION Contine ntal Illinois C o r p o r a t i o n and Subsid iaries 1984 D e c e m b e r 31 ($ in thousands) 1983 1982 2,039,281 3,415,990 2,569,866 3,586,524 2,199,386 1,880,853 2,513,080 5,082,703 4,361,504 4,294,045 646,739 761,664 1,814,334 Assets Cash and due from banks I n t e r e s t - b e a r i n g deposits Fed.funds sold and s e c u r i t i e s purch'd under a g r m t s to resell Trading a c c o u n t a s s e t s Investment securities 676,774 561,589 1,762,394 444,224 853,460 2,064,744 499,817 169,164 2,169,303 417,207 128,065 2,505,924 1981 1980 Loans: Domestic Foreign L e a s e financing r e c e i v a b l e s T o t a l loans and lease receivables 29,329,847 1,045,485 20,187,123 10,203,246 1,038,400 22,053,107 10,817,214 1,172,478 22,131,015 10,044,482 1,123,729 18,528,132 8,381,566 720,003 30,375,332 31,428,769 34,042,799 33,299,226 27,629,701 L e s s : Unearned income R e s e r v e for c r e d i t losses N e t loans and l e a s e receivables 267,333 401,384 29,706,615 269,720 382,565 30,776,484 322,551 381,083 33,339,165 423,000 289,169 32,587,057 262,663 246,113 27,120,625 325,599 337,045 342,241 298,715 276,479 870,015 1,870,572 41,450,809 859,318 967,377 42,097,371 690,442 1,084,909 42,899,424 2,469,917 1,181,999 46,971,755 1,898,071 1,087,488 42,089,408 10,146,083 18,132,704 28,278,787 13,527,978 15,903,490 29,431,468 12,690,041 15,484,980 28,175,021 14,963,103 14,630,902 29,594,005 13,579,324 13,734,343 27,313,667 5,192,723 2,801,843 870,015 1,231,387 1,247,881 39,622,636 4,830,645 2,677,047 870,106 1,210,578 1,255,953 40,275,797 5,920,332 4,028,928 692,788 1,100,169 1,272,291 41,189,529 7,998,482 3,014,740 2,477,137 1,314,402 862,297 45,261,063 7,361,000 2,203,947 1,898,816 1,110,719 676,317 40,564,466 89,400 200,780 526,904 1,021,457 89,400 200,780 526,895 1,014,539 199,761 525,525 989,244 198,009 522,812 989,871 (10,256) 1,828,285 112 1,828,173 (9,975) 1,821,639 65 1,821,574 P r o p e r t i e s and e q u i p m e n t C u s t o m e r s ' liability on acceptances Other assets Total assets Liabilities Deposits: D o m e s t i c offices Foreign offices Total deposits Fed.funds purch'd & s e c u r i t i e s sold under a g r e e m t s to r e p u r c h a s e O t h e r borrowings Acceptances outstanding O t h e r liabilities L o n g - t e r m debt Total liabilities Stockholders' Equity P r e f e r r e d stock C o m m o n stock C a p i t a l surplus R e t a i n e d earnings Accumulated translation adjustment Total Less - T r e a s u r y stock a t cost Total Stockholders' Equity Total Liabilities & Stockholders' Equity ' J H , 450,, 809 42,097,371 (4,433) 1,710,097 202 1,709,895 42,899,424 -- 1 , 7 1 0 ,-- 2 69 --1,524,942 46,971,755 42,089,408 1,710,692 As of March 31, 1984. Due to the availability of information, certain line items have been rounded or reasonably approximated. Also, inadequate information has prevented certain line items from being stated individually. In some cases, totals were used to maintain consistency for comparative purposes. -- 196,690 517,824 810,428 1,524,942 17 CONSOLIDATED STATEMENT OF CONDITION Continental Illinois Corporation and Subsidiaries December 31 ($ in thousands) Assets Cash and due from banks Interest-bearing deposits Fed.funds sold and securities purch'd under agrmts to resell Trading account assets Investment securities 3,366,816 4,035,140 3,897,143 3,926,679 2,879,378 3,932,661 1,523,849 1,761,488 308,174 189,101 2,226,340 361,591 114,349 2,174,380 183,324 299,792 2,501,082 3,942,564 383,432 2,364,019 3,235,981 205,925 2,281,344 Loans: Domestic Foreign Lease financing receivables Total loans and lease receivables 16,366,150 6,815,562 609,668 12,796,075 5,650,035 451,816 10,883,300 3,980,117 400,394 9,601,343 3,357,468 324,865 9,334,256 2,756,076 274,967 23,791,380 18,897,926 15,263,811 13,283,676 12,365,299 Less: Unearned income Reserve for credit losses Net loans and lease receivables 215,374 212,180 23,363,826 143,305 191,237 18,563,384 121,027 168,164 14,974,620 107,000 163,271 13,013,005 97,000 161,890 12,106,409 Properties and equipment Customers' liability on acceptances Other assets Total assets 226,842 195,579 164,966 120,850 87,596 1,092,622 981,258 35,790,119 900,405 925,155 31,058,665 255,893 608,564 25,800,280 125,515 511,265 21,984,899 176,736 360,264 20,215,743 12,517,200 11,490,000 20,007,200 12,142,717 9,017,533 21,160,250 10,089,704 8,664,081 18,753,785 8,708,640 7,108,487 15,817,127 9,351,904 5,938,481 15,290,385 5,865,470 1,901,351 1,096,924 1,026,740 529,532 34,027,217 5,143,594 1,492,881 905,557 680,202 450,457 29,832,941 4,383,055 450,272 257,764 586,259 357,050 24,788,185 3,981,529 325,028 126,269 557,280 265,293 21,072.526 2,934,426 313,159 177,268 494,900 180,000 19,390,138 196,095 510,349 656,458 195,839 508,646 521,239 177,824 428,148 406,123 177,335 427,243 307,795 173,937 42S.737 222,795 Liabilities Deposits: Domestic offices Foreign offices Total deposits Fed.funds purch'd <c securities 5 sold under agreemts to repurcha Other borrowings Acceptances outstanding Other liabilities Long-term debt Total liabilities Stockholders' Equity Preferred stock Common stock Capital surplus Retained earnings Accumulated translation adjustment Total Less - Treasury stock at cost Total Stockholders' Equity Total Liabilities & Stockholders' Equity * 136 1,362,902 1,225,724 1,012,095 912,373 825,605 1,362.902 1,225.724 1.012.095 912,373 825.605 35,790,119 31,058,665 25,800,280 21.984,899 20,215,743 Due to the availability of information, certain line items have been rounded or reasonably approximated. Also, inadequate information has prevented certain line items from being stated individually. In some cases, totals were used to maintain consistency for comparative purposes. 18 CONSOLIDATED STATEMENT OF CONDITION Continental Illinois Corporation and Subsidiaries December 31 ($ in thousands) Assets Cash and due from banks Interest-bearing deposits Fed.funds sold and securities purch'd under agrmts to resell Trading account assets Investment securities 1,905,849 1,556,970 1,779,892 1,340,999 1,803,907 2,151,719 356,048 1,774,445 2,237,921 339,825 2,069,506 1,593,554 181,290 1,802,936 902,863 181,992 1,707,646 918,870 413,528 1,519,447 Loans: Domestic Foreign Lease financing receivables Total loans and lease receivables 10,047,666 2,607,592 102,819 8,216,269 1,777,829 5,946,998 1,173,004 4,016,679 879,614 3,476,186 12,758,077 9,994,098 7,120,002 4,896,293 3,476,186 Less: Unearned income 3 Reserve for credit losses Net loans and lease receivables 157,378 12,600,699 142,950 9,851,1*8 129,530 6,990,072 125,639 0,770,650 123,782 3,352,000 Properties and equipment Customers' liability on acceptances Other assets Total assets 58,672 49,293 46,173 40,627 32,759 271,245 522,070 19,600,747 84,930 537,637 16,727,230 111,098 194,526 12,699,941 247,597 762,729 9,955,107 202,746 445,037 8,688,698 9,752,612 5,715,562 15,068,174 8,576,870 4,021,333 12,598,203 6,936,739 3,064,436 10,001,175 5,764,402 2,691,736 8,056,138 4,980,456 2,173,969 7,150,025 1,967,516 457,403 272,013 544,029 180,000 18,889,135 2,245,659 618,406 86,445 386,557 100,000 16,035,270 (.1,502,339 116,216 301,758 100,000 12,061,088 515,345 251,468 147,717 484,807 172,646 204,159 137,771 9,370,668 8,153,808 186 173,663 425,291 152,472 186 173,095 421,170 97,509 186 172,539 393,800 71,928 186 171,359 317,227 95,667 168,643 314,357 51,890 Liabilities Deposits: Domestic offices Foreign offices Total deposits Fed.funds purch'd & securities sold under agreemts to repurchase Other borrowings Acceptances outstanding Other liabilities Long-term debt Total liabilities Stockholders' Equity Preferred stock Common stock Capital surplus Retained earnings Accumulated translation adjustment Total Less - Treasury stock at cost Total Stockholders' Equity Total Liabilities & Stockholders' Equity _ _ 751,612 _ . 691,960 _ . 638,453 _ _ 534,890 751,612 691,960 638,053 584,039 530,890 ^9,600,707 16,727,230 12,699,901 9,955,107 8.688,698 For Continental Illinois National Bank and Trust Company of Chicago and Subsidiaries only. Due to lack of information in years 1974 to-1970, the unearned income line item was netted against the Loans (Domestic & Foreign) and Lease receivables line items. Lack of available information prevented a further breakdown of Lease receivables for the periods 1973 through 1970. Due to the availability of information, certain line items have been rounded or reasonably approximated. Also, inadequate information has prevented certain line items from being stated individually. In some cases, totals were used to maintain consistency for comparative purposes. — 584,439 19 CONSOLIDATED STATEMENT OF CONDITION C o n t i n e n t a l Illinois C o r p o r a t i o n and Subsidiaries (as percent of total assets) D e c e m b e r 31 19841 19S3 1982 1981 1980 1979 4.9 S.2 6.1 8.5 5.1 4.4 5.4 10.8 10.4 10.2 9.4 11.3 12.5 12.6 11.2 15.2 1.6 1.8 4.4 1.6 1.3 4.2 1.0 2.0 4.8 1.1 .4 4.6 1.0 .3 6.0 .9 .5 6.2 1.2 .4 7.0 .7 1.2 9.7 Loans: Domestic Foreign L e a s e financing r e c e i v a b l e s Total loans and lease receivables .70.8 2.5 48.0 24.2 2.5 51.4 25.2 2.7 47.1 21.4 2.4 44.0 19.9 1.7 45.7 19.0 1.7 41.2 1.82 1.5 42.2 15.4 1.6 73.3 74.7 79.4, 70.9 65.6 66.5 60.8 59.2 Less: Unearned i n c o m e R e s e r v e for c r e d i t losses N e t loans and lease receivables .6 1.0 71.7 .6 .9 73.1 .8 .9 77.7 .9 .6 69.* .6 .6 64.4 .6 .6 65.3 .5 .6 59.8 .5 .7 58.0 2.0 2.3 100.0 1.6 2.5 100.0 5.3 2.5 100.0 4.5 2.6 100.0 3.1 2.7 100.0 2.9 3.0 )0.0 1.0 2.4 100.0 24.5 43.7 68.2 32.1 37.8 69.9 29.6 36.1 65.7 31.9 31.1 63.0 32.3 32.6 64.9 35.0 32.1 67.1 39.1 29.0 68.1 39.1 33.6 72.7 12.5 6.8 2.1 3.0 3.0 95.6 11.5 6.4 2.1 2.9 3.0 95.7 13.8 9.4 1.6 2.6 3.0 96.9 17.0 6.4 5.3 2.8 1.8 96.4 17.5 5.2 4.5 2.6 1.6 96.4 16.4 5.3 3.1 2.9 1.5 96.2 16.6 4.8 2.9 2.2 1.5 96.1 17.0 1.7 1.0 2.3 1.4 96.1 .2 .5 1.3 2.5 .2 .5 1.3 2.4 . . . .5 1.2 2.3 .4 1.1 2.1 .5 1.2 1.9 .5 1.4 1.8 .6 1.6 1.7 .7 1.7 1.6 Assets Cash and due from banks I n t e r e s t - b e a r i n g deposits Fed.funds sold and s e c u r i t i e s purch'd under a g r m t s to resell Trading a c c o u n t assets Investment securities P r o p e r t i e s and e q u i p m e n t C u s t o m e r s ' liability on acceptances O t h e r assets Total assets Liabilities Deposits: D o m e s t i c offices Foreign offices Total deposits Fed.funds purch'd & s e c u r i t i e s sold under a g r e e m t s to r e p u r c h a s e O t h e r borrowings A c c e p t a n c e s outstanding O t h e r liabilities L o n g - t e r m debt Total liabilities Stockholders' Equity P r e f e r r e d stock C o m m o n stock C a p i t a l surplus R e t a i n e d earnings Accumulated translation adjustment Total Less - T r e a s u r y stock at cost Total Stockholders' Equity Total Liabilities & Stockholders* Equity 4.4 4.3 4.0 3.6 3.6 3.8 3.9 3.9 4.4 4.3 4.0 3.6 3.6 3.8 3.9 3.9 100.0 100.0 100.0 100.0 100.0 100.0 100.0 As of March 3 1 , 1984. * Due to the availability of information, c e r t a i n line i t e m s have been rounded or reasonably a p p r o x i m a t e d . Also, i n a d e q u a t e information has p r e v e n t e d c e r t a i n line i t e m s from being s t a t e d individually. In some c a s e s , t o t a l s w e r e used to maintain c o n s i s t e n c y for c o m p a r a t i v e purposes. 20 CONSOLIDATED STATEMENT OF CONDITION Continental Illinois Corporation and Subsidiaries (as percent of total assets) December 31 1976 Assets Cash and due from banks Interest-bearing deposits Fed.funds sold and securities purch'd under agrmts to resell Trading account assets Investment securities Loans: Domestic Foreign Lease financing receivables Total loans and lease receivables 3 Less: Unearned income Reserve for credit losses Net loans and lease receivables Properties and equipment Customers' liability on acceptances Other assets TmaJ ar-sV-s Liabilities Deposits: Domestic offices Foreign offices Total deposits Fed.funds purch'd A: securities sold under agreemts to repurchase Other borrowings Acceptances outstanding Other liabilities Long-term debt Total liabilities Stockholders' Equity Preferred stock Common stock Capital surplus Retained earnings Accumulated translation adjustment Total Less - Treasury stock at cost Total Stockholders' Equity Total Liabilities & Stockholders' Equity 1974 1975 8.7 17.9 1.7 10.8 16.0 1.0 11.3 11.0 1.8 9.0 13.4 2.0 12.4 12.5 1.4 14.2 9.1 1.8 17.2 10.6 4.8 17.5 43.7 15.3 _J_«5 46.2 13.6 1^_4 51.2 13.3 .5 49.1 10.6 46.8 9.2 0.3 8.8 C |40.0 60.4 61.2 65.0 59.7 56.1 49.2 40.0 .5 .7 59.2 .5 .8 59.9 - .8 64.2 - .9 58.9 - 1.0 55.0 1.3 47.9 .5 .4 .3 .3 .4 .4 .4 .6 2.3 100.0 .9 1.8 100.0 1.4 2.7 100.0 .5 3.2 100.0 .9 1.5 300.0 2.5 7.7 100.0 2.3 5.1 100.0 39.6 32.3 71.9 46.3 29.4 75.6 49.7 29.1 . 78.8 51.3 24.0 75.3 54.6 24.1 78.7 57.9 27.0 84.9 57.3 25.0 82.3 18.i 1.5 .6 2.5 1.2 95.9 14.5 1.5 .9 2.4 .9 95.9 10.0 2.3 1.4 2.8 .9 96.2 13.4 3.7 .5 2.3 .6 95.9 5.2 2.5 1.5 5.6 2.0 2.3 1.6 ^9471 ~9X8 .8 1.9 1.4 .9 2.1 1.1 .9 2.2 .8 _ . 1.0 2.5 .6 _ v. .9 2.4 .8 95.0 _ _ 1.4 3.1 .6 1.7 3.2 1.0 . 1.9 3.6 .6 4.1 4.1 3.8 4.1 5.0 5.9 6.2 4.1 - 4.1 - 3.8 - 4.1 - 5.0 - 5.9 - 6.2 100.0 100-0 100.0 100.0 100.0 100.0 For Continental Illinois National Bank and Trust Company of Chicago and Subsidiaries only. Due to lack ol inlormation in years 1974 to 1970, the unearned income line item was netted against the Loans (Domestic &: Foreign) and Lease receivables line items. Lack ol available inlormation prevented a further breakdown of Lease receivables for the periods 1973 through 1970. Due to the availability of inlormation, certain line items have been rounded or reasonably approximated. Also, inadequate inlormation has prevented certajn line items from being stated individually. In some cases, totals were used to maintain consistency for comparative purposes. . 1.4 38.6 - 21 SECTION 2 Analysis of the Financial Condition of Continental Illinois Corporation as Compared with Other Multinational Banks from 1976 to 1983 22 INTRODUCTION In the last decade, the banking industry has been subjected to severe recessions, inflation market shifts, increased interest rate volatility, development of new types of assets and liabilities, and encroachment by other businesses. Furthermore, banking has become less protected by regulation and has become more competitive at home and abroad. During this same period, the number of problem banks increased dramatically (from 183 at year end 1974 to 745 as of September, 1984). As described by the Federal Deposit Insurance Corporation (FDIC), a problem institution is one that has unsafe or unsound conditions and a relatively high possibility of failure. In most instances an increase in problem institutions is followed by an increase in failed institutions. Such was the case for this period. The number of failed institutions, those institutions receiving financial assistance from FDIC, increased dramatically from 4 at year end 1974 to 42, 48, and 55 in 1982, 1983, and 1984, respectively. But what causes an institution such as Continental Illinois National Bank to become a problem or even a failed bank? The remaining sections of this report will attempt to answer this question by reviewing the objectives and components of the federal regulatory agencies' surveillance system and analyzing the financial condition/performance of Continental Illinois Corporation from 1976 to 1983. More specifically, these sections will focus on how well Continental has performed in comparison with other multinational banks and what factors led to its current situation. OBJECTIVES AND COMPONENTS OF A SUREVEILLANCE SYSTEM Each of the three bank regulators, the Office of the Comptroller of the Currency (OCC), Federal Reserve System (FRS), and FDIC maintain a surveillance system. A surveillance system is designed to identify financial institutions that have or are likely to have financial conditions that warrant special supervisory action. Prior to 1975, the regulators determined the financial condition of a financial institution solely through onsite examinations. However, in the mid to late 1970's, each regulator designed and implemented a surveillance screening system. The surveillance screening systems are not intended as substitutes for bank examinations nor are they intended to replace the skills and judgements needed to monitor banks or resolve their problems. The primary objective of the systems is to aid the examination process by identifying changes in the financial condition of banks and bank holding companies between examinations. Detection of such changes enables the regulators to focus on a select number of banks as opposed to focusing on the total universe. In turn, the regulators can allocate examination resources efficiently by giving the most attention to those banks that warrant the closest scrutiny. Essentially, the early warning system is made up of three components: (1) a computer screening program to identify financial institutions that fail certain ratios, (2) a detailed financial performance analysis of the institution to its peers, and (3) a notification of corrective action and follow up of problems identified from components (1) and (2). 23 Although the regulators consider the present surveillance screening systems extremely useful, they do have several limitations. The results of a computer screen are only as good as the data and ratios used in the screen. A screen will not normally identify those banks subjected to fraud, embezzlement, or other theft nor will it readily identify understated amounts on the financial statements. Also, screens are based on predetermined ratios, thus they will not necessarily identify problems from an emerging industry trend, such as problems caused by bad energy loans, unless such information has been programmed into the computer. None of the systems are designed to predict bank failures nor will they identify all unsound banks. The systems simply tell the regulator that the financial condition of a financial institution has changed since the last bank examination. FINANCIAL RATIOS As mentioned in the previous section, the screening of specific ratios is basically the technique or tool used by the regulators to monitor/analyze the financial condition of an organization. The basic component of ratio analysis is a single ratio, constructed by dividing one balance-sheet and/or income-expense item by another. The denominator of such ratios may be conceived as a "base" or scale factor. For example, a profitability ratio would relate a firm's profits to its asset or equity-capital base to provide a returnon-assets or return-on-equity measure of a firm's overall performance. It is important to recognize that ratios by themselves do not tell us much about the financial condition of the organization. To provide a meaningful basis for evaluating an organization's financial condition, comparisons with other organizations and/or with its own performance at other times are required. Also, ratio analysis focuses only on symptoms not on causes of financial difficulty. The driving force behind an organization's performance is its management: financial planning, policies, and internal controls ultimately determine an organization's performance. FINANCIAL ANALYSIS In our analysis of Continental's financial condition from 1976 to 1983, we have basically taken the approach used by the regulators and relied upon ratio analysis. We have selected 13 financial ratios under 5 major categories that are used to measure an institution's financial condition. For each ratio we have compared Continental's financial condition with two peer groups. The first peer group includes 16 multinational banking organizations, while the second peer group includes 4 of Chicago's largest banking organizations. The ratios used in the analysis were determined from financial information as filed by bank holding compnies with the Federal Reserve. The data obtained is based on year-end financial data which has not been adjusted for prior year restatements. To supplement the Federal Reserve data, we obtained 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 to date. 24 Listed below are the 5 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 4- Allowance for Possible Loan Losses to Total Loans, Net of Unearned Income Ratio 5 Nonperforming Assets to Total Assets Capital Adequacy Ratio 6 Equity Capital + Allowance for Possible Loan Losses to Total Assets + Allowance for Possible Loan Losses Ratio 7 Equity Capital + Allowance for Possible Loan Losses + Subordinated Notes and Debentures to Total Assets + Allowance for Possible Loan Losses Ratio 8 Equity Capital + Allowance for Possible Loan Losses to 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 Continental's financial condition as it relates to other multinational organizations. Additional information related to the components of the above ratios and the multinational and regional peer group data discussed below may be obtained from the Committee upon request. 25 PROFITABILITY Profitability ratios are designed for the evaluation of an organization's operational performance. The ratios yield 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 1) is the most important measure of profitability for shareholders because it relates net income to the book value of their claims. An analysis of the multinational and regional data reveals that Continental's return on equity capital for the period 1976 to 1981 was high and very stable, averaging 14.31 percent, almost 2 percentage points above its multinational peer group. This high return on equity capital is 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, Continental's return was 4.56 and 5.95 percent, respectively. This was 7 and 5 percentage points below the average of the multinational and 4 and 2 percentage points below the regional peer groups, respectively. In both analyses, Continental ranked last and next to last. The extremely low return was due primarily to a significant increase in the provision for loan loss expenses, a direct result of Penn Square's failure and the bankruptcy and near bankruptcy of several of the Bank'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 reveals that Continental's return on assets for the period 1976 to 1981 was high and very stable^" averaging ,55 percent, approximately .06 percentage points above its multinational peefr group. This high return on assets is due primarily to the continued increase in the 4pllarV level of domestic and foreign earning assets. Also, the Bank channeled a large amount 6 ^ ^ funds traditionally held in the form of short term money market investments into loans offering higher yields but less liquidity. In 1982 and 1983, Continental's return was .18 and .26 percent, respectively. This was .31 and .26 percentage points below the average of its multinational and regional peer groups, respectively. The low return was due primarily to an increase in loans designated as nonperforming. Continental'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, Continental'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. Our financial analysis coupled with a review of bank examination reports from 1977 to 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 26 expansion of the credit card operation in 1978. However, in mid-1982, poor asset quality, as evidenced by an unprecendented volume of nonperforming loans, dominated Continental's condition. Continental's earnings became severely depressed resulting in a significantly 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 reserves; and management's ability to administer and collect problem credits. The asset quality ratios analyzed are: 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 5) 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. Continental's ratio of allowance for possible loan losses to total loans was as much as .09 and .25 percentage points below the average for the peer groups. Continental'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 percent. Finally, the Bank's ratio of nonperforming assets averaged 1.30, just slightly above the multinational peer group. During 1982 and 1983, Continental experienced a severe deterioration in its asset quality ratios as compared to the multinational peer group. The Bank's allowance for possible loan losses to total loans increased significantly from .89 percent in 1981, to 1.15 and 1.24 percent in 1982 and 1983, respectively. The Bank's net charge-offs to total loans increased dramatically from a low of .29 percent in 1981 to 1.28 and 1.37 percent in 1982 and 1983, respectively (.73 percentage points above its peer group average of .55 and .64 for those years). Finally, Continental's ratio of nonperforming 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 (2.4 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 are: equity capital to total assets and equity capital to total loans. Equity capital to total assets Equity capital to total assets (ratios 6 <c 7) indicates the percentage decline in total 5 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 27 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 effects of the default risk and market risk through the law of large numbers. An analysis of the multinational peer group data reveals that Continental's equity capital to total assets ratios were relatively constant for the period 1976 to 1983, averaging 4.6 and 4.7 percent, approximately .15 and .69 percentage points below the peer average. On the other hand, an analysis of the regional data ranked Continental last, at least .67 and .90 percentage points below the peer averages. Equity capital to total loans Equity Capital to total loans (ratio 8) also indicates the percentage decline in assets that could be covered with equity capital. However, this ratio uses total loans in the denominator based on the belief that the majority of the risk in total assets is in the loan portfolio. An analysis of the multinational peer group data reveals a steady decline in Continental's ratio from 7.13 percent in 1976 to 5.26 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. Our financial analysis and a review of the bank examination reports from 1976 to 1982 reveals that Continental's level of equity capital over the period did not keep pace in relation to the extremely high volume of loan and asset growth. As a result, the below average base that existed in 1976 continued to erode. Continental was able to assume the additional risk and maintain a strained capital base, whereas others with the same capital ratios could not, because of its continued increase 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 periods: (1) the short-run, a period of less than 1 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. Loans to assets Total loans net of unearned income institution's liquidity. An analysis of the Continental's loans continued to increase, assets. During the period 1976 to 1983, to total assets (ratio 9) is a measure of an multinational and regional data reveals that becoming far and away its major source of the Bank's ratio rose significantly from an 28 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 1.5, 5.S5, and 10.3 percentage points above its peers. In general, this ratio reveals 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 liablilities 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 reveals that Continental's ratio was extremely poor during 1976 to 1983, averaging -45.97 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 78 to -46 percent for 1979 to 1980 to -54.2 percent for 1981 to 1983). Our analysis of the period from 1977 to 1983 revealed that 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 other commercial banks, particularly foreign banks, by in some cases paying them more interest than domestic banks. At 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. GROWTH Steady and controlled growth is a desirable characteristic for 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 exists among all three ratios, growth in loans, assets, and earnings (ratios 11, 12, and 13). Assets which represent Continental's use of funds have 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 reveals a steady growth in earnings averaging 14.8 percent. This consistent earnings growth, mandated by Continental's management, was driven by a 16.4 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 3.4 and 5.2 percentage points, resepectively. However, the growth in earnings considered strong by management was as much as 3.6 percentage points below its peer group. 29 In 1982 and 1983, the strong and stable growth trends were eliminated. By late 1982 significant concern centered on the quality of Continental's assets. This management to take an extremely cautious approach in acquiring additional loans. number of loans were classified as nonperforming and were written off. As a earnings from interest and fees on loans were serverly depressed. mid to caused Also, a result, Our analysis confirmed an increase in the growth of loans, assets, and earnings for Continental 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 shown by Continental's loan portfolio increases in overseas loans, energy loans, and loans to lesser-developed countries. Our analysis revealed that from 1976 to early 1982, the Bank's loans grew from 60.4 to about 79 percent of total assets. Particularly, growth was shown in energy, specifically oil and gas loans. 39-133 0—84 3 30 SECTION 3 Financial History of Continental Illinois Corporation from 1970-1984 INTRODUCTION In an attempt to protect the safety and soundness of the banking industry, the Federal Deposit Insurance Corporation (FDIC), the Comptroller of the Currency (OCC), and the Federal Reserve (FRS) on May 17, 1984, arranged an interim emergency financial assistance program and guaranteed all depositors and creditors of Continental Illinois National Bank and Trust Company (the Bank). At the time, the Bank had more than $40 billion in assets and had huge amounts of funds either loaned to or borrowed from many U.S. banks. Regulators were concerned that if the Bank failed it could have had a domino effect on the banking industry resulting in many other bank failures. The assistance program was designed to alleviate the cash shortages facing the Bank so that it would have time to recover in an orderly and permanent manner. After an evaluation of various alternatives, the regulatory agencies on July 26, 1984, provided the Bank a permanent financial assistance program intended to restore it, over time, to a profitable business entity. The major components of the plan, which is subject to stockholders' approval, include (1) installing a proven internationally recognized management team, (2) moving $4.5 billion in problem loans to FDIC, (3) infusing $1 billion in new capital from FDIC in exchange for preferred stock convertible to 80 percent of the equity of Continental Illinois Corporation (the Corporation) which is the holding company for the Bank, and (4) ensuring an ongoing line of credit from the regulators and participating banks. * But what caused the financial condition of the Bank to deteriorate? This section of the report presents information on the Corporation's and Bank's organizational structure and financial history along with a discussion of relevant events from 1970 to 1984 to help understand how the problems developed. CONTINENTAL ILLINOIS CORPORATION Continental Illinois Corporation was incorporated in Delaware in November 1968 and commenced operations on April 1, 1969, after it acquired all of the outstanding stock, except for directors' qualifying snares, of Continental Illinois National Bank and Trust Company of Chicago. The Corporation directly or through wholly-owned subsidiaries engages in lease and debt financing, mortgage lending and banking, financing of energy development and exploration, asset-based financing, reinsurance of credit life and credit health insurance directly related to extensions of credit by the Bank, fiduciary and investment services, and merchant banking overseas. The Corporation also owns two banks in the suburbs of Chicago, Illinois, a small business investment company, and an equity investment company. 31 Through a worldwide network of branches, representative offices, subsidiaries, and affiliates staffed by more than 12,000 people, Continental provides commercial, personal, trust, and money market services to individuals, businesses, and governmental entities. Its business units are organized according to market areas. SUBSIDIARY ACQUISITIONS The Corporation's significant subsidiaries as of 1984 were as follows: Name^ Jurisdiction of incorporation Percent of voting securities owned Continental Illinois National Bank & Trust Co. of Chicago Illinois 100(2) Continental Bank International Illinois 100 Continental International Finance Corporation Illinois 100 Continental Illinois Bank (Canada) Canada 100 Republic Realty Mortgage Corporation Delaware 100 Continental Illinois Leasing Corporation Delaware 100 Continental Illinois (Delaware) Limited Delaware 100 Continental Illinois Equity Corporation Delaware 100 Continental Illinois Service Corporation Delaware 100 Continental Illinois Venture Corporation Delaware 100 Continental Illinois International Investment Corporation Cayman Islands 100 Great Lakes Life Insurance Company Arizona 100 Continental Illinois Overseas Finance Corporation, N.V. Netherlands Antilles 100 Continental Illinois Trust Company of Florida, N.A.3 Florida 100 Continental Illinois Trust Company of Sarasota, N.A.3 Florida 100 32 3urisdiction of incorporation Name Percent of voting securities owned Continental Illinois Energy Development Corporation Delaware 100 Continental Illinois Commercial Corp. Delaware 100 Continental Bank of Buffalo Grove, N.A.3 Illinois 100 Continental Bank of Oakbrook Terrace^ Illinois 100 Continental Illinois Corporation Financial Futures Delaware 100 CONTINENTAL ILLINOIS NATIONAL BANK The Bank, which became a subsidiary of the Corporation, has been in business for more than 124 years. At the end of 1983, it was the largest bank in Chicago and was seventh in size in order of both assets and deposits among approximately 15,000 national and state banks in the United States. Operating a full service commercial banking and trust business, the Bank serves individuals, businesses and government in the metropolitan area of Chicago; other major metropolitan areas throughout the Nation; and overseas. It receives deposits; makes and services secured and unsecured loans; distributes U.S. government and municipal securities; and performs a wide variety of personal, corporate, and pension trust and investment advisory services. Over the past two decades the Bank changed from a conservative institution whose principal functions were providing a safe place for people and businesses to keep their money and lending to good credit risks, to an institution striving for constant growth at home and abroad. During the 1960's, the Bank developed extensive international operations; established groups to render specialized services to the Bank's oil, utility, and finance company customers; established a unified Retail Banking Department to fully serve the consumer and small businessperson; developed a separate Real Estate Department to make commercial and home loans and to service the properties which the Bank holds in a fiduciary capacity; and established a division to provide counseling to companies wishing to relocate in the Chicago metropolitan area. The Bank has a large network of correspondent banking relationships in the United States and throughout the world and provides a wide variety of services for banks. 33 ORGANIZATION OF THE BANK The organization of the Bank is built around markets it defines as groups of customers who have common needs for the services offered. The activities of each of the five customer-service units are summarized below. General Banking Services General Banking Services provides depository and financial services to corporations and correspondent banks wherever located and to governments and their agencies outside the United States. The responsibilities of the five units which comprise General Banking Services are as follows: U.S. Banking Services is divided into two areas, that generally provide commercial deposit and loan facilities to corporations, banks, bank holding companies, other financial institutions, and other entities not classified as multinational.^ The Metro-Midwest Groups, which are organized to provide specialized skills adapted to specific industries, serve customers in the greater Chicago metropolitan area, other parts of Illinois, as well as Indiana, Michigan and Wisconsin. The National Groups, organized on a geographical basis, serve domestic commercial customers not classified as multinational or served by Special Industries Services, including as many as 2,600 domestic correspondent banks^ at one point. Special Industries Services is organized to (1) supply specialized skills adapted to specific industries and (2) to provide credit and loan facilities to customers worldwide in the oil and gas, mining, construction and engineering, and shipping and marine industries. The Service also provides nationwide credit and loan facilities to public utilities, surface transportation, and equipment leasing industries. International Banking Services is comprised of two Edge Act*> Corporation subsidiaries and specialized geographic groups. It is headquartered in Chicago and has overseas branches, representative offices, and subsidiaries in 29 foreign countries. It assists foreign correspondent banks, government entities, and corporations not classified as multinational by providing them with international financial services that include short- and medium-term loans, letters of credit, acceptances, collections, remittances, deposit accounts, and foreign exchange services. Under the Edge Act, the Bank currently operates an Edge Act Corporation subsidiary headquartered in Chicago named Continental Bank International, which has branches in New York, Miami, Houston, and Los Angeles. The branches provide international banking and financial services to corporations and correspondent banks in their respective markets. Another Edge Act Corporation subsidiary, Continental International Finance Corporation, also headquartered in Chicago, has investments (ranging from 100 percent ownership to minority interests) in various foreign financial institutions that serve to supplement the Bank's international services. 34 Multinational Banking Services provides the special expertise and worldwide capabilities required by major corporate customers that have extensive worldwide operations and are classified as multinational. In addition to Chicago, MultinationalBanking Services has personnel located in New York, London, Tokyo, Brussels, Frankfurt, and other cities where multinational corporations are located. Financial Services provides the other units of General Banking Services with worldwide capability to serve clients by offering a comprehensive variety of trade financing, global cash management, and investment banking functions, including private placements, mergers and acquisitions, and corporate financial advisory services. Trust and Investment Services Trust and Investment Services provides a variety of services to a large number of individuals, associations, businesses, government entities, and institutions. Through it, the Bank acts as trustee, executor, administrator, guardian, conservator, depository, transfer agent, and registrar. In addition to the separate investment of trust assets, it maintains collective funds for trust investment, including Continental Illinois Investment Trust for employee benefit plans. It also offers custodian and investment counseling services, as well as portfolio management, and financial planning and advisory services for both domestic and international clients. Real Estate Services Real Estate Services makes a wide variety of residential, industrial, and commercial real estate loans, including secured and unsecured credits, to the real estate industry. The Bank's activities include extensions of credit to home builders and developers, mortgage bankers, and real estate investment trusts, and the origination, sales, and servicing of residential mortgages as well as other activities. Bond and Treasury Services Through Bond and Treasury Services, the Bank is a primary dealer in government and federal agency securities as one of approximately 35 primary government bond dealers authorized to deal directly with the Federal Reserve trading desk. It underwrites and distributes state and local government and public housing securities, provides short-term investment facilities to many corporations, supplies correspondent banks with services ranging from periodic pricing of portfolios to complete portfolio management, serves the primary banking needs of public bodies, funds the Corporation and its subsidiaries, manages the Corporation's interest rate sensitivity program and capital account, and controls the non-credit risk of the Corporation. Personal Banking Services The banking needs of individuals and households are the responsibility of Personal Banking Services. It administers savings accounts, time deposits, checking accounts, and 35 a broad spectrum of consumer lending activities which includes personal loans, real estate loans, and the MasterCard/Visa bank card programs until their sale in 1984. The Executive Financial Center has been established in an effort to meet the complete banking, borrowing, and short-term investment counseling needs of a select group of Bank customers. SUBSIDIARY ACQUISITIONS The Bank has established a number of subsidiaries since 1970. Under the Edge Act, it owns and operates Continental Bank International and Continental International Finance Corporation. Headquartered in New York, Continental Bank International is an international banking organization, receiving deposits, making loans, and handling all forms of international banking transactions. It maintains direct correspondent banking relationships in most major countries, and its services are available to domestic and foreign banks, corporations, and individuals. The Continental International Finance Corporation, headquartered in Chicago, provides long-term equity and debt financing for businesses operating abroad. The Bank also has equity interests (ranging from 100 percent ownership to minority interests) in various foreign financial institutions located in various countries worldwide.' These institutions supplement the Bank's international operations. The statute limits Edge Act subsidiaries to serving foreign trade-related and other international banking needs as opposed to U.S. banking needs. CHRONOLOGY OF EVENTS AND FINANCIAL HISTORY The purpose of this section is to recount the events that took place and financial performance of the bank during the period from 1970 to the present. It is not intended to explain why these events occurred. Early events and financial information is grouped into two time periods —1970-74 and 1975-79. More recent events and financial information related to the period from 1980 to 1984 is presented on a year by year basis. 1970-1974 INDUSTRY ECONOMIC CONDITIONS During the period 1970-74, the U.S. economy was in the midst of the most prolonged recession since 1933. Spending cutbacks by business, which reduced inventories and shifted borrowings into the bond and commercial paper markets, caused a decline in the volume of bank loans. In addition, the banking system was also affected by impending industrywide problems throughout 1974 resulting from the unusual failures of two large banks and the relatively high level of uncollectible loans. 36 BUSINESS SERVICES In spite of the economic conditions during this period, the Bank emerged in a position of strength and stability by expanding in many areas. As of December 31, 1974, the Corporation and its subsidiaries had approximately 9,880 officers and employees, an increase of 1,600, or 19 percent, from 1970. All but 220 of the officers and employees were employed by the Bank. The commercial banking department, which provided commercial deposit and loan facilities to individuals and corporations, was reorganized in 1973 around industry, customer size, and geographic markets in order to develop new markets. Represented among the approximately 33,000 accounts in the commercial banking department were 94 of the 100 largest American corporations and 318 of the Fortune 500 list. The international and overseas operations grew rapidly and placed greater emphasis on regionalizing business development efforts and penetrating growth markets in each of the countries where the Bank operated. By the end of 1974, the Bank's international network included 122 facilities in 37 nations on six continents, making it the largest of such networks operated by a U.S. financial institution. Several other Bank operations grew rapidly during this period. The real estate function expanded particularly as to lines-of-credit to home builders and developers, mortgage bankers, real estate investment trusts, and interim construction lending; bond operations enlarged its services to include underwriting and distributing state and local government and public housing securities, providing short-term investment facilities to many corporations and portfolio advisory services for correspondent banks, managing the Bank's investment portfolios, and procuring a large share of the funds required by the Bank; and Personal banking increased consumer credit services by implementing the Master Charge International Charge Credit system. SUBSIDIARY ACTIVITY The early 1970s was a period of rapid growth in the Corporation's subsidiary operations as evidenced by its activities. The Corporation — participated in organizing a venture capital firm which operated under the name of Continental Illinois Venture Corporation, in which the Corporation held 29 percent of the voting stock. — acquired the business and properties of Republic Realty Mortgage Corporation in June 1970 and continued to operate it as a mortgage banking firm doing business in Illinois, Missouri, Wisconsin, and Georgia. — acquired Group Counselors, Inc. by merger into Continental Illinois Realty Advisors, Inc. in March 1971. 37 — entered into a joint venture with The Royal Trust Company in October 1971. The Corporation and The Royal Trust Company then organized Builders Financial Co. Limited and its wholly-owned subsidiaries, Builders Capital Limited and Western Builders Capital Limited, to engage in construction and development lending and other interim financing of Canadian real estate. The Corporation held 50 percent of the common stock and 49.9 percent of the preferred stock (voting) of Builders Financial Co. Limited. The balance of the Builders Financial Co. Limited stock was held by the Royal Trust Company. ~ formed Continental Illinois Leasing Corporation to engage in lease and debt financing in March 1972. ~ formed Continental Illinois (Delaware) Limited in July 1972 to engage in merchant banking overseas through subsidiaries chartered under the laws of Hong Kong and the United Kingdom. ~ formed Continental Illinois Leasing and Financial Ltd. in April 1974, a Canadian corporation, to engage in medium-term lease and debt financing in Canada. MANAGEMENT On March 26, 1973, Roger E. Anderson and John H. Perkins were elected by the Board of Directors to succeed Donald M. Graham and Tilden Cummings as Chairman of the Board and President, respectively. No other major changes occurred. FINANCES The financial position of the Corporation continued to improve for the fifth consecutive year since the bank holding company was formed. The increasing demand for loans over the previous 5 years was satisfied largely through an increased reliance on time deposits and interest-sensitive funds of all kinds. Total deposits had increased from $8.1 billion in 1972 to $15.5 billion in 1974. Particularly noticeable was the growth in overseas branches and subsidiaries where time deposits increased $2.5 billion from 1972 to $5.7 billion in 1974. Dividends on common stock continued to increase in accordance with the Corporation's policy to increase dividends as earnings increased. Dividends declared in 1974 were $2.20 per share, as compared to $1.93 per share in 1973. Earnings Earnings for 1974 increased 11 percent from 1973 to $95.9 million, with a 5-year annual growth rate reaching 11.7 percent. The Bank's return on shareholders' equity in 1974 was 13.5 percent and had exceeded 12 percent annually for the fifth consecutive year. These accomplishments for 1974 were due in part to a 33 percent increase in net interest income, resulting from a sharp decline in interest rates during the fourth quarter. Total operating income increased dramatically in 1974 to $1.7 billion, as compared with $1.1 billion in 1973 and $478 million in 1972. The 1974 increase was due primarily to interest fees on loans of $1.3 billion (representing 72 percent of total operating income) which nearly doubled the $720 million recorded in 1973 and quadrupled the $369 million in 1972. 38 The growth in income was offset somewhat by the growth in expenses. Total operating expenses also increased dramatically in 1974 to $1.6 billion, as compared with $967 million in 1973 and $422 million in 1972. The 1974 increase was due primarily to interest expenses of $1.3 billion (representing 83 percent of total operating expenses) which nearly doubled the $767 million and quadrupled the $346 million in 1972. Other expenses such as salaries, wages, and compensation increased from $110 million in 1973 to $130 million in 1974. Assets Total assets grew at a record rate from $10.7 billion at the end of 1972 to $19.8 billion in 1974, with a 5-year annual growth rate of 20 percent. This growth in assets was due largely to an increased demand for loans. At year-end 1973, loans were $9.9 billion, an increase of 40.4 percent over 1972. By year-end 1974, loans increased another $2.8 billion to $12.7 billion, representing 64 percent of total assets. Domestic loans in 1974 rose to $10.1 billion, an increase of $1.9 billion from 1973, while overseas loans reached $2.6 billion, an increase of $.8 billion. Nonperforming Loans and Losses The loan loss reserve for 1974 was increased to $213 million, or 23 percent, from 1973 in recognition of possible future losses in a number of areas, including the real estate field. This increase represented 1.2 percent of gross year-end loans. 1975-1979 INDUSTRY ECONOMIC CONDITIONS The severe recession during the prior period which created financial difficulties for a number of companies began to recede in early 1976. The improvement in the banking industry occurred largely as a result of an increase in business borrowing, which was fueled primarily by a sharp rise in inflation, but also by increases in corporate spending for new plant and equipment and a continuing downturn in corporate liquidity. As noted above, the economy during this period experienced a sharp rise in inflation. The consumer price index increased 13.3 percent between the beginning and end of 1979, or 11.2 percent on the average during the year, as compared with a 9.1 percent increase on the average for 1978. Also, world oil prices more than doubled in 1979 and were still rising, outracing the rate of inflation and fueling still more inflation. BUSINESS SERVICES During this period, as in the prior period, the Corporation experienced continued growth despite the economic conditions. General Banking Services, which includes commercial, multinational, and international activities, experienced profitable gains in volume and market position. New business development and increased market penetration, together with efforts at more effective comprehensive service for multinational customers worldwide further enhanced the Corporation's position. Results 39 in all markets reflected an announcement made on Duly 7, 1976, by Continental's Chairman, Roger E. Anderson, that the Bank would embark on a strategy to make it one of the three biggest lenders to industrial and commercial companies by 1981. Commercial Banking exhibited continued growth, especially in domestic commercial and industrial loans. In addition to competing aggressively for large loans, the Bank opened offices in the Midwest to enhance its position among small to mid-sized companies. International Banking increased its services during the period by opening five new branch and representative offices and three new bank subsidiaries. Also, a correspondent banking relationship was established with the Bank of China to conduct business both with its Peking headquarters and its branches. Real Estate Services' loan portfolio continued to grow, aided primarily by the strength in the commercial construction market. Also, asset swap and repayment programs further improved the Bank's position and accelerated the repayment of real estate credits. SUBSIDIARY ACTIVITY The Corporation, through Continental Illinois Leasing and Financial Corporation, formed Continental Illinois Capital (Canada) Ltd. in 1975, a Canadian subsidiary, to engage in mortgage lending in Canada, acquired all outstanding common stock of Continental Illinois Venture Corporation in 1976; formed Great Lakes Life Insurance Company in 1977 which acts as a reinsurance underwriter of credit, life, accident, and health insurance; and formed Continental Illinois Equity Corporation in 1979 which makes equity type investments in unaffiliated companies. MANAGEMENT Executive management remained unchanged, with the exception of George R. Baker, who was placed in charge of the Commercial and International Banking Services consolidated under General Banking Services. FINANCES Continental's financial position continued developing during this period at a rate consistent with that of the previous 4 years. Stockholders' equity increased by $137 million or 11 percent to $1.4 billion at December 31, 1979. The rate of return on stockholders' equity has held steady over the period at 15 percent. In addition, the capital base has provided a steadily rising dividend to stockholders. The 1979 dividend was increased 11 percent to a new annual rate of $1.60 per share. This rate reflects a twofor-one common stock split which became effective in May, 1977. Earnings Income before security transactions increased 15 percent to a record $194.1 million, for a 5-year compound growth rate of 14.2 percent, the same as in 1978. Net interest income increased by $80 million, or 13.3 percent, to $677.3 million. Other operating income increased by $41 million, or 24.5 percent, to $207.7 million, reflecting emphasis on 40 noninterest income. Against the $121 million gain from these two principal income sources, other operating expenses were up $80.5 million, or 20.9 percent, to $464.5 million, reflecting business growth and the impact of inflation. Assets Loans and other earning assets averaged 20 percent above the 1978 level, and total assets increased by $4.7 billion, or 15.2 percent, to $35.7 billion. Nonperforming Loans and Losses The 1979 provision for credit losses and net charge-offs, which are applicable to both loans and lease financing receivables, were $70 and $49.1 million, respectively, as compared to $62.5 and $41.4 million, espectively in 1978. In each of the prior two years the provision had exceeded the charge-offs by approximately $21 million, thus slightly increasing the reserve to $212.1 million at December 31, 1979. Although the reserve increased during the period, the reserve as a percent of total loans and leased receivables decreased from 1.27 at year end 1976, to .91 at year end 1979. 1980 INDUSTRY ECONOMIC CONDITIONS During 1980, the banking industry's attention was directed towards the continued concern over accelerating inflation, volatile financial markets and uncertain economic growth. The level of economic activity for 1980 was similar to the prior year. Unlike 1979, however, when the acceleration of prices was heavily concentrated in the energy sector, no single factor accounted for 1980's rise. The inflation rate remained high due to a deterioration in the price situation. For example, labor costs increased due to an acceleration of compensation per hour and a poor performance in productivity. Food prices surged under the influence of rebounding farm prices and rising costs of marketing. Conditions in the mortgage and housing markets deteriorated sharply. Also, inflation produced serious problems for the nonbank thrift institution and other entities that concentrate their holdings in longer-term instruments bearing fixed interest rates. BUSINESS SERVICES The Bank continued to work toward its goal of becoming one of the three top institutions serving American and foreign-based multinational customers by further developing its business services. General Banking Services, building on national presence of 25 offices, opened new offices in the South and West. Four Edge Act subsidiaries based in major cities were reorganized as branches of a single Edge corporation based in Chicago. Selective expansion of the international network continued with the opening of three new branches. In addition, a minority interest was purchased in a Nigerian firm, and 41 service to correspondent banks in Europe was enhanced through a newly formed European Banking section headquartered in London. In other areas, commercial finance activity was augmented by a new Commercial Services unit that specialized in helping businesses, such as smaller oil and gas producers that might not qualify for traditional bank financing, with loans secured by the value of equipment or merchandise. SUBSIDIARY ACTIVITY In February 1980, the Corporation established Continental Illinois Energy Development Corporation to make loans to energy development and exploration companies and to service such loans; formed Continental Illinois of Florida, Inc., to engage primarily in the marketing of trust and investment services provided by the Bank; and funded Continental Illinois Overseas Finance Corporation N.V. in the Netherlands Antilles. MANAGEMENT Donald C. Miller was permanently assigned as Vice Chairman of the Board of Directors; Edwin 3. Hlavka was designated as the Vice President and Auditor of the Corporate Financial Services; and Edward S. Bottum was assigned as the Vice President of Trust and Investment Services, replacing Charles R. Hall. FINANCES The Corporation's financial growth continued amid 1980's high rate of inflation and unprecedented interest rate swings. The Multinational Lending Department placed heavy emphasis upon extending commitments to carefully identified targets and increasing these commitments to the full lending limit. International Banking Services and the Financial Institution Division stressed expansion of wholesale banking both nationally and internationally. Equity capital increased by 11.8 percent to 3.62 percent of total assets. Retained earnings increased by $162 million, bringing the year-end total to $1.5 billion, thus building the capital base for further growth. Earnings Earnings reflected continued, steady earnings on the part of major profit contributors, General Banking Services and the Special Industries Group. The Oil and Gas Division was the Special Industries Group's single largest source of profit for the year. Net income was up $30.1 million, or 76 cents a share, to $225.9 million. The overall return on assets declined by two-hundredths of 1 percent. 42 Assets Loan volume averaged $4.2 billion and other earning assets $1.3 billion above the 1979 level, increasing net interest income on a taxable equivalent basis from this source by $140 million, or 20.6 percent. Except for April and May, the Corporation recorded increases in average total loans each month. Growth in loans was heavier in the second half of the year and more pronounced in domestic loans, in contrast with the first half, in which foreign loan growth predominated. Average total assets grew by about $6.3 billion. The growth in assets was financed largely through higher balances of interest-bearing liabilities. Nonperforming loans and losses Nonperforming credits were $444 million. Mortgage and real estate loans on a renegotiated basis were up $21 million from the prior year. The reserve for credit losses increased 13.9 percent from 1979. Relatively lower growth of loans in 1980, coupled with a higher net addition (provision for credit losses minus net credit losses) to the reserve, maintained the percentage relationship of the reserve to total credits at the 1979 yearend level. Net credit losses on consumer installment loans were the highest single loss category in 1980. These losses were 45.9 percent of total net charge-offs in 1980 as opposed to 64 percent in 1979. Net losses on commercial and industrial loans were up $15.2 million in 1980 and represented 39.3 percent of total net losses, compared with 16.5 percent in 1979. 1981 INDUSTRY ECONOMIC CONDITIONS The year 1981 was a year of extremes for banks in a number of key areas. There were general domestic and worldwide economic weaknesses and wide fluctuations in interest rate levels. Furthermore, the banking industry's capitalization base was eroding causing concern to the bank regulators. The overall level of economic activity during 1981 accelerated and the rate of price increases slowed, but the burden of high interest rates placed some sectors of the economy under heavy pressure. The housing industry was devastated, many auto dealers closed because of declining sales and the extremely high cost of financing inventories, and many other small firms in other lines went out of business. The thrift industry experienced a severe squeeze on earnings and high interest rates impeded the formation of business capital needed for improving productivity performance. BUSINESS SERVICES The Corporation's performance in 1981 was strong and compared well with the previous strong year, 1980. The Bank moved up in the order of banks ranked by asset size, takin^ over the sixth position from Chemical Bank. The Corporation's performance stemmed from its concentrating in a number of areas, including significant non-interest 43 expense restrain and substantial expansion in the size of its loan portfolio. In 1981 the Bank became the largest domestic corporate and industrial lender in the Nation. One of the primary growth areas within the Bank was in the Oil and Gas Division of the Special Industries Group. By mid-year, domestic oil and gas loans totaled $2.9 billion and represented more than 10 percent of the Bank's total loan portfolio. The Bank had developed a presence in most of the active areas in the industry by establishing regional offices in Texas; Colorado; and Alberta, Canada. As with the oil and gas loans, commercial real estate loans also made up about 10 percent of the Bank's total loan portfolio. SUBSIDIARY ACTIVITY New regional offices in Atlanta; Detroit; Minneapolis; and White Plains, New York, further expanded the Corporation's U.S. network to 13 locations. Agreements were reached to acquire two small Chicago banks. The Corporation continued to enhance its position in the international financial marketplace through selective foreign branch office expansion. Growth overseas was principally related to the Multinational Banking Department and the Special Industries Group. Branch offices were opened in Canada, Barcelona, and Puerto Rico, while satellite facilities were closed in Dusseidorf, Edinburgh, Munich, Rotterdam, and Vienna. FINANCES As a concrete step toward further enhancing the attractiveness of stock as an investment, long-range targets for two key performance measures were raised in 1981, and new higher goals were set. The return on equity goal was raised from 15 percent to 18 percent, and return on total assets was raised to 0.65 percent, or 6 basis points 8 above the average return of the previous 5 years. The commercial and industrial loan portfolio grew to $12.8 billion at year-end. Stockholders equity averaged $1.6 billion in 1981, a 12.0 percent increase from 1980, and was 3.6 percent of total assets at year-end. Stockholders received 28.8 percent of 1981 income before security transactions in the form of dividends, while in 1980 the dividend payout ratio was 29.78 percent. Earnings Attention to resource allocation, expense control, funding, and liquidity management made an important contribution to record earnings. Income before security transactions of $260.3 million increased 16.1 percent from the $224.1 million recorded in 1980. Net income rose 12.7 percent from the previous year to $254.6 million. Return on total assets increased 3 basis points over 1980. Net interest income was up 8.8 percent over the 1980 level. The increase was made possible by a 17.7 percent increase in average loans and a 27.3 percent increase in average leases. Assets Average total loans increased each month, except for February, with heavier growth occurring in the second half of the year. The commercial and industrial loan portfolio 44 grew to $12.8 billion from about $9.8 billion in 1980 and real estate loans increased by 12 percent to a total of $3.9 billion. The Bank continued to be the leading lender to domestic energy producers. Although only sixth in assets among American banks, it loaned more money to domestic commercial and industrial companies than any other bank in the Nation. During the year, Continental moved toward higher yielding earning assets with shorter maturities. This move was in line with the Bank's interest rate sensitivity management policy which involved lengthening and shortening maturity schedules of assets and liabilities in anticipation of interest rate cycles. Foreign operations accounted for kOJ percent of total assets at year-end and produced 29 percent of total net income for the Corporation. Average earning assets increased 12.8 percent, due primarily to growth in loans and lease financing. The increase in average earning assets was financed primarily through interest-bearing liabilities. These sources increased 13 percent in 1981 over the 1980 average, while interest-free funds increased 8.7 percent over the same period. The 15.2percent rate on average foreign time deposits tied the overall rate of average savings and time deposits, and together these deposits increased 13.3 percent in 1981 over the 1980 average. The more expensive money-market liability, short-term borrowed funds, also increased 11.8 percent over the same period. Nonperforming Loans and Losses As a result of high interest rate levels and an economic slowdown in 1981, the Bank had nonperforming credits of $653 million; representing 1.9 percent of total loans and lease receivables outstanding at year end, compared wiht $Mk million, or 1.6 percent at year end 1980. Before this rise, nonperforming credits had declined steadily from $705 million, or 5J percent of the total loan and lease portfolio reported at year end 1975. Net credit losses increased 15.8 percent from 1980 to $71.1 million. Increased domestic and industrial loans and overseas loan charge-offs contributed to the entire increase amid sluggish economic conditions. 1982 INDUSTRY ECONOMIC CONDITIONS Persistent weakness in business activity and employment, along with high interest rates, exerted pressure on commercial banks. Profits edged down and returns on assets and on equity reached lows last observed in the recovery from the 1973-75 recession. Potential losses became worrisome as the financial difficulties of some major borrowing countries impaired their ability to maintain payments on debt owed to U.S. banks. Most commercial banks recorded substantial profits, but the proportion of banks with operating losses rose to nearly 8 percent, about equal to the mid-1970's peak and more than double the recent low in 1979. BUSINESS SERVICES The Corporation experienced serious difficulties because of an inordinately high level of problem assets. Significant publicity of its relationship with the defunct Penn Square Bank caused Continental's image in the financial community to fall precipitately. This in turn, caused a significant change in its funding profile. Because domestic 45 investors were reluctant to purchase long-term instruments, the Euromarkets were heavily used in order to maintain a relatively stable mix between long- and short-term funding. Problems were evident in all lending departments with oil and gas and real estate accounting for a large portion of the problem loans. Between 1981 and 1982, outstanding loans in the Oil and Gas Division increased from $2.8 billion to $5.2 billion, more than 15 percent of the Bank's total loan portfolio. Under market pressure, the Bank removed its name in late July from the list of banks where CDs were eligible for delivery to fill Chicago Board of Trade and Chicago Mercantile Exchange futures contracts. In early September, Standard and Poor's reduced the Bank's credit rating for the second time. SUBSIDIARY ACTIVITY Growth through establishment or acquisition of subsidiaries slowed to almost a standstill. The Corporation completed the acquisition of two smaller banks in Chicago which it initiated in 1981 and established a subsidiary to deal in the financial futures market. MANAGEMENT As a result of Penn Square problem loans, a group of the Bank's senior officers conducted a comprehensive management review of its operation and recommended a number of management changes. A new auditor and Executive Vice President for General Banking Services were appointed, and a new credit risk evaluation division was created. A special litigation committee was also appointed to assess the Bank's officers' and directors' responsibility for the Bank's actions in connection with derivative and class action lawsuits. In 1983, the Bank entered into a written agreement with OCC agreeing to address certain problems noted in OCC's 1982 examination of the Bank. Under the agreement, the Bank was required to continue implementation and maintenance of new and strengthened plans, policies, and procedures designed to improve overall performance in accordance with the Bank's revised corporate objectives and to report periodically on such matters to OCC. These actions cover such areas as asset and liability management and the Bank's credit approval, evaluation, and collection activities. By May 1984 the Bank was experiencing severe cash flow problems requiring assistance from the FDIC and a consortium of United States banks. FINANCES The Bank began to lose its position as a top money center bank. Total assets of the Corporation declined by S.^ percent from $46.9 billion in 1981 to $42.9 billion in 1982. Stock prices fell from $36.90 per share to as low as $15 per share. Sources of funds declined in all major categories except other borrowing, foreign deposits, and long-term debt, which increased from the previous year by $1 billion, $800 million, and $400 million, respectively. The greatest decline in source of funds was in domestic demand and time deposits which decreased by $634 million and $1.6 billion, respectively, from 1981. 0—84 39-133 4 46 Severe market resistance curtailed the issuance of domestic CDs and commercial paper to such a degree that the Bank was able to rollover only about 60 percent of its commercial paper. When sizeable amounts of term money were obtained, the Bank had to pay substantial premiums. By September 1982, the Bank's primary incremental funding sources were overnight Eurodollars and brokered Federal funds. Total stockholders' equity declined by $797,000 at year-end 1982, over year-end 1981. As a result of reduced 1982 earnings and maintenance of the $0.50 a share quarterly dividend, stockholders received 94.34 percent of income before security transactions as dividends in 1982 compared with 28.88 percent in 1981. Retained earnings were down by $627,000 from 1981's total. Earnings Net interest and other operating income was a record $1.2 billion before provision for credit losses. But net income was the lowest in 5 years, primarily due to a sharply increased provision for loan losses of $492 million, compared to $120 million the year before. Both the earnings decline and the increased provision reflected a steep rise in problem credits. Income before security transactions totaled $84.3 million, down substantially from $260.3 million in 1981. Net income for the year was $77.8 million, down from $254.6 million a year earlier. Net interest income accounted for 73.5 percent of total operating revenues before provisions for credit losses, compared with 71.4 percent a year earlier. Assets Average total loans increased from 1981 levels in 8 of the first 9 months of 1982 but declined in 2 of the final 3 months for a 15.8 percent overall increase over 1981. Commercial and industrial loans averaged $13.7 billion in 1982 and remained the largest domestic loan category, increasing by 28 percent in 1982. Mortgage and real estate loans rose 9.6 percent, compared with 12.9 percent growth in 1981, while loans to financial institutions were up 11.6 percent in 1982. Average interest earning assets, reflecting higher loan and lease receivable balances, were up 15.8 percent to $33 billion. Nonperforming Loans and Losses At the close of 1982, nonperforming loans totaled $1.9 billion or 5.6 percent of total loans and leases receivables, up substantially from $653 million or 1.9 percent of 1981 loan and lease receivables. The provision for loan losses totaled $492 million, which included a $220 million increase in the provision for loan losses during the second quarter due to problem credits as a result of Penn Square loans. Net credit losses were $393.2 million, up substantially from $71.1 million in 1981. Net losses of $191 million on participations purchased from the Penn Square Bank were a major factor in the increase. 1983 INDUSTRY AND ECONOMIC CONDITIONS The economy in the aggregate proved strong but banks experienced fewer demands for business loans, which in the past had been among the highest yielding assets in banks' 47 portfolios. Credit problems intensified in energy and energy related businesses as the recession lingered in that area. Housing and consumer spending provided the main thrust for the economy. Business spending for autos, trucks, and high technology goods accelerated, but investment in structures and heavy machinery remained weak. Federal government spending was stimulative, but part of this effect was offset by declines in state and local government spending. Exports remained weak and the trade deficit ballooned as imports responded to rising domestic demand. BUSINESS SERVICES The Corporation continued to experience losses especially in the oil and gas area which accounted for a high percentage of problem loans. Between nonperforming loans and loss provisions, the Bank was carrying close to $590 million pretax drag on earnings. Although funding had reasosnably stabilized, resistance to the Bank was still apparent, especially in the domestic markets. Reduced premiums on term funds and asset reductions allowed overnight funds to decrease by about $4.6 billion. A shift to offshore funding began in mid-1982, and in mid-1983 over one-half of term funds were obtained in the Euromarkets. SUBSIDIARY ACTIVITY Subsidiaries of the Corporation, excluding the Bank, represented 5 percent of total consolidated assets at December 31, 1983, down slightly from 5.1 percent a year earlier. For the year the subsidiaries contributed $33 million to net income, compared with $43 million for 1982. No new acquisitions were reported by the Corporation. MANAGEMENT The Board and management responded to serious credit problems uncovered in 1982 by conducting an in-depth management review of operations. As a result, management made major changes in lending policies and restructured senior management to better define lines of authority and responsibility and provide for orderly management succession. The "corporate office"^ concept was dissolved, with most department heads reporting to the Chairman. In August, the Board elected Executive Vice Presidents Taylor and Bottum to the Board. Mr. Taylor became Vice Chairman and retained his position as head of Bond and Treasury Services, with Mr. Bottum shifting duties to become the head of General Banking Services. In November, the Bank realigned the investment responsibilities and restructured the credit review function. A Credit Evaluation Department was created to replace the old rating committee. FINANCES The Corporation turned its attention to overcoming the problem of large amounts of nonperforming loans causing depressed earnings far below that experienced during the past few years. During 1983, the Corporation continued to pay a premium for certain of its liabilities. Funding sources were shifted substantially to offshore markets. Foreign deposits accounted for 38 percent of the Bank's funds, followed by 16 percent from time deposits, and 16 percent from purchased federal funds. Subsequent to year-end 1983, one of the major rating agencies reduced the Corporation's rating on nonredeemable preferred stock and further reduced its rating of the Corporation's long-term debt. 48 Earnings continued to be depressed because of heavy loan loss provisions, income reductions due to nonperforming assets, and increased funding costs. In addition, interest expense continued to be higher than normal due to funding premiums of 25 to 50 basis points paid on a portion of the Bank's liabilities. Net income was $108.3 million in 1983, $30 million one-third of 1981 net income. The return on average percent, compared with 0.17 percent in 1982 and 0.57 income on a taxable equivalent basis declined 8.4 percent from 1981. greater than 1982 but only about total assets for 1983 was 0.26 percent in 1981. Net interest from 1982 but increased slightly Assets Earning assets averaged $36.1 billion in 1983 reflecting a decline of $4.1 billion or 9 percent from 1982. Of the total earning assets, $23.4 billion was domestic and the balance, $12.7 billion, foreign. Domestic and foreign loans made up $30.8 billion of total earning assets and of these loans $20.5 billion was domestic and $10.3 billion was foreign. Nonperforming Loans and Losses Loan quality continued to decline as more loans entered the nonperforming category. Nonperforming loans totaled $1.9 billion, or 6.2 percent, of total loans and lease receivables. This compared with 1.9 percent at year-end 1981. Nonperforming loans included $456 million in participations purchased from Penn Square, down from $595 million at year-end 1982. Loans purchased from Penn Square in the amount of $135 million were written off during the year. The provision for credit losses was $382.5 million or 1.21 percent of total loans compared with 1.11 percent at the end of 1982. Net loan losses for the year totaled $386.5 million compared with $393.2 million in 1982 and $71.1 million in 1981. 1984 INDUSTRY ECONOMIC OUTLOOK Continuing economic expansion set the stage for improved banking industry performance in 1984. The cash flow of corporations was much improved over earlier periods and business borrowing from banks was increasing because of low current inventory levels. Corporations did some restocking, a process normally financed with bank borrowings. Rising levels of industry capacity utilization and the expressed intention of corporate executives to boost capital spending indicated an increasing demand for funds. Foreign loans increased in 1984, but banks shifted their emphasis from foreign to domestic consumers. The rate of growth in consumer lending, in the form of personal loans and mortgages, was expected to surpass all other lending categories in 1984, according to Standard and Poor's. Personal income was up, unemployment down, consumer confidence high, and the demand for durables and housing brisk. 49 BUSINESS SERVICES Beginning in May 1984, the Bank experienced a serious liquidity crisis resulting from the loss of a major portion of its funding base domestically and abroad. Major providers of overnight and term funds failed to renew their holdings and the Bank was forced to prepay time deposits in the Eurodollar and domestic markets and to arrange for the replacement of CD's in the domestic, market. Because no other adequate funding sources were available, the Bank resorted to Federal Reserve Bank borrowings which rose to an average daily level of $2.6 billion. SUBSIDIARY ACTIVITY During March 1984, the Bank sold its charge card operations, and during July 1984 the Corporation sold Continental Illinois Limited, its London-based merchant bank. The Corporation announced plans to sell its leasing company and real estate mortgage company. MANAGEMENT In early 1984, Chairman Anderson was replaced by David Taylor. Edward S. Bottum was made President. In August, Messrs. Taylor and Bottum were replaced by John E. Swearingen (Chairman of the Board of Directors and Chief Executive Officer of the Corporation) and William S. Ogden (Chairman of the Board of Directors and Chief Executive Officer of the Bank). FINANCES The Corporation's financial position eroded rapidly in early 1984, resulting primarily from a run-off of deposits and other funding sources starting in May 1984. Business was sluggish because of sharply narrowed margins and the effects of a large amount of Latin American loans classified as nonperforming. At June 30, 1984, interest bearing deposits totaled $14.5 billion, down from $24.9 billion at December 31, 1983. Earnings Earnings were offset by lower net interest income, reflecting the impact of interest earnings reversals from nonperforming credits and increases in the general level of interest rates which raised the cost of funding and narrowed margins. Higher other operating income during the quarter more than offset the declines in net interest income. Net income was $29 million for the first quarter; however, it was dependent upon a nonrecurring revenue item totaling $188 million from the sale of the Bank's credit card operations. The Corporation would have experienced a pretax loss of $140 million without the nonrecurring income. The second quarter net loss was $1.2 billion. Net interest income on a taxable equivalent basis was $166 million for the first quarter of 1984, down from $241.5 million in the prior year's quarter. The net interest margin was 1.83 percent, compared with 2.63 percent during the same period last year. 50 Assets Earning assets averaged $34.5 billion during the second quarter — $21.9 billion domestic and $12.6 billion foreign — down from $36.6 billion a year earlier. A significant portion of this decline was in reduced domestic loan volume including the sale of the charge card portfolio. At period end, earning assets totaled $32.3 billion, including loan balances of $29.6 billion. Nonperforming Loans and Losses Nonperforming loans and lease financing receivables amounted to $2.7 billion at June 30, 1984 and represented 9.2 percent of the loan and lease portfolio. Loans and lease financing receivables to borrowers in the oil and gas industry totaled approximately $4.7 billion of which $1.1 billion were nonperforming. The provision for credit losses was $705 million. Net credit losses totaled $748 million. 51 FOOTNOTES Participants include 28 major American banks. Certain subsidiaries of Continental Illinois National Bank and Trust Company of Chicago and certain subsidiaries of Continental Illinois Corporation are omitted because such subsidiaries, considered in the aggregate, would not constitute a significant subsidiary. Except for directors' qualifying shares. A multinational business is one that serves customers in the U.S. and other countries. U.S. banks that provide service to other domestic banks. A Federal statute which authorizes national banks to form subsidiary corporations for development of overseas business. These countries are Argentina, Australia, Austria, Belgium, Brazil, Canada, the Cayman Islands, Colombia, Ecuador, France, Indonesia, Iran, Jamaica, Japan, Lebanon, Luxembourg, Malaysia, Morocco, Pakistan, Peru, the Philippines, Singapore, Spain, Switzerland, Taiwan, Thailand, and the United Kingdom. 100 basis points equals 1 percent. The corporate office included the Chairman, Vice Chairman, and the President. The concept provided for most department heads to report to the corporate office rather than to specific individuals. 52 EXAMINATION FINDINGS REGARDING CONTINENTAL ILLINOIS NATIONAL BANK'S LOAN MANAGEMENT AND CAPITAL SEPTEMBER 18, 198* STAFF REPORT TO SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS This report is the result of staff findings to date, and does not necessarily reflect the views of the Members of the Subcommittee. 53 EXAMINATION FINDINGS REGARDING CONTINENTAL ILLINOIS NATIONAL BANK'S LOAN MANAGEMENT AND CAPITAL This report presents in summary form the findings of examinations of Continental Illinois National Bank (CINB) relating to its loan management and capital. CINB was examined by the Office of the Comptroller of the Currency once every year from 1976 through the present except 1978. The examiners-in-charge of the examinations discussed in this report were 3ohn Meade (1976), Richard Kovarik (1977 and 1982), and Allan McCarte (1979, 1980, and 1981). Section I provides a brief review of CINB's financial history from 1976 to 1981. Section II discusses the findings of the OCC examiners regarding CINB's loan management and credit quality control systems. Section III reviews OCC examiner comments about CINB's capitalization. The boldface emphasis in some quotations has been added by staff. 54 SECTION I 1976 THROUGH 1981, A BRIEF REVIEW In July 1976, Continental Bank's chief executive officer, Roger Anderson, announced his intention to make Continental one of the three top U.S. banks serving industry. This was a bold objective and Continental's starting point was not the strongest. 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, 63% in September 1974, and 109% in June 1975. (See attached tables of supervisory ratios.) Three months before Anderson's July 1976 announcement, OCC examiners had rated the Bank's 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 5.5% 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 continuing concern." "Credit files are missing, or incomplete in comments, in cases where swaps have been entered into." (Examiner's Comments on Matters Requiring Attention, Report of Examination, April 1976, Comptroller of the Currency, p. 2.) In the confidential section of the report, the OCC examiner John Meade evaluated CINB's capital position as: "Inadequate. Gross capital funds are loaned 10.5 times which is unchanged from 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." (Confidential Memorandum to the Comptroller of the Currency, Report of Examination, April 1976, p. D-c.) 55 Meade, however, rated both Continental's management and future prospects as "Excellent". (Confidential Memorandum to the Comptroller of the Currency, Report of Examination, April 1976, pp. D-a and D-d.) Despite its weak starting point, Continental's management started out aggressively and confidently on a path of remarkable growth and earnings increases. So taken were the financial markets with Continental's performance, Dun's Review, a widely read financial magazine, included Continental in its 1973 list of the five best-managed companies in America. Dun's Review said: "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 1973 to $ 4.9 billion at the end of 1977. And its domestic loan business was up 19% over a year earlier at the end of 1978's third quarter." ("The Five Best-Managed Companies", Dun's Review, December 1978, p. 42.) 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 simply outgrew 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, and rose only slightly in 1981 to 67%. The financial markets looking at published financial statements showing steadily increased earnings and apparent portfolio soundness, were greatly impressed with CINB and bid its stock up accordingly. In 1981, five years after Anderson's announcement, Continental attained its goal of becoming 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 15%. This remarkable size increase was the result of a heavy dedication throughout the Continental corporation to loan expansion, reflected clearly in Continental planning and budgeting documents. The growth was made possible by a management responsibility and accountability framework that gave individual loan officers more lending authority than is generally found in other money center banks and that encouraged and rewarded loan growth. The management objectives of CINB were clearly reflected in the 1980 corporate plan. CINB's corporate goals were ranked as follows: 1. Earnings per share 2. Average assets growth 3. Average earning assets growth 4. Return on average stockholders equity 5. Return on average assets 6. Return on average earning assets 7. Average assets/Average total capital 8. Average earning assets/Ave rage total capital 9. Average risk assets/Average equity and reserves 10. Average debt/Average total capital 11. Dividend payout 56 12. Internal funding rate ("Performance Relative to Corporate Goals", Internal Competitive and Performance Analysis, Continental Illinois Corporation, Annual 1980, p. 8) Associated with each corporate goal was a specific and clear numerical target. In light of CINB's later problems and the practices of other money center banks, it is noteworthy that there was no specific target for loan quality. Though the examiners remarked about CINB's corporate goals in examination reports, during staff interviews of them they acknowledged that they had never actually seen CINB's planning documents. 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 vunerabie to the effects 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 by Richard Kovarik, author of the 1982 OCC examination report, this way: "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 reflection 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 of a goal to become one of the leading domestic wholesale banks, but was also driven by a need to show higher earnings to the marketplace. Although earnings growth, in dollars, has been impressive, it has mirrored asset growth. Earnings efficiency has remained relatively unchanged over the past five years. Therefore, in order to show better earnings (in dollar terms) more assets had to be generated. Recent asset growth, especially over the past year, was not generated in concert with strategies necessary to insure that the growth was controlled from the standpoint of quality and the organization's ability to handle the increases efficiently. It had become increasingly difficult to maintain asset quality for a combination of reasons. First, the quality of the pool of available assets had decreased due to economic conditions. Secondly, the internal support staffs (operational and lending) were insufficient to properly handle the loan volume involved." (Letter to the Board of Directors, Report of Examination, November 1982, p. 2.) 57 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 writeoffs and their effect on income became clear. In the Spring of 1984, financial market concern about the true condition of Continental became serious. Rumors abounded about potential bankruptcy, and market confidence in Continental's financial strength declined despite the assurances of regulators. The resulting outflow of 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. In hindsight, CINB required federal aid to remain in existence because (1) its loan management system was inadequate and permitted credit problems to grow undetected, and (2) its focus on earnings per share growth required keeping capital at a minimum. Both of these matters were commented upon repeatedly in examination reports but their significance was masked by the decline in the ratio of classified assets to capital. Understanding the relationship among loan management, capitalization, and classified loans is critical to understanding what happened to CINB. 58 SECTION II DISCUSSION OF CINB LOAN ADMINISTRATION AND CREDIT QUALITY SYSTEMS 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 effective, the problems will be detected early and kept within acceptable ranges. At 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. The examiners' comments regarding loan management year-by-year are set out below. Commenting in 1977, Examiner Kovarik 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 evaluation is employed for personnel and divisional units that encompasses the entire lending operation. The committee system employed is considered sound with a majority of the members drawn from senior levels. Sound hiring practices are pursued and a comprehensive training program is in operation." "The underlying causes of the present burdensome volume of criticized loans stem from external conditions primarily. The majority of loan criticisms reflect the effects of a period of rapid inflation followed by an economic recession. It is now evident these external conditions are improving with a resulting direct effect 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 quickly as conditions permit." (Loan Portfolio Management, Report of Examination, August 1977, p. 7-1.) 59 Kovarik also said: "The initial review of credit files revealed numerous instances of incomplete or noncurrent information. As this material was made available during Divisional 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." (Loan Portfolio Management, Report of Examination, August 1979, p. 7-1.) At the time, Kovarik did not view the credit file situation as serious and did not include it in his letter to the Continental board of directors. In hindsight, it may have been the first sign of future loan management problems. Two years later, in his 1979 examination report transmittal letter to Continental's board of directors, OCC's Deputy Comptroller for Multinational Banking, Billy Wood, raised the issue of credit administration more pointedly and related it to Continental's heavy dependence on purchased funds and its need for a strong market reputation. "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 which are internally rated "B", and which have traditionally been regarded as sound from a review evaluation standpoint, are criticized in the report of 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." (Transmittal Letter to the Board,-Report of Examination, August 1979, p. 1.) The examiner-in-charge of the 1979 examination, Allan McCarte, provided more detail on internal credit management in his letter tc the board of 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 heavily 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." (Letter to the Board of Directors, Report of Examination, August 1979, p. 1.) By mid-1980, Continental's total assets reached $ 39 billion and its net income was well on its way to another annual record. Its ratio of problem loans to capital also declined significantly from 80% the year before to 61%. In his 1980 letter to the board of directors, McCarte said: "While 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." (Letter to the Board of Directors, Report of Examination, October 1980, p. 1.) 60 Concerning the deficiencies he had cited management, McCarte wrote: the year before in the area of credit "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. The results of these efforts were favorable to the bank and revealed what is considered to be a generally efficient loan process." (Letter to the Board of Directors, Report of Examination, October 1980, p. 1.) McCarte took his analysis a step further and warned Continental officials about an inherent weakness in its 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 officers around the world, a means of periodically checking the performance of lending personnel in this matter might be considered. This point is raised because the existing procedure followed by the Rating Committee does not include any "on-site" or interim independent review. Once a credit is assigned a quality rating, unless subsequent negative press/knowledge or a watch loan report is submitted, a deteriorating situation may go unnoticed until the next rating period." (Letter to the Board of Directors, Report of Examination, October 1980, p. 1.) In light of CINB's later problems, this warning was very significant. CINB's decentralized, growth-oriented loan management system gave individual loan officers 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 official than could be obtained from loan officials 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 officer to put the loan on a "watch list". If the loan officer chose not to put the loan on the watch list, senior management would not 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 non-accrual 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, McCarte in his letter to the board of directors wrote: "The majority of our efforts 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 classified assets increasing from 61% of gross capital funds to 67%. A more detailed analysis revealed that doubtful assets now equate 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 criticized to 99% of gross capital funds." (Letter to the Board of Directors, Report of Examination, August 1981, p. 1) 61 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, McCarte wrote: "A review of 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 375 credits, aggregating $2.* billion had not been reviewed within one year, with fifty-five of these credits not reviewed within two years. 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 is monitoring this situation to ensure that all credits are receiving timely reviews, as required by the corporate office." (Loan Portfolio Management, Report of Examination, August 1981, p. 16.) 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. Examiner McCarte 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 with the wishes of the Corporate Office. Although 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." (Letter to the Board of Directors, Report of Examination, August 1981, p. 1.) Regarding the system overall, Examiner McCarte said: "We found it to be functioning well and accurately reporting the more severely rated advances to the Board and senior management." (p.l) (Letter to the Board of Directors, Report of Examination, August 1981, p. 1.) When the staff interviewed the examiners, questions were posed to both Meade and Kovarik, regarding such situations. Both responded that absent detailed information concerning the loans not reviewed, a situation such as that described by McCarte sounded significant. McCarte, however, viewed it as significant in retrospect, but at the time in light of the Bank's overall declining classified loan levels and asset growth, he did not view it as an overriding problem. 39-133 0—84 5 62 The second anomaly is the examination report's description of the oil and gas division: "One of the primary growth areas within the bank over the past two years is the Oil and Gas (O&G) division within the Special Industries Group. Domestic O&G loans 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 officers and scientific (engineers and geologists) personnel to handle current relationships and meet continued strong growth anticipations. The bank has developed a presence in most of the active areas in the industry through the establishment of regional offices in Texas (which have generated loans representing 38% of O&G credits), Denver, Colorado and Calgary, Alberta, Canada. No significant problems are evident as noted by the fact that only two 0<5cG credits were classified herein." (Loan Portfolio Management, Report of Examination, August 1981, p. 13.) In contrast, Kathleen Kenefick, a loan officer in the oil and gas division, described the situation this way in July 1981: "The status of the Oklahoma accounts (particularly Penn Square Bank) is a cause for concern and corrective action should be instigated quickly to 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 of CINB and/or customer actions occurring. 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 writeup. Followup and accountability have been rare. Thorough monitoring is hindered when both strengths and 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. Ail 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." (Memorandum of Kathleen Kenefick, July 29, 1981, p. 1.) 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 $85 million in 1981, the level of classified oil and gas loans rose to $ 649 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, Examiner-in-charge, Richard Kovarik, explained what happened to Continental and the relation to Penn Square this way: "Although the Penn Square relationship accounts for a relatively small portion of problem loans (less than 20%) the publicity surrounding its closing was surely the one event that has done the most damage." 63 "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." (Memorandum from Richard Kovarik to William Martin, November 15, 1982, p. 1.) Regarding the question of whether Continental loan officers were filing watch loan reports on their loans that had developed problems, Mr. Kovarik in the examination report wrote: "Our review of credits criticized at this examination reflects 99 "B" rated credits. Differences are generally due to timing in the rating system (23 had not been rated within one year) and to subjective differences of opinion. It should be noted that many of these credits were added to the WLR system by loan officiers at 4-30-82, and subsequently downgraded by the Rating Committee in the normal rating process. Of more concern is the fact 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." (Loan Portfolio Management, Report of Examination, November 1982, p. 23.) Before turning to a review of what examiners said over the years about CINB's capitalization, one final piece of evidence concerning CINB's loan management needs to be presented. This evidence consists of what Chemical Bank, First Chicago National Bank, and Citibank found when they went into CINB in the Spring of 1984 to evaluate it prior to making the FDIC a purchase and assumption offer. The individuals overseeing each bank's review of CINB were interviewed by the staff. 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. "The Latin American portfolio was mostly private sector with loans to a number of customers with which the people were not familiar. The same 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 $2& billion in charge-offs 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 1 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." 64 " compared their internal loan rating system (1-9) against the rating system at Continental (1-9) on 21 borrowers which were common to both banks. 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 ; on another 5, Continental's rating was 2 better than 's and, on another four credits, Continental's rating was 3 or more better than 's. Based upon this review, - 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 non-performing. 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 of the reports generated are done for the benefit of the line officers, not for the benefit of upper management. There appears to be a large number of credits (up to $50 million each) to corporations with which the people were not familiar." "None of the top level people at Continental are credit people, all have come from the funding or treasury side. There is no loan workout department at Continental; the officers which originally made the loans are also expected to collect them." "He indicated that 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 officers and it is almost impossible to create useful management information reports." "He indicated that there were 38 cases involving $ 6 million or more which the Cont. attorneys indicated could be settled for about >175 million. He then indicated that not included in the $175 million figure were: a $50 million dispute with the IRS; the $60 million lawsuit regarding , Inc.; and another $100-$ 150 million in lawsuits with very questionable outcomes. He then stated that Continental had spent $19 65 million in 1983 to outside firms for litigation and the same in 1982. In comparison, — only spent $10 million in 1983 for ail legal services. Continental has set up a reserve for litigation losses, but only $5 million in 1983 and only $8 million in 1984. attorneys expressed concern about other legal action which may be taken by shareholders." " 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." "As a result of the above, a June 24, 1984 meeting between and the FDIC closed with the comment that enthusiasm for the merger was dying at with each passing day." 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 efforts and OCC supervisory efforts spanning almost twenty-four months since the Penn Square Bank failure. 66 SECTION III REVIEW OF EXAMINATION COMMENTS ON CINB CAPITALIZATION 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 Kovarik to write: "Over the last three years, your earnings have allowed the bank's capital accounts to be increased by $225 million through retained earnings and in 1976, $62 million was added to the surplus account from the proceeds of a debt offering by CIO Equity capital at $1,049 million represents 5.1% of total resources compared to 4.6% at the February 1976 examination. Loans to equity capital at 11.32:1 also shows improvement from 12.11:1 in February 1976. Although these improvements are viewed positively, it must also be noted that your bank's capital ratios still remain below the norm when compared to your peer group of banks." (Analysis of Earnings and Capital, Report of Examination, August 1977, p. 13-1.) CINB's subsequent growth led Deputy Comptroller Wood in 1979 to say: "The growth in earnings has been achieved by virtue of increasing loan and asset volume leverage. The interest margin has remained relatively level since 1977. The ratio of 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." (Examination report transmital letter, from Billy Wood to Continental Board of Directors, October 25, 1979, p. 2). In 1980, in his analysis, of CINB's capital position McCarte 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 first among the top nine domestic bank holding companies (Continental's definitional peer group). Total equity increased only 10.8%, ... Continued strong asset growth throughout the first half of 1980 further perpetuated the decline in equity capital, which averages 3.65% of average total assets, compared to 3.94% for the first six months of 1979." (Analysis of Earnings and Capital, Report of Examination, October 1980, p.27). In the letter transmitting the 1980 examination report, Wood 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 Office. While neither the present level of capital nor the current capital planning efforts are subject to criticism, management is 67 encouraged to continue seeking alternative sources of capital and to bring the capital and asset growth rates into balance. " (Transmittal Letter to Board of Directors, Report of Examination, October 1980, p.2.) 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." (Transmittal Letter to the Board of Directors, Report of Examination, August 1981, p.2.) "It must be realized however, that leverage and risk ratios continue to increase thus placing increased strain on the xapital 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 Office." (Letter to the Board of Directors, Report of Examination, August 1981, p. 2.) 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, after the revelations that took place that year, begins to undercut one's belief that the OCC was truly concerned about bank capital adequacy. 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 of 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, examiner Meade 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 25% , and dependence on purchased money was up to $0%. In 1976, CINB's capital was rated a clear and emphatic "Inadequate". 68 In 1982, CINB's capital was commented upon as follows: "As a result of the above factors, particularly the underlying strength of management and the recent trend of improving capital ratios, CICs capital base 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 for future growth." (SIC) (Analytical Review of Earnings and Capital, Report of Examination, November 1982, p. *1.) 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." Why and how the OCC's capital standards have changed over the years merit close study. 69 Attachment I TOTAL CRITICIZED ASSETS 1975 to 1983 (In millions of dollars) Dates of Examinations Category 6/15/75 2/27/76 3/31/77 4/30/79 6/30/80 4/30/81 4/30/82 6/30/83 Substandard §J 760 n 81 4 1,025 180 29 4,113 485 !i 1,045 72 12 2,908 357 806 197 28 921 Doubtful b/ Loss c/ 848 381 1,131 " 1,240 1,031 1,129 1,006 1,234 3,686 4,733 491 306 429 173 340 597 1,934 2,853 1.622 1,546 1,460 1,302 1,346 1,831 5,620 7,586 Total Classified Assets d/ OAEM s/ Total Criticized Assets U 548 230 135 §' A Substandard classification is assigned to those assets inadequately protected by the current sound worth and paying capacity of the obligor, or pledged collateral, if any. W A Doubtful classification is assigned to those assets that have ail the weaknesses inherent in an asset classified substandard and their collection or liquidation in full is highly questionable. SJ A Loss classification is assigned to those assets considered uncollectible and of such little value that their continuance as an active asset of the bank is not warranted. Loss classification does not mean that an asset has absolutely no recovery or salvage value. dl Total Classified Assets is the sum of a, b, and c. 1' Other Assets Especially Mentioned are assets, not including those identified as substandard, doubtul, or loss, that the regulator has some question about or is concerned about for any reason such as lack of loan documentation, that if not corrected or checked may weaken the bank's credit position at some future date. 1' Total Criticized Assets is the sum of d and e. 70 Attachment II SELECTED SUPERVISORY DATA 1975 to 1983 (In millions of dollars) Dates of Examinations Category 6/15/75 2/27/76 3/31/77 4/30/79 6/3Q/80 4/30/81 4/30/82 6/30/83 Gross Capital Funds(GCF)a/ 1,038 1,025 1,193 1,410 1,651 1,848 2,144 2,157 Percent of Classified Assets toGCF 109.02 120.97 86.41 80.10 60.88 66.76 171.90 219.42 Percent of Criticized Assets to GCF 156.27 150.85 97.23 92.33 81.50 99.08 262.19 351.72 Reserve for Possible Losses (RPLL) 166 151 144 175 208 235 287 363 Percent of RPLL to Total Loans 1.53 1.41 1.20 .96 .89 .89 1.22 38 513 545 1,198 2,937 5,060 4,444 Standby Letters of Credit W 2,272 §/ Gross Capital Funds represents total capital plus reserve for possible loan losses. k' Standby Letters of Credit represent an obligation on the part of a bank, issuing such a document on behalf of its customer, to a designated third party contingent upon the failure of the issuing bank's customer to perform under the terms of the underlying contract with the third party. Cap j t a I Adequacy Uhange in Ratio* 6.8 6.4 5.2 4.8 i 4.4 4.8 i DPeer group • Continental 1976 1977 1978 1979 T :#:EI.^I.J i t y Cap. i 1980 1981 1982 1983 ear . J ^<.jt..r.r-.d i n a t . f d c =. M o * .as: to To taI brouith i n Loans Percent Uhanqe :-:M 25 26 15 to 10 DPeer group •Cont inental -10 I 7i i 17 i O I 7i 7 1989 Year 1981 1982 1983 Net Charqe-offs to Total Loans Change in Ratio 1.6 1.4 1.2 1.0 GO 8.8 9.6 0.4 8.2 8 fi D P e e r group • Cont mental 1976 1977 197S 1979 1980 Year 1981 1982 1988 74 Chairman S T GERMAIN. At this point, I call on the very distinguished ranking minority Member, Mr. Wylie, for a statement. Mr. WYLIE. Thank you very much, Mr. Chairman. That was a very far-reaching and thought-provoking opening statement, and certainly sets the stage for this hearing this morning. There is indeed a desire, at least on this Member's part, to proceed with vigor and thoroughness to probe the Continental case. We do not want it to be laced with acrimony or politics, but rather to stress the many positive aspects of this inquiry, t h a t this subcommittee is conducting into the case of Continental Illinois to ascertain if there are indeed some things that we need to learn for the future. I would associate myself with your compliment of our staff. They have done an enormous amount of good, hard preliminary work through a bipartisan effort, and with assistance of the General Accounting Office have come up with some general ground rules which the chairman and I have discussed. I think the delicate nature of the information in some of the documents with which we must deal has required careful coordination between the majority and minority with respect to certain investigatory tools of the regulatory agencies; and despite some differences along the way, most of the problems have been resolved with reference to the ascertainment of the information which will be developed before this committee in a very cooperative relationship. I believe we all agree t h a t the purpose of this hearing is not to engage in any political debate but to learn what factors contributed to the deterioration of Continental Illinois to the place where Federal assistance was required, and to consider what measures might be taken to prevent this situation from occurring again. We should make certain t h a t we do not create the expectation that as long as an institution is big enough, there is no limit to the amount of risk the Federal Government is willing to go to accommodate. As we begin these hearings, I want to stress several points t h a t should be borne in mind throughout the long hours we will spend on this case. This is a unique inquiry because it is being conducted on an open bank, one t h a t we all want very much to succeed in its efforts to restructure itself with Federal assistance. Therefore, our inquiry is historical in nature in t h a t respect. We should refrain as much as humanly possible from speculation as to the current condition or future prospects of the bank, I think. Major banks operate in an environment drastically different from t h a t which prevailed 50 years ago when the regulatory and deposit systems were designed by Congress. Large banks now fund themselves twice a day. Electronic communications make it possible for institutions to raise or lose funds practically instantaneousiyThis inquiry should prod the next Congress to give urgent consideration to the forthcoming recommendations for reform of the regulation of depository to institutions be made by the Vice President's task force, as well as to the deposit insurance reforms already submitted by the regulatory agencies. We are all aware of the need to maintain the stability of our monetary system. Despite deposit insurance and the part it has 75 played as a central part of this effort, we do need to do other things to maintain t h a t stability. But stability should not imply t h a t no bank should fail. Rather t h a n that, the banks which fail should not threaten the system as a whole. To provide absolute protection against failure would imply a degree of regulation and supervision t h a t would stifle innovation and reduce the efficiency of the entire economy. With respect to the particular situation involving Continental, I think it is remarkable t h a t a small group of regulators were able to develop a $4.5-billion rescue package without guidance or consultation with Congress. This rescue package was necessary to maintain the stability of the domestic and international financial markets, in my judgment. It is unfortunate t h a t these solutions have had to be fashioned on an ad hoc basis whenever a failure or crisis has occurred. Too often in the past, hearings have focused on the m a n n e r in which the regulatory process functioned in a particular case without giving adequate consideration to the larger policy issue of the most appropriate needs of maintaining reasonable stability in financial markets and who should be responsible for this and what price should be paid. In your statement on Continental, Mr. Chairman, you have suggested t h a t perhaps this rescue should have been debated by Congress, as was the case with Lockheed and Chrysler. But would t h a t have been practical? Legislation to assist Lockheed was introduced in May 1971, but was not enacted until August 1971. The Chrysler legislation was introduced in October 1979 but was not enacted until J a n u a r y 1980. Continental's problem was basically a liquidity crisis prompted by a run on the bank. In a day when funds can be transferred internationally almost instantaneously, the bank's deposit base would have been eliminated before we got a bill out of this committee. I think prompt action was essential. And rather than attempt to inject ourselves into the process, which I do not believe we really want to do, we should concentrate on providing guidance to the regulators as to how they should proceed in the future. Mr. Chairman, I look forward to working with you toward t h a t end. Thank you very much. [The opening statement of Congressman Wylie follows:] 76 STATEMENT OF REP. CHALMERS P. WYLIE, OHIO SEPTEMBER 18, 198^ SUBCOMMITTEE ON FINANCIAL INSTITUTIONS HEARINGS ON CONTINENTAL ILLINOIS MR. CHAIRMAN: THAT WAS A VERY FAR REACHING, THOUGHT PROVOKING STATEMENT, MR. CHAIRMAN, - - AND CERTAINLY SETS THE STAGE. THERE IS INDEED A DESIRE ON THIS MEMBER'S PART TO PROCEED WITH VIGOR AND THOROUGHNESS TO PROBE THE CONTINENTAL CASE. WE DO NOT WANT IT TO BE LACED WITH ACRIMONY OR POLITICS BUT, RATHER TO STRESS THE MANY POSITIVE ASPECTS OF THE INQUIRY THIS SUBCOMMITTEE IS CONDUCTING INTO THE CASE OF CONTINENTAL ILLINOIS. THE PRELIMINARY WORK HAS BEEN CONDUCTED THROUGH A BIPARTISAN STAFF EFFORT WITH THE ASSISTANCE OF STAFF FROM THE GENERAL ACCOUNTING OFFICE, UNDER GROUND RULES AGREED TO BY THE CHAIRMAN AND MYSELF. THE DELICATE NATURE OF THE INFORMATION IN THE DOCUMENTS WITH WHICH WE MUST DEAL HAS REQUIRED CAREFUL COORDINATION BETWEEN THE MAJORITY AND MINORITY AND WITH THE RESPECTIVE REGULATORY AGENCIES. DESPITE SOME DIFFERENCES ALONG THE WAY, MOST OF THE PROBLEMS HAVE BEEN RESOLVED, AND THERE IS EVERY REASON TO BELIEVE THAT WE CAN CONTINUE TO ENJOY A COOPERATIVE RELATIONSHIP. I BELIEVE WE ALL AGREE THAT THE PURPOSE OF THIS HEARING IS NOT TO ENGAGE IN A POLITICAL DEBATE, BUT TO LEARN WHAT FACTORS CONTRIBUTED TO THE DETERIORATION OF CONTINENTAL ILLINOIS TO THE POINT WHERE FEDERAL ASSISTANCE WAS REQUIRED AND TO CONSIDER WHAT MEASURES MIGHT BE TAKEN TO PREVENT THIS SITUATION FROM OCCURRING AGAIN. WE SHOULD MAKE CERTAIN THAT 77 WE DO NOT CREATE THE EXPECTATION THAT AS LONG AS AN INSTITUTION IS BIG ENOUGH/ THERE IS NO LIMIT TO THE AMOUNT OF RISK THE FEDERAL GOVERNMENT WILL BE WILLING TO ACCOMMODATE. AS WE BEGIN THESE HEARINGS I WANT TO STRESS SEVERAL POINTS THAT SHOULD BE BORNE IN MIND THROUGHOUT THE LONG HOURS WE WILL SPEND ON THIS CASE. THIS IS A UNIQUE INQUIRY, BECAUSE IT IS BEING CONDUCTED ON AN OPEN BANK, ONE THAT WE ALL WANT VERY MUCH TO SUCCEED IN ITS EFFORT TO RESTRUCTURE ITSELF WITH FEDERAL ASSISTANCE. HISTORICAL IN NATURE. THEREFORE, OUR INQUIRY IS WE SHOULD REFRAIN AS MUCH AS IS HUMANLY POSSIBLE FROM SPECULATION AS TO THE CURRENT CONDITION OR FUTURE PROSPECTS OF THE BANK. MAJOR BANKS OPERATE IN AN ENVIRONMENT DRASTICALLY DIFFERENT FROM THAT WHICH PREVAILED FIFTY YEARS AGO/ WHEN THE REGULATORY AND DEPOSIT INSURANCE SYSTEMS WERE DESIGNED BY CONGRESS. A DAY. LARGE BANKS NOW FUND THEMSELVES TWICE ELECTRONIC COMMUNICATIONS MAKE IT POSSIBLE FOR INSTITUTIONS TO RAISE OR LOSE FUNDS PRACTICALLY INSTANTANEOUSLY. THIS INQUIRY SHOULD PROD THE NEXT CONGRESS TO GIVE URGENT CONSIDERATION TO THE FORTHCOMING RECOMMENDATIONS FOR REFORM OF THE REGULATION OF DEPOSITORY INSTITUTIONS TO BE MADE BY THE VICE PRESIDENT'S TASK GROUP. AS WELL AS TO THE DEPOSIT INSURANCE REFORMS ALREADY SUBMITTED BY THE AGENCIES. WE ARE ALL AWARE OF THE NEED TO MAINTAIN THE STABILITY OF OUR MONETARY SYSTEM. EFFORT. DEPOSIT INSURANCE HAS PLAYED A CENTRAL PART IN THIS BUT STABILITY SHOULD NOT IMPLY THAT NO BANK SHOULD FAIL. THE CONCERN SHOULD BE THAT THOSE FAILURES THAT DO OCCUR SHOULD NOT 39-133 0-84 6 RATHER, 78 THREATEN THE SYSTEM AS A WHOLE. TO PROVIDE ABSOLUTE PROTECTION AGAINST FAILURE WOULD IMPLY A DEGREE OF REGULATION AND SUPERVISION THAT WOULD STIFLE INNOVATION AND REDUCE THE EFFICIENCY OF THE ENTIRE ECONOMY. WITH RESPECT TO THE PARTICULAR SITUATION INVOLVING CONTINENTAL/ I THINK IT IS REMARKABLE THAT A SMALL GROUP OF REGULATORS WERE ABLE TO DEVELOP A %K.5 BILLION RESCUE PACKAGE WITHOUT GUIDANCE OR CONSULTATION WITH CONGRESS. THIS RESCUE PACKAGE WAS NECESSARY TO MAINTAIN THE STABILITY OF DOMESTIC AND INTERNATIONAL FINANCIAL MARKETS. IT IS UNFORTUNATE/ THOUGH, THAT THESE SOLUTIONS HAVE HAD TO BE FASHIONED ON AN AD HOC BASIS WHENEVER A FAILURE OR A CRISIS HAS OCCURRED. TOO OFTEN IN THE PAST/ HEARINGS HAVE FOCUSED ON THE MANNER IN WHICH THE REGULATORY PROCESS FUNCTIONED IN A PARTICULAR CASE/ WITHOUT GIVING ADEQUATE CONSIDERATION TO THE LARGER POLICY ISSUE OF THE MOST APPROPRIATE MEANS OF MAINTAINING REASONABLE STABILITY IN FINANCIAL MARKETS/ WHO SHOULD BE RESPONSIBLE FOR THIS/ WHAT PRICE SHOULD BE PAID/ AND BY WHOM. IN YOUR STATEMENTS ON CONTINENTAL/ MR. CHAIRMAN/ YOU HAVE SUGGESTED THAT PERHAPS THIS RESCUE SHOULD HAVE BEEN DEBATED BY CONGRESS/ AS WAS THE CASE WITH LOCKHEED AND CHRYSLER/ BUT WOULD THAT HAVE BEEN PRACTICAL? LEGISLATION TO ASSIST LOCKHEED WAS INTRODUCED IN MAY 1971 BUT WAS NOT ENACTED UNTIL AUGUST 1971. THE CHRYSLER LEGISLATION WAS INTRODUCED IN OCTOBER 1979 BUT NOT ENACTED UNTIL JANUARY 1980. CONTINENTAL'S PROBLEM WAS A LIQUIDITY CRISIS PROMPTED BY A RUN ON THE BANK. IN A DAY WHEN FUNDS CAN BE TRANSFERRED INTERNATIONAL ALMOST INSTANTANEOUSLY/ THE BANK'S DEPOSIT BASE WOULD HAVE BEEN ELIMINATED BEFORE WE GOT A BILL OUT OF COMMITTEE. I THINK PROMPT ACTION WAS ESSENTIAL. RATHER THAN ATTEMPT TO INJECT OURSELVES INTO WHAT THE FUTURE HOLDS FOR THE RESCUE PROCESS/ WHICH I DO NOT BELIEVE WE REALLY WANT TO DO/ WE SHOULD CONCENTRATE ON PROVIDING GUIDANCE TO THE REGULATORS AS TO HOW THEY SHOULD PROCEED IN THE FUTURE. THAT END. I LOOK FORWARD TO WORKING WITH THE CHAIRMAN TOWARD 79 Chairman S T GERMAIN. I t h a n k the gentleman for his excellent statement. However, I would like to make a point in response to what he said. In my delineation of the Lockheed, New York City and Chrysler situations, what I was illustrating was the enormity of this bailout with no discussion whatsoever as compared to those three combined. And as we know, they hit every financial publication in the world for months and months, as you outlined. What I am pointing out is that in this instance we discovered t h a t the regulators have taken unto themselves powers t h a t the President of the United States does not have, and we have to determine whether or not this is to continue in the future. I think t h a t is the purpose of these hearings. Mr. WYLIE. I do think there is another dimension in the Lockheed and Chrysler case. There was obviously an instance where there might have been some exposure on the part of the Federal Government. I happen to have a disagreement in t h a t respect. I think t h a t this went through the insurance process. The FDIC does have a fund, and perhaps this is what it is to be used for. But, in that case, we did have to have legislation because the Federal Government was indeed involved in the bailout. And I am pleased to say t h a t in both cases they worked out. I supported the chairman in the case of Lockheed and the Chrysler matter—one of the few Republicans who did. But, in both cases, t h a t proved to be a good investment. I thought there was a little different dimension in this case in t h a t we do not need legislation. But, of course, that is the subject of these hearings this morning. Chairman S T GERMAIN. And as the case evolves, we will get more information. At this point, I will call on the distinguished gentleman from Chicago, the Honorable Frank Annunzio. Mr. ANNUNZIO. Thank you, Mr. Chairman. Mr. Chairman, I support you in the holding of these hearings on the subject matter under consideration. However, I have serious reservations about the timing of the hearings. Whether or not the Continental situation was handled properly by the banking agencies and the management of Continental is important and a subject t h a t must be addressed. Of greater concern is whether Continental will survive or fail. I feel certain t h a t given the new management at the bank, the recapitalization and increased attention by the regulatory agencies, Continental will survive. But the bank is not completely out of the woods. I hope these hearings will not cause damage to the bank's future. The rescue plan for Continental, the promise of insurance guarantees, regardless of the amount of deposits, are precedent setting. But these hearings mark the first time in history t h a t a hearing has been held dealing with a federally insured financial institution while that institution was open and operating. The Congress has carefully guarded the need not to cause public panic. Yesterday a member of this committee pointed out t h a t these hearings are really not about Continental but rather about the regulation of banks, and we must bear this in mind. 80 That may be the case, but in practice, it is like the father preparing to give his son a spanking who announces to the child, "Son, this spanking is going to hurt me more than it does you." It may be the regulators who are spanked during these hearings, but it is Continental that will feel the pain. If Continental, its depositors, its employees, its stockholders, and the U.S. taxpayers are injured by these hearings, then this committee must be prepared to take the blame. I fail to see why the timeframe under which we are holding these hearings is so critical. And if the timeframe is indeed critical, why these hearings could not be held in executive session the way other hearings have been held dealing with an open institution. Let me turn now to the question of the Continental bailout which seems to hold most of the public interest. Twenty years I have been a member of this committee. In that time, we have bailed out Lockheed Corp., the city of New York on two different occasions, the Chrysler Corporation, and the International Monetary Fund This committee has had more bailouts than the 82d Airborne Division. Too much attention has been given to the negative side of the bailout of Continental, but not enough to the positive side. Continental prior to the bailout had correspondent banking relationships with some 2,200 banks. That is, banks who had deposits with Continental. Of t h a t figure, 976 banks had deposits in excess of the federally insured ceiling. Breaking that figure down further, 66 banks had deposits which were more than 100 percent of their equity capital, and 113 banks had deposits in the amount of between 50 and 100 percent of their equity capital. Had there not been a bailout plan, not only would Continental have failed, but at least 66 other banks in the Midwest would have failed because their capital would have been wiped out. And, a large number of additional banks would have gone under because much of their capital was tied up with Continental. On the people side of the ledger—which I have always advocated in this committee—between 10,000 and 12,000 Continental employees would have lost their jobs, as well as the employees of the other banks who had large uninsured deposits in Continental. Top-level management is not out of work long in a situation such as Continental, but it is the lower, the middle-level groups, the tellers, the clerks, the janitors, the messengers, the cleaning force, and other administrative personnel who have the tough times. While we cannot get too upset about losses to large and wealthy stockholders, we should be concerned about the losses to the small stockholders of the banks and the stocks held by pension plans and other similar groups. There is concern, and rightfully so, t h a t Continental was given a 100-percent guarantee of insurance for losses suffered by depositors while other troubled or failed banks received no such guarantees. While I commend the regulatory agencies for saving Continental, I am concerned about the dual standard. On J u n e 6, 1984, I wrote to FDIC Chairman Isaac asking him to clarify the FDIC policy in the future. 81 I am disturbed that even today no such hard line policy exists. The need to know the FDIC policy is more critical now than at any time since the Great Depression. There are 750 banks on the socalled problem list, 3 years ago that figure was only 250. Bank failures for 1984 are running at record rates. Today I reiterate my request to the FDIC to give the American people a policy on deposit insurance. In closing, let me make it clear that I am not carrying the water of the top-level management of Continental who failed to run the bank properly. But I make no apology or excuses for carrying the water of those 12,000 Continental employees and those thousands of small shareholders, many of whom are widows and pensioners and many, many of the pension funds involving hundreds and thousands of workers that are on the books of the Continental Bank. [The following news release containing a copy of the letter sent to FDIC Chairman Isaac on J u n e 6, 1984 by Congressman Annunzio referred to above was submitted for inclusion in the record:] 82 Congressman FRANK ANNUNZIO 1th Congressional District - Illinois FOR IMMEDIATE RELEASE CONTACT: Curtis A. Prins Subcommittee on Cosumer Affairs and Coinage (202) 226-3280 Wednesday, June 6, 1984 ANNUNZIO ASKS FDIC FOR GAME PLAN The following is the text of a letter sent today by Chairman Frank Annunzio (D-Ill.) of the House Consumer Affairs and Coinage Subcommittee to Chairman William Isaac of the Federal Deposit Insurance Corporation: June 6, 1984 Honorable William M. Isaac Chairman Federal Deposit Insurance Corporation 550 17th Street. N.W. Washington, D.C. 20429 Dear Mr. Chairman: While I applaud your decision to guarantee all deposits and general creditors of the Continental Illinois bank, I am at the same time concerned about the overall procedures used by your agency 1n dealing with bank failures. My observations lead me to the conclusion that the Federal Deposit Insurance Corporation operates by a "seat of the pants" technique in dealing with bank failures. Instead of presenting a well thought out game plan on bank failures, your team looks as if it is drawing the plays 1n the sand after each bank failure. This approach has caused anger, resentment and frustration on the part of many bank depositors, bank officers and bank customers. Many of my constituents have contacted me concerning the failure of the United of America bank, and the government assistance and guarantees provided the Continental bank. In the United failure, your agency used the so-called "market discipline" approach, under which depositors have received 60 percent of their uninsured deposits. Please tell me how I can explain to my constituents that deposits 1n one bank are not Insured the same way they are 1n another bank. As I stated 1n the beginning of this letter, I applaud your action on Continental, but what position will your agency take when the next bank 1s 1n trouble or falls? Will your decision be based on size alone? I urge you, Mr. Chairman, to develop a publicly stated position on bank failures and troubled banks. While there may be disagreement on what that position may be, at least bankers and their customers will know 1n advance what the rules of the game are. If the market discipline approach 1s to be used, then use it. If guarantees such as those used in the Continental case are to be employed, then let everyone know that fact, but there must be a stated policy. Without such a policy, I foresee massive lawsuits, charges of favoritism and insurance by size rather than equity. I urge you to adopt such a policy with the utmost speed. By the time this letter reaches you another bank may well have failed, and the question of the treatment of those depositors and creditors will be raised anew. I hope you will give this your urgent and immediate attention, and that you will favor me with a reply as quickly as possible. Sincerely, Frank Annunzio Chairman 83 Chairman S T GERMAIN. I t h a n k the gentleman. I am sure he has t h a t same feeling for the widows and the unfortunates who were h u r t by the failure of Penn Square Bank. Now, I call on Mr. Leach for an opening statement. Mr. ANNUNZIO. Mr. Chairman, I would like to respond to that. I was one of those t h a t went to Oklahoma City. I reiterated my feelings. I expressed myself to the gentleman who had lost his son in a plane crash and received $1 million and put t h a t money in Penn Square and thereby losing over $900,000. There is no question Chairman S T GERMAIN. He should have put it in Continental. Mr. A N N U N Z I O . Well, he put it in Penn Square. He came close. But I do want to point out here, Mr. Chairman, t h a t when the Federal Deposit Insurance Corporation acted and the other regulatories, they acted under what they feel is the authority given them by the Garn-St Germain bill that was passed and signed by the President. So what needs clarification is the legislation t h a t you sponsored with Mr. Garn, t h a t I voted for and the members of this committee voted for, because we had faith in your leadership and in Mr. Garn's leadership, and if t h a t legislation needs fixing, you will bring it back before this committee, and we will fix it. Chairman S T GERMAIN. Well, I will say to the gentleman, since I indeed was responsible for writing t h a t legislation and contend that that did not give them this authority, we will have you testify at one of the hearings. Mr. ANNUNZIO. I am not a lawyer, so I don't know. Chairman S T GERMAIN. Mr. Leach, you are recognized for your statement. Mr. LEACH. Thank you, Mr. Chairman. I have a lengthy statement that I would ask be submitted for the record. Chairman S T GERMAIN. Without objection, so ordered. Mr. LEACH. I would just like to make a few remarks. One, it is hard not to decide that in a free enterprise society, any institution, no matter how large, should be allowed to fail. What we have here is a regulatory, as well as banking scandal. The problems of this bank were largely undetected by the regulators and loose banking practices were allowed to continue. The biggest regulatory problem of all is t h a t standard rules for large bank failures didn't and don't now exist. Therefore, instead of simply pointing fingers of blame at the regulators and Continental, I would hope the committee and the regulators would explore ways to prevent this from occurring again. One approach might well be to consider guaranteeing a hefty percentage—perhaps as much as 80—of all deposits above $100,000 in insolvent institutions, so t h a t insolvent institutions can be liquidated with a minimum disruption of the financial system. It is quite clear t h a t the issues we face in American banking today are question about quality of money center bank loans, the adequacy of the capital of our larger banks and lack of uniformity in regulation. I think it is time t h a t "get tough" policy of national bank regulation is instituted and greater attention is given at the larger banks to the capital adequacy problem. The big should be 84 regulated as firmly as the small and if circumstances warrant, they should be allowed to fail. Finally, one comment about the distinguished gentleman from Illinois' reference to the timing of this hearing. I think it is important and fair to note that what we have here are potential taxpayer liabilities. I would stress the regulators refused earlier this summer to come before this committee to talk about this issue. So we have postponed consideration for a number of months. I would also stress that I don't think survival of Continental is very much in question. The Chairman of the FDIC has announced publicly that he is prepared to infuse new funds into Continental and what we really have in Continental is a situation where miracle workers are not needed as they were needed at Chrysler, just glad-handers. What we have here is a newly organized bank with a fair capital base, few nonperforming loans—thanks to the Government—and an open-ended commitment from the FDIC to provide more funds. That is unlike any other bank in this country today, and I think that what we really have here is a question of whether we embarrass the regulators, not whether we have a bank that is going to exist. This bank has got it made. Thank you. Chairman ST GERMAIN. I thank the gentleman. I now would like to put your entire statement in the record, without objection. [The opening statement of Congressman Leach follows:] 85 Statement by REPRESENTATIVE JIM LEACH before the Subcommittee on Financial Institutions, Supervision, Regulation and Insurance September 18, 1984 I am sure that I speak for the committee in stressing that the purpose of these hearings is not to diminish confidence in the newly created Continental Bank nor to unravel the FDIC rescue package, but to explore ways to prevent the need for this type of unprecedented government intervention from recurring. But I must confess at the outset that I have grave doubts about the wisdom of the course of action the regulators took. In a free enterprise society, all institutions, no matter how large, should have the right to fail. Fifty-six banks have been declared insolvent this year and either closed or merged. Yet Continential, the nation's eighth largest bank, has received a massive aid package that will allow it to continue to compete as a quasi-nationalized entity. This action has serious implications both for market discipline and for large bank-small bank competition. The Continental precedent would appear to imply that large banks have a better brand of deposit insurance. Thus, large depositors are given an incentive to place their funds in money center banks, no matter how imprudently managed, rather than in small banks, which may well be on a percentage basis better capitalized. I am hopeful that one of the results of these hearings will be that Congress redress this inequity. One approach to this dilemma might be for the federal bank regulators to develop uniform rules and procedures for handling bank liquidations. In order to assure broad confidence in the U.S. banking system, but not go to the brink of protecting high-flying banks and high-risk depositors, they might consider announcing a policy of guaranteeing that a hefty percent (perhaps 80) of all deposits above $100,000 will be immediately returned to depositors in banks that become insolvent, with assurances of the return of any additional recoverable assets after liquidation. Such an approach would have the advantage of assuring standard rules and orderliness, without dulling market discipline. The bailouts of Lockheed, Chrysler and New York City stand as controversial acts of government, but at least they were widely debated and received the specific statutory support of Congress and the President. The bailout of Continental is based on broad stand-by authority transferred to regulators by previous Congresses. What makes it particularly unseemly is that the regulators who decided on the nationalization approach are the very ones who failed to stop the banking practices that caused the problem in the first place. The ultimate irony may be that the only approval required for the regulator's approach had to come from a formal vote of stockholders who were to be saved, not from taxpayers or their representatives in Congress who potentially have to foot the bill. 86 Chosen to head the newly reorganized bank are two distinguished businessmen — John Swearingen, formerly Chairman of Standard Oil of Indiana and William Ogden, formerly vice-chairman of Chase Manhattan. But the public need not hold its breath in doubt, as it did with Chrysler, whether Continental will make it. Unlike Chrysler and Lockheed before it, actual cash — not just a leveraged loan guarantee -- has been infused into the bank and the most dubious portion of Continental's liabilities assumed by the government. William Isaac, the chairman of the FDIC, even pledged at a news conference that if things do not go well in the months ahead, his agency is prepared to give more. Survival is not in question. Continental does not need miracle workers, just glad handers. Swearingen and Ogden have taken the helm of a financier's Utopia: a newly organized bank with a solid capital base, few non-performing loans, and an open-ended commitment of the FDIC for more funds. Can there be any doubt that Continental represents as much a regulatory as a banking scandal? A wiser approach, it would seem, would simply have been to liquidate the bank, selling off at a discounted value its loan portfolio. The regulators argued this would have taken years, sparked a loss of confidence in America's banking system, and caused in a domino fashion the collapse of numerous smaller banks. I doubt it. Give or take a few billion, what Continental represented when the regulators stepped in was a bank with no capital base, approximately $35 billion in responsible loans and perhaps as much as $5 billion in uncollectables. Instead of moving to insure all depositors on May 18 and eventually making what appears to be a $4.5 billion mistake, the FDIC could have closed the bank, sold its loan portfolio, paid off fully the $3 billion in insured deposits, and 86C on a dollar of uninsured deposits. The shareholders and bondholders would have lost all, and the uninsured depositors been burned to the tune of 14 cents on the dollar -- not an unrealistic penalty for poor risk management of funds, nor one likely to have caused the failure of other banks or a collapse in confidence in America's banking system. Instead of rewarding risk-prone banking practices, the precedent established would be one of providing a firm but not panicked warning to stockholders and depositors to watch management more carefully. All growth is not good growth. Smaller can be more beautiful. Rather than reinforcing the safety and soundness of the nation's banking system, the approach federal regulators took emboldens improvidential banking practices. The consequences for taxpayers are grave. But far graver are the consequences for management of the money supply and, in effect, the economy itself. If banks do not face the discipline of the marketplace and keep prudent loan portfolios, the money supply will grow disproportionately in industries or geographic regions where growth-at-all-eosts banking takes place. While Continental's problems are unlike those of other money center banks in that they largely relate to inadequately supervised domestic as opposed to foreign loans, the Continental bailout carries with it implications for the international lending practices of other larger banks. When lending is unrestrained by either the enforcement of an adequate capital base or, as in the case of foreign reserve requirements, financial institutions have a tendency to create excessive capital through the multiplier effect of making loans. The inflation of the late 1970s as well as the overextension in foreign lending can be traced in no small measure to the 25 percent per year growth regulators allowed to occur in Eurocurrency financing. Since any bank can grow simply by taking on more loans as long as depositors can be attracted and protected, it is imperative that incentives be established for depositors to be wary of institutions like Continental. Management's decision to expand the bank's loan base at twice the national average -- over 20 percent per year from 1977 to 1981 and to rely excessively on high cost, short term money should have been warning enough to depositors as well as shareholders. Perhaps the most important reform that occurred in banking as a result of the bank failures of the Depression was the establishment of deposit insurance, which today covers accounts up to $100,000. But the FDIC announcement May 18 that it intended to insure all deposits of any size at Continental signalled for the world that bankers need give little heed to risk management. Uncle Sam would provide a safety net for the big and powerful even at a time government agencies were given a mandate to prune programs for the weak and defenseless. The Continental bailout could not more graphically illustrate that deregulation is a matter of rhetoric rather than substance in Washington. If the most free enterprise biased administration in recent history blinks in the face of political embarrassment involved in the potential folding of our eighth largest bank, what can be said about the future of our market economy? 87 Ironically for smaller banks that have stronger capital requirements than larger ones, the ramifications of the Continental bailout are likely to be similar to those that occured after the Bert Lance episode. The regulation will be toughened. For larger banks, boardrooms can breathe easier. The precedent will be comforting. Pressure to put our biggest banking houses in order will be reduced. Attention will be focused on broadening FDIC insurance coverage rather than on the real problem, which is capital adequacy. The scatter-gun decisionmaking that hallmarked the regulators' handling of the Continental issue underlines the appropriateness of Congress' rethinking the entire federal bank regulatory structure. Three separate federal agencies were responsible for overseeing Continental, and this diffusion of responsibility may be partially responsible for the negligence that appears to have characterized the oversight of the bank. A single federal banking agency might have some advantages in eliminating the problems of overlapping jurisdiction and vague responsibility which plague the system. The burden of proof, generally speaking, rests with those who advocate institutional change and while it may be premature for Congress to take a definitive position, the case for a thorough review of the regulatory system is powerful. One footnote speaks for itself. Congress, as the elected body of the American people empowered to make spending decisions for taxpayers, was not only not fully consulted in advance on the policies that were applied to Continental, but regulators refused this summer to come before the appropriate oversight committee except on the agreed upon premise that they would not respond to questions about Continental. It is alway easy to suggest that confidence in the banking system might have been jeopardized if the issue received a thorough review, but this Representative is hard pressed not to wonder whether confidence in the judgment of the regulators is not the real issue. The bailout that is needed for our large banks is a private- rather than public-sector one -- a recapitalization based on the selling of equity. Large banks don't want to sell stock because it implies dilution at a time when the vast majority of bank stocks sell for less than book value. But raising money the old-fashioned way makes a lot more sense than relying on the government for newfangled bailouts. 88 Chairman S T GERMAIN. Mr. Schumer has an opening statement. Mr. SCHUMER. I have an opening statement I won't read, but I ask unanimous consent that it be read into the record. Chairman S T GERMAIN. Without objection. Mr. Barnard. Mr. BARNARD. Thank you, Mr. Chairman. Mr. Chairman, I would just like to make a couple of observations as we proceed with this very important hearing today. Perhaps I am emphasizing something that Mr. Wylie mentioned in his opening statement, but I can see t h a t the hearings beginning today will serve a very beneficial purpose. We have had on the menu for several years issues t h a t I think will give us further light and edification as we begin to consider them. One is regulatory reform. That has been a consideration and even the vice president formed a task force. We haven't heard anything final from that task force's recommendations, but I think these hearings will show further t h a t regulatory reform should be a consideration of this committee in the next session. Second, insurance reform; I think we already see t h a t the FDIC and FSLIC can't be the sole support of risk t h a t banks take and t h a t this is another subject t h a t needs some very definite consideration. Three, I think possibly we need to rethink the Garn-St Germain bill. As beneficial as t h a t was in solving the crisis of the savings and loan industry when it was passed, perhaps these hearings show t h a t this is a consideration t h a t we ought to also anticipate in the next session, as to what guidelines we need to set up t h a t the regulators should follow instead of following their own desires in solving these problems. Four, I think t h a t this also should give us an opportunity to further examine the issue of deregulation and how far deregulation really should go and whether or not deregulation had any really significant effect on the condition of this institution or the other institutions t h a t have failed. So, I summarize by saying t h a t I think these can be beneficial as to setting us on a course of action that this committee, the Financial Institutions Subcommittee of Banking, should take in the ensuing months and years to come. Chairman S T GERMAIN. I t h a n k the gentleman. Mr. McKinney is recognized. Mr. M C K I N N E Y . Thank you, Mr. Chairman. As disagreeable a topic as Continental Illinois bailout is for us, I am glad t h a t the subcommittee is finally moving ahead with this oversight investigation. I find myself increasingly annoyed at what I am reading and hearing about the way this bank conducted its business and the role played by the regulators responsible for examining the financial condition of that institution. My curiosity is heightened, Mr. Chairman, by the appearance in the last few days of an interview with a senior official of the Comptroller's Office published by the Washington Post 4 days ago and a report in the New York Times of a memorandum circulated to the media by the Comptroller's Office. It appears to me the motivation behind this sudden outburst is to seize the offensive before this subcommittee can ask any embarrassing questions. Why t h a t office 89 might be embarrassed eludes me since the questions have all been asked before. Approximately 2 years ago, in fact, we conducted hearings into the failure of the Penn Square Bank, I would expect that Mr. Conover could come before us with boiler plate testimony today, changing only the names of the bank. Mr. Chairman, in addition to learning how this bank fell to such a state, I hope we focus some attention on future hearings and how to prevent similar occurrence. I think t h a t will demonstrate there is a relationship between poor bank management practices and potential risks involved in other business lines.Why should we trust a banker who can't manage a loan portfolio to be able to successfully engage in insurance, securities, or real estate? There are several other points which need to be made during the course of these hearings. There is a great distinction between a congressionally approved bailout of New York City or Chrysler and an administratively approved Continental bailout. I don't want to abuse the kindness of the chairman and the subcommittee to elaborate, but the difference is valid and I hope, it will be made very clear to the public as time goes on. I would also like to find out what the regulators feel they have done, No. 1, by creating a new class of bank in the United States of America, a TBTF—too big to fail. What have they done to the soundness of the funding of the Federal Deposit Insurance Corporation and its future; what have they done to the myth of the wall of separation between the holding company and the banks since they have really in fact saved the holding company rather than the bank, and what have they done to determine what is a safe level of assets in short-term foreign deposits. If I sound as though my mind is made up on this issue, it is only because we have been there before. No city followed New York to ask Congress for help, no corporation came asking for the treatment we gave Chrysler. That was because no one in charge of a city or industrial company wanted to be laced with the stringent oversight conditions we—the Congress of the United States, acting for the people of this country—imposed on that city and on that corporation as a precondition for Federal assistance. Why do the regulators treat banks differently? It seems to me t h a t regulators have decided that, in fact, a bailout may be conducted without the consent of those who are going to pay the bill and without stringent requirements and regulations that we put on those other Federal assistance bills, Mr. Chairman. In fact, it is with great interest I note that the regulators have decided that the very people who issued those rotten loans will now manage them. Chairman S T GERMAIN. The Chair recognizes Mr. Shumway for a unanimous consent request, I believe. Mr. SHUMWAY. Thank you, Mr. Chairman. While I believe this to be largely an exercise of Monday morning quarterbacking, I do recognize the high state of emotions on this issue, indeed on both sides of the aisle. I share the concern regarding the timing of these hearings expressed by the gentleman from Illinois, Mr. Annunzio. 90 Without taking further get to the witnesses, Mr. that my full statement be [The opening statement of the committee's time so that we can Chairman, I request unanimous consent included in the record. of Congressman Shumway follows:] 91 STATEMENT OP THE HONORABLE NORMAN D. SHUMWAY September 18 1984 Mr. Chairman, I commend you for calling these hearings which, hopefully, will provide the Committee Members with a fuller understanding of the backdrop of events occurring at Continental which led to its recent crisis and subsequent federal intervention, as well as the implications of these actions for the banking industry. I am, however, concerned that the focus of these hearings may shift away from their original goals and delve into the possible relationship between Continental's woes and proposals now before the House and Senate to deregulate further the banking industry. I am all too aware that opponents of product deregulation for banks will try to cite the Continental experience as still one more piece of evidence that bankers are so inept at handling their own business that it would be folly to trust them with additional powers. What is even more disturbing to me is that these opponents are inflaming the gereral — and largely unsophisticated — public into assuming that Continental's problems were even attributable to the limited deregulation that has already occurred...I would suggest that not only are these notions fallacious but also are submitted by those competitors of banks seeking to protect their respective turfs. Let's examine some of the fallacies. First, I would note that deregulation did not cause the problems of Continental when it* troubles first became apparent. Rather, Continental's operations were conducted in one of the most regulated states in the country, which prohibits even branch banking. Because Continental was more geographically limited in its deposit taking function than other banks, it was forced to seek and to rely on high-cost — not to mention volatile — international deposits to fund its lending program. Further, the bank's problems appear to have been the result of unusually poor management of a quite traditional banking function of taking in deposits and lending them out, and not from the new activities sought such as securities trading or investment banking. The bank's reliance on international purchased funds, together with non-performing loans purchased from the now-failed Penn Square Bank, created a real drain on earnings and increased its exposure to speculation as to the future viability of the institution. This speculation reached a crisis level in mid-May of this year when Continental was hit by the classic run on deposits, something, from which, I might add, no financial depository institution is immune. I am convinced that had the Federal regulators not stepped in when they did, the effect on public confidence in and the stability of our nation's financial system would have been devastating. Just why the panic run developed when it did, the extent of federal involvement in and the favorable treatment of Continental will be the subject of great debate. Suffice it to say that I, too, am anxious to have the cards put out on the table. However, I am afraid that when all is said and done, the true culprit in the Continental debacle will not be forced into the open. Who is the culprit? The current system is. The laws that were designed to regulate and restore confidence in the nation's banking system bear a large share of the responsibility for the problems facing the financial services industry today. This is particularly true of federal deposit insurance, which eliminates market discipline in- the banking industry and encourages insured depository institutions to take additional risks. I am convinced that until we change our perspective of providing blanket guarantees where the institution is too large to fail and applying uniform insurance premiums — rather than assessing premiums based upon institutional risk of exposure — we will be faced with many more "Continentals". We cannot let this happen to the American depositor or to the American banking system. 92 Chairman S T GERMAIN. DO any other members of the subcommittee seek recognition? Ms. OAKAR. Mr. Chairman. Just a brief comment. Chairman ST GERMAIN. Mary Rose. Ms. OAKAR. Mr. Chairman, I want to commend you for these hearings on Continental Illinois. Hopefully, the thrust of the hearings will not be what Continental is today, because I share the gentleman from Illinois , concern about a run on the bank. Consumers ought to know that they are probably dealing with a bank t h a t is very well protected and assured t h a t their investments with the bank are fine. However, I have some concerns about the Comptroller, the primary regulator of Continental Illinois, and I think we ought to use this hearing not so much in terms of identifying the bank but as a point of departure, as a benchmark for how we don't want to see banks operate. I really want to know why the Comptroller issued a statement on May 10, 1984, t h a t he was not aware of any problems when, 7 days later, a massive rescue program was announced. I can understand my friend from Chicago's concern, and I hope t h a t the focus will be on the regulators and their oversight and what we do in the future to assure that this kind of catastrophe doesn't happen again. Consumers should know that they are protected, which is important, for managing the situation in Chicago. Thank you. Chairman S T GERMAIN. Mr. Dreier. Mr. DREIER. Thank you very much, Mr. Chairman. Like everybody here, I am extremely concerned about the twotiered handling of the Federal insurance system, but although it is becoming more and more difficult after having listened to my senior colleagues on this subcommittee, I am going to try to keep an open mind as we face the issue. Thank you, Mr. Chairman. Chairman S T GERMAIN. Mr. Vento. Mr. VENTO. Thank you, Mr. Chairman. I want to commend you for holding these hearings. I frankly felt that we should have moved as quickly as possible to evaluate this because I think there is a debate whether or not the regulators actually had the power to do what they have done. I think all of us recognize the volatility of this problem, the types of concerns that affect our colleague from Illinois, which in fact affected our entire international economy with the demise of Continental Illinois. Nevertheless, these meetings and our role as a part of representative democracy are such that we should exercise it with care and responsibility and trust that our constituents have in us. Mr. Chairman, I am concerned about the issue that arises with almost 800 banks in trouble this year, many of them have been treated far differently than this large financial institution. The challenge to this committee fundamentally relates to these large money center banks, megabanks, if you would, and whether or not we are able to supervise them adequately, whether, for instance, the FDIC action to protect consumers here has been used for a far different purpose in essence, to reinforce and deal with a different problem. 93 After all, the $4.5 billion t h a t we put in at the discount window t h a t is open to all banks with the special charters t h a t banks have, those types of loans and responsibilities and decisions to make those loans basically on an international basis throughout our country are decisions which we end up underwriting as a National Government. So we are, in essence, opening the economic book to be used in the private sector to write a whole host of loans which are then bought by the public sector through insurance and chartering functions we have. It is as if these private entities, the private banking system in this country and financial institutions are absorbed and nationalized. And yet we have an inadequate control over the economic writing and loan capacity of these particular institutions. This is the fundamental question t h a t we, as a committee in terms of our charter and in terms of our relation, have to come to deal with. I might remind the committee they are all not losers, the bondholders, those with the golden parachutes, many others t h a t benefited from these types of actions. So I commend the chairman and look forward to working with him and the other members of the committee as we try to resolve these and many other questions being raised. Chairman S T GERMAIN. Thank you. Mr. Patman. Mr. PATMAN. Thank you, Mr. Chairman. I am grateful for the opportunity to attend this hearing and listen to what I hope will be somber good testimony. I do urge this committee press forward immediately to clarify the rules on insurance companies for the largest banks as compared to the insurance coverage available to the depositors in the smaller banks. Where is the dividing line? What are the questions? What are the guidelines t h a t enter into the minds of those regulators who are undertaking to determine whether or not the bank in Seminole, TX, for example, t h a t went broke a few weeks ago apparently, has only 55 cents on the dollar for its depositors above $100,000? What are we going to do about Financial Corp. of America out on the west coast and these many, many other large institutions that appear to be very fragile in their financial stability? I am hoping that we can develop the guidelines, the information needed, for the depositors and the investors all over this Nation and come out with legislation t h a t may be necessary in order to strengthen the regulatory process, grant greater authority if necessary to the regulatory agencies, but do give more safety and soundness to our system of financial institutions. Mr. SCHUMER. Mr. Chairman. Chairman ST GERMAIN. Mr. Schumer. Mr. SCHUMER. I can't resist making it a straight flush on the top row by saying a few words. I think the question we must address concerns not just the regulators, Mr. Chairman. I think the question is how many more large money center banks will run into the same problems t h a t Continental has run into? We are in a new world of go-go banking. We are in a world where banks are under tremendous pressure to 39-133 0—84 7 94 maximize the return they get from loans. We have seen not just too much money pushed into oil and gas loans, we have seen money pushed into Third World countries and now into leveraged buyouts. Will we be sitting here 3 years from now having another hearing about 1 or another of the 10 largest banks that put too much into leveraged buyouts? One thing is clear, if a penny candy store was r u n the way Continental was run, it would be bankrupt in 6 months. The issue is how many more banks are in this problem? And it is our responsibility to look at that because, one, banks are not an unregulated industry, the Federal Government gives them all sorts of advantages; but, two, they are too important to the lifeblood of this country to be left simply to the bankers themselves. Chairman S T GERMAIN. The Chair would observe t h a t after my many years on this committee, this is probably one of the most stimulating and participatory openings of any set of hearings. It would appear to me t h a t there is a slight bit of interest on the part of the members of this subcommittee in these proceedings. Certainly, I have been listening attentively to my colleagues, each and every one of them, and I appreciate the fact that they see challenges in this set of hearings and have questions about what occurred. So all I can say is that it bodes well for the work of the committee t h a t we have so many members who are so intensely interested. Now, we will begin the actual proceedings. I would ask Mr. Meade, Mr. Kovarik, Mr. McCarte and Ms. Kenefick if they would be kind enough to stand and raise their right hands. Do you swear t h a t the testimony you are about to give will be the truth, the whole t r u t h and nothing but the truth? [Witnesses sworn.] Chairman S T GERMAIN. Please be seated. I would ask t h a t when Mr. Meade, Mr. Kovarik, Mr. McCarte are called upon to answer their initial questions t h a t they provide for the subcommittee the information on the sheet t h a t I have provided to you, to wit, your OCC employment background and current employment, which examinations you served as examiner in charge, which examinations you participated in, and whether or not you had the opportunity to reacquaint yourselves with the examination reports, and if so, which ones? When you are called upon for your initial answer to a question, we would ask you to address those points for the benefit of the members of the subcommittee and for the record. I would like to address my first question to Ms. Kenefick. But before I do, I would ask unanimous consent to place in the record at the conclusion of my questioning the September 17 staff report on Continental Bank's financial history, the September 18 staff report on examiner findings, the November 15, 1982 memorandum from Richard Kovarik to William Martin, and the July 1982 Kathleen Kenefick memorandum which will be the subject of my questioning with Ms. Kenefick. There being no objection, so ordered. Ms. Kenefick, I am going to ask you to outline for us your employment history at Continental and the staff has made copies of your July 1982 memorandum on oil and gas lending available to all 95 the members. We will ask you to describe the circumstances t h a t led up to your writing, of this memo, we will ask you to summarize the memo; and we will ask you to explain the following excerpts from it: what you meant by the status of the Oklahoma accounts— particularly Penn Square Bank—as a cause for concern; next, management of credit relationships has not taken place; next, in some cases the initial credit writeup had customer information missing, out-of-date or incorrect, and in other cases there has not been a credit writeup. Furthermore please comment on: followup of accountability having been rare; next, housekeeping problems, missing note sheets on approvals, documentation errors and omissions, past due principal and interest compounding the situation. Do you consider these housekeeping? They sound like fundamental documentation problems. Then, the Oklahoma calling personnel continuing to fight to keep their heads above water with time spent putting out fires and, therefore, falling further behind. At the conclusion of her outline or explanation of her memorandum, I would ask the examiners to reply as to whether or not they feel the conditions Ms. Kenefick described would have been viewed as serious by OCC examiners. In other words, please comment on the seriousness of the conditions described in the Kenefick memorandum. Ms. Kenefick, I would like you to address one last thing in your reply. I would like to know if you feel—this is important to a lot of my staff members on this side—that perhaps the memorandum you wrote—that to many of us seemed very penetrating and well done—perhaps due consideration was not given to this memorandum because despite the fact that a lot of people tout t h a t they have females in high positions in their organizations, unfortunately often times it is more lip service t h a n anything else, and I would like to know whether you feel t h a t t h a t had any bearing on the fact that your memorandum was not given due consideration by upper management in Continental Illinois. That is the conclusion of my question. You are now recognized to reply, Ms. Kenefick. TESTIMONY OF KATHLEEN KENEFICK, FORMER EMPLOYEE, CONTINENTAL ILLINOIS NATIONAL BANK Ms. KENEFICK. Thank you, Mr. Chairman. You asked me to outline my employment history at Continental Bank. I started in the bank in J a n u a r y 1975 as a management trainee in the commercial lending department of the bank, and I was in t h a t training program until late summer or early fall of that year. I then received my first assignment in one of the commercial lending departments as a member of the surface transportation division. My title at that time was commercial banking associate, and I worked in the section which was responsible for the area west of the Mississippi River. During t h a t time period I received two promotions from—to comercial banking officer and again in late summer or early fall of 1976, and then secondly—should I continue? 96 Chairman S T GERMAIN. Yes, please. Ms. KENEFICK. Then to second vice president, again in late summer or early fall of 1978. My responsibilities during t h a t time grew as I had more experience. I originally worked assisting others with their customers and eventually came to handle independently my own customers and territories. I was responsible for marketing bank products to the various customers and prospects, doing financial analysis and negotiating on behalf of the bank. In the late fall of 1979, I was asked to take a new assignment as a supervisor in the management training program. In t h a t responsibility I managed various associates with backgrounds from BA's to MBA's. This is, in effect, the same training program t h a t I had started in at the bank. I supervised, evaluated, reviewed, I also had various administrative functions and worked on recruiting and interviewing for the bank. In the spring of 1981, I had completed my assignment as supervisor in the training program, and I was assigned to the midcontinent division of the oil and gas group. I left the bank in September of 1981. Chairman S T GERMAIN. NOW, would you continue to address the other portions of the question? The circumstances t h a t led to your writing the memorandum t h a t we have inserted in the record. Ms. KENEFICK. During the time I was in the division, before writing the memo, approximately 4 months, I was trying to learn about the oil and gas industry, and the division and the customers. I became more uncomfortable with the decision process t h a t was being followed in order to make the credit decisions. I was also becoming less and less comfortable with our relationship with Penn Square Bank. I had had several conversations with Mr. Lytle of specific instances or questions or concerns, and I felt t h a t I wasn't Chairman S T GERMAIN. Mr. Lytle, what was his capacity in this area? Ms. KENEFICK. Mr. Lytle was division manager of the midcontinent division of the oil and gas group. Chairman S T GERMAIN. Was he the principal contact with Penn Square? Ms. KENEFICK. Yes, he was, Mr. Chairman. Chairman S T GERMAIN. IS he the individual who borrowed rather substantial sums of money from Penn Square during this period of time, he was also pursuing participation loans from Penn Square on behalf of Continental Illinois? Ms. KENEFICK. Mr. Chairman, I don't have any personal knowledge of his loans. Mr. BARNARD. Mr. Chairman, could you ask her to speak up? I can't hear her. Ms. KENEFICK. I am sorry. Mr. WYLIE. If the chairman will yield so I might edify the memorandum we are talking about. Chairman S T GERMAIN. We have placed it in the record. Mr. WYLIE. IS this it here? There are no names on it, and it doesn't indicate who prepared the memorandum or to whom it was sent. 97 Chairman S T GERMAIN. The memorandum is the one we have before us; unfortunately, the Xerox is not as good as it might be, but it is on stationery of Continental Bank, and it says, "Oklahom a " in big letters and the first lines read "Status of the Oklahoma accounts, particularly Penn Square Bank, is a cause for concern." That is the memorandum. Mr. WYLIE. I want to be sure we were referring to the same memo. It doesn't have any identifying names on it. Chairman S T GERMAIN. Except with the initials of Ms. Kenefick at the end—CK. Mr. WYLIE. Did you prepare the memorandum on your own initiative, or was t h a t at the request of someone else? Ms. KENEFICK. Congressman Chairman S T GERMAIN. That she is right now describing—she is describing the circumstances t h a t led to her preparation of the memorandum. Mr. WYLIE. That is a good question then. OK; t h a n k you. Ms. KENEFICK. A S I was saying, I felt t h a t I wasn't making much progress in various conversations I was having with Mr. Lytle regarding some areas of discomfort and concern that I had, and I felt perhaps t h a t the best way to approach it would be to put some thoughts in writing, so Mr. Lytle and I could discuss them. Basically, t h a t is the circumstances. Chairman S T GERMAIN. Would you just summarize the memo for us? Ms. KENEFICK. All right. The memo is basically five pages long; it is a memo t h a t I wrote in July 1981 addressed to Mr. Lytle, titled "Oklahoma." The purpose of the memo was to summarize what I felt were various problems and the reasons for those problems that were occurring in the midcontinent division, but the primary reason of the memo was to propose what I felt were solutions to the issues t h a t I raised. Chairman S T GERMAIN. NOW, if you would explain specifically the items I have listed under (3). Ms. KENEFICK. The first sentence, status of Chairman S T GERMAIN. These are excerpts from your memo. Ms. KENEFICK. The first sentence in my memo in here is what I am saying is t h a t the Oklahoma accounts, and particularly those accounts where we have participated with Penn Square Bank, were in my opinion a cause for concern. This really just summarizes my feelings at the time. Chairman S T GERMAIN. Next, management of credit relationships has not been consistently taking place. Ms. KENEFICK. Again, this summarizes some of the feelings t h a t I had at the time where I felt that we were not consistently on top of our accounts, we were not able to anticipate future requirements or future actions that Chairman S T GERMAIN. What do you mean by "on top of your accounts"? Ms. KENEFICK. Well, to the extent that we would be managing the credit relationship of the account, we would be monitoring the situation, watching for certain things, anticipating the next step. 98 Chairman S T GERMAIN. Could you be a little more specific, because what you are saying is, they had not taken place. So what we would like to know is, what was it that didn't take place? Ms. KENEFICK. Perhaps, Mr. Chairman, I can answer it this way, t h a t the environment of the division at the time I was there was a very reactionary type of environment due to the growth in the division, as well as what I felt were shortages of people in the division, and, therefore Chairman S T GERMAIN. People or qualified people? Ms. KENEFICK. People. People in the section, I should say, not division. And, therefore, we were not able to really take charge of the relationship as best perhaps we could have. Chairman S T GERMAIN. Next, in some cases, the initial credit writeup had customer information, et cetera. Ms. KENEFICK. This is just another one of the problems I felt were present in the division at the time. I can't recall numerous specific instances. I just say t h a t at the time my thoughts were, after having reviewed various different credit writeups and things and doing some questioning of the people t h a t had written them, t h a t perhaps there was additional information that should have been included, some information that was out of date. In a couple occasions with further digging, we found information t h a t was provided to us t h a t was not correct. In other cases, I say there has not been a credit writeup, there were again—again, this is a hazy memory, but I do recall that many of the credits were approved with just a commercial reporting form which is a computer input form without a detailed note sheet in many occasions explaining the purpose of the credit. Chairman S T GERMAIN. What size loans are we talking about here, roughly? Ms. KENEFICK. Most of these loans were small loans, $5 million or under. Chairman S T GERMAIN. Five million or under? Ms. KENEFICK. Yes. Chairman S T GERMAIN. TO a lot of us, t h a t is a lot of money. Mr. Barnard said it turned out to be housekeeping problems, t h a t is, missing note sheets, approvals documentation, errors and omissions, and past due principal and interest compounding the situation. Were those really housekeeping problems and or do you think t h a t missing note sheets, document errors—never existed? Ms. KENEFICK. Mr. Chairman, I don't know if they never existed or if they were missing. Chairman S T GERMAIN. In other words, you never saw them? They were not available? Ms. KENEFICK. Correct. Chairman S T GERMAIN. SO it could be t h a t they never existed. Ms. KENEFICK. That is possible. Chairman S T GERMAIN. And then, one more after this, the Oklahoma calling personnel continue the fight to keep their heads above water with time spent putting out fliers and, therefore, falling further behind. Would you elaborate on that? Ms. KENEFICK. In this sentence I was basically trying to summarize what I felt at the time the environment in the division was. I 99 felt we were short people, I felt that we were continually expected to react in a very short timeframe. The demands for turnaround were very quick. Chairman S T GERMAIN. What do you mean by "turnaround?" Ms. KENEFICK. TO make a decision on a credit request. And because we seemed to be suffering from some catchup work, we were never able really to both catch up and go forward at the same time with growth in the division. Chairman S T GERMAIN. Are you essentially saying that within that division one of the big problems t h a t you found was that you were always appeared to be beh/nd rather t h a n acting currently, to something t h a t had already happened, No. 1. Second, I asked you, you said you were short of people, and I said "qualified people" and you said "people". But is it not a fact you need scientific personnel as well, engineers, et cetera, to go out and look at these properties and properly evaluate them, and did they have t h a t type of personnel available to them in sufficient numbers to do the work t h a t had to be done in reviewing these loan applications and loan approvals? Ms. KENEFICK. Well, Mr. Chairman, during the time period t h a t I was in the division, there were initially two petroleum engineers and one chemical engineer and an additional chemical engineer was added to the division, and I do believe t h a t Mr. Lytle was looking for an additional petroleum engineer. I am not sure I am qualified to say whether that was adequate staff or not, but they were extremely busy. Chairman S T GERMAIN. But you did say there were not enough people. Ms. KENEFICK. The engineers were extremely busy individuals. My comment about enough people was primarily relating to the account managers, people calling directly on the customers. Chairman S T GERMAIN. Thank you, Ms. Kenefick. [Copies of the memorandum by Ms. Kenefick to Mr. Lytle of July 1981 and the bank examination report of Mr. Kovarik dated Nov. 15, 1982, follow:] 100 '.MEMORANDUM BlOG 11 fL . • i ' - ' NO @ £ CONTINENTAL BANK :} DIVISION" UK.LAHUMA The status of the Oklahoma accounts (particularly Penn Square bank) is a cause for concern and corrective action should be instigated quickly to 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 of CIN'B and/or customer actions occurring. 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 writeup* Followup and accountability have been rare* Thorough monitoring is hindered when both strengths and 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 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. Customer dissatisfaction is a possible next occurence. The explosive growth in the number of relationships, combined with personnel shortages and the organizational structure followed,-"are the perceived primary causes* In addition, however, the short term transaction philosophy (put the loan on for 30-90 days with either a strategy or more information to follow) adds to the problem* This builds the workload and potentially limits options* The 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 of concern as the situation may change without our being aware of it* Suggested actions address both the immediacy needed to handle the current situation and procedures to follow in the future which try to prevent the same problems* It should be recognized that this redirection and reprioritizing of efforts involves tradeoffs, primarily affecting the rate of growth of new business at least in the short term. The long run positive effects of knowing where we are and where we should be going should outweigh this* In addition it should facilitate a smoother transition ot account relationships (customer benefit) and potentially improve people development while hopefully using them more effectively. Short Term Proposal Using a team of people made up ot calling personnel and administrative support, the following steps should be tatten: 1) Organize accounts by "family" exposure and prioritize by available credit; make assignments of responsibility to calling persons. 101 I) Totaiiy re-examine the relationship, i.e.: a) b) critically evaluate the situation, emphasizing strengths ana weaknesses of the credit c) recommend future action, both what we and the customer should be doing to improve the relationship d) examine documentation, comparing what we think we have and what we actuaily possess; determine what we need e) 3) verify cus turner iuf or;aat lo"., t'iiing in any raissl:*^ information or updating it as needed present the above material in written form. Lytle and Kenefick "reapprove" each exposure and the steps to be taken. 4) Work with Penn Square bank, Loan Division, Collateral Vault, Credit Files, etc. to complete our requirements. 5) Start new procedures (outlined in Long Terra Proposal) on any new transactions that arise. Timing of completion is impacted by the number of people and other resources dedicated to the project, as well as the number of accounts to be examined. The first step may take a week to ten days. It is estimated it will take one calling officer on average Z to J full days to handle the second step per "family" of accounts, with (2A) being potentially very time consuming. With respect to (2d), the calling officer should work with a senior counterman to determine what we need while the administrative people can handle the other requirements. Step 4 may drag on for quite some tiue, potentially months. It is suggested that a minimum of six calling personnel and three administrative support people be assigned to the team. At least one calling person would handle current -business, though possibly two may be needed on some days. The remaining members would devote their time to their responsibilities connected with this team. Travel during this phase should be limited to obtaining any information needed, by either meeting with Penn Square Bank and/or the customer as necessary. Other resources such as a work area away from other distractions, storage space to accumulate materials and a designated typist or two would speed results. 102 ''MgacRANDuaa « | K CCNTJNEJ^JTAL S A N K C C M I M S t U ' l U t O K HMI ••*» C»!»» »l»0 ' » "St -•*««•'«»• < -«f Ml Suggested Members: Kenefick, Lucas, Liddell, Sullivan, Cavallo, two banking associates, Donis, Maliey, two operating trainees. MOTE: Winget and Bainbridge would be especially valuable in the early stages so addressing tins course of action early on would be important. Their help would facilitate the organization of accounts and assist the development of the new banking associates. Long Term Proposal: Probable causes of the situation at hand should be addressed in order to attempt to keep the same situation from happening again. 1) Rapid Growth in the number of relationships This in itself is a benefit and a cause we don't want to change. We should however recognize its side effects when we and Penn Square Bank are not able to keep pace with it. We should also recognize some of the time requirements for turnaround may be lengthened by what is proposed here. 2) People Shortages It is my understanding that close to half of the available credit and approximately two-thirds to three quarters of the borrowing accounts are located in the Oklahoma territory. Having four people handling this volume in the past was not adequate. The ideal would be to have two calling personnel handling Tulsa and four handling the rest of the state. They would report to a Sectiou head who would be able to devote full time to their direction. 3) Organizational Structure The account relationships should be divided among the calling personnel. Accountability and follow thru should be more consistent as a result. Duplication of effort and inefficient use of time may diminish. Some of the more active and/or complex accounts should utilize a backup arrangement. Management of the relationship, both the credit risks and the profitability of the account, should be stressed. All credit requests should initially be examined by the calling officer whose responsibility it is to decide whether to proceed. They will also have the responsibility to monitor the situation. All necessary 103 '.'•' &S2BCRANDUM. .<$& CCfrJTINEri TAL EA^:X I materials to aid them (i.e., j>ast due notices, Customer balance Reports, Loan Review writeups, etc.; should be directed to them. Account assignments should come utter the short-term proposal is at least assigned. We should also utiLize tie engineers properly without confusing the (function ot the account officers, i.e., loans based on reserve quality suould be reviewed by the engineers whose responsibility it is to set loan values. 4) Transaction Philosophy As mentioned previously, the philosophy or Keeping our customers on a "short string" (3u-9u day transaction loans) with either a strategy or more information to toHow adds to our problems* Besides requiring us to look at the same transaction at Least twice, our options are potentially limited when the money is out the door. We should strive to match the length ot the transaction to repayment source. Strategy and necessary information should be known up front before a decision to lend occurs. Short term credits may make sense in situations when a specific event is supposed to occur. 5) Standards of Acceptability Hopefully with additional personnel we will have the ability to improve our output while keeping pace with new business and handling the old effectively. Our credit proposals would be enhanced if in addition to the purpose of the loan and possible repayment, qualitative discussion occurred which examined both the strengths and weaknesses of the deal before reaching a conclusion. Minimal information should include current financial information (audited or unaudited); Other debt especially in the event secured (and by what) should be noted. Basis used for assets (book/market) should be included and any significant investments should be examined, besides a balance sheet and income statement contingent liabilities should be included (especially in the case of individual statements). All these comments apply to both corporate and individual statements. We should also require the statements be signed by either the individual or an officer of the company (if unaudited). We should stress internally with our people and externally with Penn Square Bank and other banks, the importance of putting the loan on properly the first time, bunding should occur not only after we have the proper approvals but after we have the proper documents on hand, documents which have been approved to form by the account officer, counterman and legal counsel. We must particularly remember to have 104 -*• MEMORANDUM CONTINENTAL BANK COIUIMNUt. ILLINOIS NMIONM. 9ANK A.10 TRUST COMPANY OF CHICACO counsel approve any documents we did not draft internally. We have to better train ourselves first and then others as to what is expected; they won't change unless we do. 6) Lack of Control It is not clear whether the participation agreements are currently drafted in a way which allows Penn Square Bank to "change" the deal after the fact and merely inform us (rather than consult us) or that they just do it anyway. It is thus not clear whether using a multibank agreement would .be an advantage over a participation certificate (or even then if they would recognize the different requirements) but it is potentially something to consider. In any event we should consider taking on more responsibility ourselves, whether directly (both in terms of decision making and in terms of adminstrative functions) or indirectly (keeping copies of everything, "auditing" their material,'etc.). We should recognize that the problems we have had keeping pace with the growth have been even greater at Penn Square. We should also make sure that in the event any set-off would take place, the banks would share pro-rata based on exposure. Conclusion Again the importance of recognizing tradeoffs comes to mind, both in terms of timing and scope of actions taken and not taken. Both short term and long term solutions should be sought. We need to get our own house in order first while at the same time potentially changing our procedures. Only then can we get others to change. Positive steps taken today may minimize future losses and alleviate problems. Making sure we explore the credit request thoughtfully, putting the loan on right the first time and then monitoring the results afterward should be re-emphasized. Having an adequate number of people to handle the volume is also important for success. The desired results from these steps would be to have a good understanding of what shape the current Oklahoma portfolio is in (at the same time allowing us to catch up on all of our exceptions), a plan of action to be taken if necessary in the future, a smoother transition of account managers, and a reduced likelihood that the current situation would occur again. MJH:CK 17-66 105 TO: Hilliare E. Martin, Deputy Comptroller for hlaltinati nnal Banking rrom:^Richard M. ItovariX, Senior national Bank Dcaminer Oete: Itovenber 25, 1982 Subject:Continental I l l i n o i s National Bank and Trust Co., Chlcacp, I I . SCM^Hy OF PiTRT.r>S Problems are centered i n heavy volumes o f problem loans which have received wide eaqposure i n the p r e s s , and t h e i r a f f e c t on earrings which resulted in a second quarter l o s s o f $61 m i l l i o n after a-special provision t o the BFLL of $220 million on loans purchased from the Perm*Square Bank, N. x . Trie increasing l e v e l s o f non-performing loans and the second quarter l o s s r e s u l t e d in a severe blow t o CXC*s p o s i t i o n and reputation, with duties Lie investors shunning many of CIC's l i a b i l i t y instruments. Although the Perm Square relationship accounts for a r e l a t i v e l y small portion of pmhlere loans ( l e s s than 20%) the publicity surrounding i t s c l o s i n g was surely the one event that has done the most damage. I t i s my opinion that there are b o inter-related causes of the present s i t u a t i o n . ELrst, the aggressive growth philosophy of QC was not tempered by increased controls (loan quality safeguards) and second, the management s t y l e of great authority and r e s p o n s i b i l i t y resting in individual unit managers, was without proper supervision from t h e i r superiors. Althoutfi in the f i r s t instance i t can be said the lack of q u a l i t y control i s universal for the bank, the second cause i s more l o c a l i z e d - p a r t i c u l a r l y i n the Special Industries and Real Estate Croupe. The loan Review function at CXNB has been the recipient of c r i t i c i s m from the CCC for at l e a s t three years, However, as i t was functioning f a i r l y w e l l , that c r i t i c i s m was not as strong as i t now appears i t should have been. The decentralized management philosophy works well i n many areas of the bank which i s truly the r e s u l t of having good managers e v e r a l l . In the Special Industries Group, the chain of command from John Lytic through Gerald Bergman was deficient in attending to matters such as c o l l a t e r a l documentation and f b l l o w i ^ / bank p o l i c y with respect t o reporting c r e d i t s . The b i g problem here, was that there was no system in place t o uniformly assure that managers at various l e v e l s were taking the r e s p o n s i b i l i t y along with t h e i r authority. As long as everything appeared t o be going along sroothly, no one bothered to check. In f a c t , when there were signs of trouble, (bad press about Penn Square Bank and C^Q's relationship audit and operations memos discussing various operational problems with Penn Square) no one took the steps t o independently look at the s i t u a t i o n . They merely went to those i n charge of the area and ware reassured that things would be/ware OR. The bank now faces the job of rebuilding i t s image, m the present environment t h i s w i l l prove to be a,, d i f f i c u l t task. Third quarter earnings w i l l be respectable but not overly encouraging. ^tan-performing loans w i l l h i t the $2 b i l l i o n mark and the acme may s t i l l not have been reached, although any r i s e in the fourth quarter I s not expected t o be steep at t h i s time. SUBS3QUg*T SVPTTS After becoming aware of the problemi related to Perm Square, Chairman Roger Anderson asked the Board to form a Special Peview Conrittee c o n s i s t i n g of Directors Robert Melott (CBD, IMZ Corporation), Blaine J. Yarrington (rfP, Standard Oil Co. Indiana) and Chairman W i l l i s e s * 3 . Johnson (CSD, IC Industires, Inc.) to oversee reviews to be marfc by manaoem?nfr_ H%.naosrent i s beinjsy aided i n t h e i r reviews by acaountantsHand attorneys A^rom S n s t fc vcu-nnTO *& Mayer, Brow* & P i a t t , both CLEW connected to CIC, however, those "outside' individuals have not been d i r e c t l y involved with CIC i n the p a s t . Additionally, the Directors Review Committee i s advised by independent legal counsel (a retired judge) and accounting counsel (partner from Price Waterhouee i C o . ) . The f i r s t phase o f management's review i s completed and has received Board approval. This resulted in numerous personnel changes and a redistribution of r e s p o n s i b i l i t i e s among the senior s t a f f . Phase two i s in process with preliminary r e s u l t s encouraging. Loan review w i l l be completely revamped and numerous other internal control changes w i l l be i n s t i t u t e d , 106 HBCa*gNCED OJHiCLTXVC fCTZCtt Urn situation i s scr«r«, but not bsUeued c r i t i c a l . Although msnageaent i s surely tD blarm fer the shortcomings in the s y s t e m that allowed the present p z o b l e c s , th*y hawt recognized them and are taking steps to deal withtthen. htany o f the loan problem need an improved econondc environment to turn around and u n t i l that, happens, s i g n i f i c a n t reductions in problem a s s e t s cannot be e j e c t e d . Th« funding problem w i l l only go away with inprov«d earnings and a s s e t q u a l i t y , although presently i t nust be considered s t a b l e . Sam enforcement action to r e l a t e our aonoexns i s appropriate. Zt should, however, be i n l i n e with, and take note of, what they hare already done o r hav* i n s t i t u t e d . Further, I have imrie a strong bid toward g e t t i n g the bank t o be nach sore open with us. Vie should take t h i s apcortinitv to get the flow o f infbxsBtion we need s t a r t e d . Chairman S T GERMAIN. I now ask Mr. Meade and Mr. Kovarik and Mr. McCarte to introduce themselves as provided for in the outline I gave them and then to tell us whether or not Ms. Kenefick's memorandum was an accurate one from their experience. Mr. Meade. TESTIMONY OF JOHN MEADE, SENIOR NATIONAL BANK EXAMINER, OFFICE OF THE COMPTROLLER OF THE CURRENCY Mr. MEADE. Mr. Chairman, and members of the committee, my n a m e is John Meade, and I am from Northfield, IL. I am senior national bank examiner with the Office of the Comptroller of the Currency. The Office of the Comptroller of the Currency supervises the national banking system. To perform its task, the Comptroller's Office through its examination force, examines each of the more t h a n 4,500 national banks located throughout the United States. An examination may include, among other things, a review of the bank's asset quality, liquidity, earnings, and any other areas deemed necessary or appropriate. The end result of the examination is detailed in a report of examination. I joined the Comptroller's Office in 1964 as an assistant national bank examiner, and I was commissioned a national bank examiner in 1968. From 1966 to 1969, I primarily examined the foreign branches of national banks and the international departments of multinational banks. From 1970 to 1976, I examined banks of all sizes and complexity in the Chicago area. In 1977,1 was Chairman S T GERMAIN. Excuse me, Mr. Meade. Staff will try to get t h a t microphone a little better placed for you. Now, Ms. Kenefick realizes she is not the only one who has problems with the mike. Thank you. Mr. MEADE. In 1977, I was appointed Deputy Regional Administrator in Cleveland. In t h a t position—which I held for 6 years—I was responsible for surveillance and supervision of national banks in Ohio, Indiana and Kentucky. My duties included scheduling examination, monitoring and reviewing reports of examination, and initiating appropriate action to address problems in national banks. I have been in my current position as a senior national bank examiner in Chicago since August 1983, currently serving as examiner in charge of multinational banks in Chicago. Chairman S T GERMAIN. Would you tell the subcommittee what you mean by the term "multinational banks"? 107 Mr. MEADE. Multinational banks are those generally defined in the Comptroller's Office as the 10 or 11 largest national banks throughout the country. Chairman S T GERMAIN. And in Chicago there would be how many of those? Mr. MEADE. There would be two. In early 1973, I was first selected to be the examiner in charge of the examination of Continental Illinois National Bank. As examiner in charge, I was responsible for planning, organizing, directing, and controlling the examination function. I also supervised the examining personnel assigned to me, prepared the report of examination, and reviewed the results of the examination with executive management. Between 1973 and mid1976, I examined the bank five times. Since t h a t time, I have participated in the summer of 1983 examination of the bank, and I also participated in the May 1984, examination of the bank, assisting Examiner Kovarik. I have had the opportunity to review the five reports of examination that I conducted from 1973 to 1976. At this point, I would be happy to answer any questions you may have concerning Continental Illinois or the examination process. Chairman S T GERMAIN. Would you just briefly tell us, when the Comptroller's Office goes into a bank, specifically Continental Illinois, which, as you say, is one of the 10 largest banks in the country, a multinational, how many personnel do you usually have with you and for how long a period of time does an examination ordinarily take place? What is the average time span? Mr. MEADE. I think, Mr. Chairman, I will speak for the period prior to 1977, because in 1977, we changed our examination procedures, and the approach was somewhat different. So for exams prior to 1977, an examination would take approximately 2 months; we would have a number of people assigned to us that would peak at 50 or maybe 55 people and toward the end of the examination, the numbers would diminish, so t h a t at the conclusion there were 3 or 4 people assigned there. Chairman S T GERMAIN. And the frequency of examination? Mr. MEADE. At t h a t time, we were examining the bank three times every 2 years. Chairman S T GERMAIN. SO actually, the exams were about 6 months out of every 36 months? Mr. MEADE. Approximately 6 to 8 months. Chairman S T GERMAIN. Every 6 months, thank you. Mr. MEADE. Every 8 months. Chairman ST GERMAIN. Mr. Kovarik. TESTIMONY OF RICHARD KOVARIK, SENIOR NATIONAL BANK EXAMINER, OFFICE OF THE COMPTROLLER OF THE CURRENCY Mr. KOVARIK. Thank you, Mr. Chairman. My name is Richard Kovarik, I am senior national bank examiner with the Office of the Comptroller of the Currency from Naperville, IL. I have been employed by the Comptroller since 1966 with my first employment being as an assistant national bank examiner. In 108 1970, I was commissioned a national bank examiner and in 1979, I was appointed a senior national bank examiner. Chairman S T GERMAIN. Have you always been in the Chicago area? Mr. KOVARIK. Yes, sir. I have. During my 18 years with the Comptroller's Office, I have examined a number of banks, primarily in Illinois and Michigan. I have participated in all areas of the commercial examination process and most recently I have been functioning as the examiner in charge or concentrating on asset quality evaluations. Since 1977, my primary duties have involved examining Continental Illinois National Bank and the First National Bank of Chicago. As examiner in charge of those banks, it has been my responsibility to coordinate the examination team, ensure timely completion of those examinations, and, of course, write the resulting report of examination. I was first involved in the examination of Continental Illinois in the late 1960's, and, at one time or another, I have been involved in numerous facets of the commercial examination at Continental Illinois. I conducted the examination as examiner in charge of Continental in 1977, 1982, 1983, and 1984. While the principal focus of these examinations concerned asset quality, other areas such as liquidity, earnings, capital, policy and procedure, systems and internal controls, were also reviewed. Examination timeframes at the examinations I was in charge of varied from 4 to 6 months, consumed as many as 2,200 work days, and involved as many as 60 assisting examiners. I have had an opportunity to review my 1977, 1982, and 1983 reports of examination. Chairman S T GERMAIN. NOW, you were examining during the period of time Ms. Kenefick wrote her memorandum. Had you been aware of that memorandum? Mr. KOVARIK. I was not examiner in charge. Chairman S T GERMAIN. YOU were examining at that point? Mr. KOVARIK. I examined in 1982, yes. Chairman S T GERMAIN. Did you have an opportunity to review her memorandum? Mr. KOVARIK. I read her memorandum, I believe it was in either July—no, it was August or September of 1982. Chairman S T GERMAIN. And what was your reaction to her memorandum at that time, as to its value and its accuracy? Mr. KOVARIK. I think I said to myself I wish I would have known this 3 months ago. Chairman S T GERMAIN. Thank you. Mr. McCarte. TESTIMONY OF ALLAN McCARTE, FORMER NATIONAL BANK EXAMINER, OFFICE OF THE COMPTROLLER OF THE CURRENCY Mr. MCCARTE. Mr. Chairman, I am Allan McCarte, former member of the Office of the Comptroller of the Currency. I wel 109 come this opportunity to visit with you and I would like to give you some of my background when I was employed by the OCC. I joined the Comptroller's Office in 1963 as an assistant national bank examiner, and was promoted to the level of commissioned national bank examiner in 1967. From approximately 1966 through June 1981, I was involved in and responsible for a variety of assignments which included the following. I served as regional coordinator for college relations which primarily was recruitment efforts in the States of Illinois and Michigan. I also functioned as an administrative assistant in the regional office and became involved in the budgeting and monitoring of human resources as they were involved in the examination process for Chicago and the various subregions. Additionally, as part of my assignment as administrative assistant I was responsible for reviewing reports of examination at the regional level. I have also been involved in the investigative process as it relates to new bank charters as well as to branch sites of existing banks. I was one of 3 Chicago area crew chiefs with personnel responsibility for approximately 24 assisting examiners as well as the scheduling and examination responsibilities for approximately 50 banks, one of which was the Continental Illinois. During the years of 1979, 1980, and 1981, I served as examiner in charge of the Continental. The 1981 examination was commensed in early J u n e of t h a t year and employed financial data with an "as o f date of April 30, 1981. The examination was concluded in early to mid-August 1981. I was scheduled to perform the 1982 examination of the bank and had gone so far as to schedule personnel and arrange for working space and request list data when the bank approached me with an employment opportunity on J u n e 10, 1982. Chairman S T GERMAIN. The bank approached you with an employment opportunity? Mr. MCCARTE. Opportunity, yes, on J u n e 10, 1982. Once this overture was made, I removed myself from the examination to avoid a conflict of interest situation. I would mention at this juncture t h a t at the time the Continental Bank approached me I was entertaining another employment opportunity with another sizeable bank holding company outside of the seventh region. I was immediately assigned to the Chicago Office and I made the decision to join Continental in late J u n e 1982. I have had the opportunity of reviewing the 1981 examination report in some detail but have had lesser time to spend on the 1979 and 1980 reports. Chairman S T GERMAIN. Thank you. Mr. Annunzio. Mr. ANNUNZIO. I would like to ask one question. You know, we heard after Oklahoma City about the administration of the bank, and the mismanagement and all the ills that led to the problems that Continental is facing. Are any of you—Ms. Kenefick, are you in a position to tell us now t h a t all the ills are out in the open? What kind of position, in your opinion, is the bank in now? Ms. KENEFICK. Mr. Congressman, the only information I have to reach an opinion, of course, is what I have read in the press. I am 39-133 0—84 8 110 quite hopeful for Continental Bank based on the steps t h a t have been taken. I believe they are a strong bank and they still have a strong management team in place. Mr. ANNUNZIO. Thank you. Mr. Meade, you have heard my question, and you have been examining the bank. When was your last examination? Mr. MEADE. It was in 1976, sir. Mr. ANNUNZIO. The last time you were there? Mr. MEADE. 1976 was the last time I was examiner-in-charge. I assisted Examiner Kovarik in 1983, and 1984. Mr. ANNUNZIO. Can you add an answer to the question t h a t I have asked? In your opinion, what kind of situation is the bank in today? Mr. MEADE. I believe t h a t in light of some of the concerns raised by members of the committee, it wouldn't be appropriate for me to comment on this point. Mr. ANNUNZIO. Mr. Kovarik? Mr. KOVARIK. I would also submit t h a t it would not be appropriate for me to comment on the present circumstance of Continental. Mr. ANNUNZIO. Mr. McCarte? Mr. MCCARTE. Well, of course, I would be hard pressed to have an unbiased observation, but I am personally encouraged by the condition of the bank right now. Mr. ANNUNZIO. Well, Mr. McCarte, when was the last time you were in the bank to examine? Mr. MCCARTE. A S I stated, I was there for the 1981 examination. Mr. A N I W N Z I O . And, Mr. Kovarik? Mr. KOVARIK. I performed the examinations in 1982, after having done one in 1977, and also in 1983 and 1984. Mr. ANNUNZIO. And your last examination, Mr. Meade? Mr. MEADE. Was 1976. When I was in charge, yes. Mr. ANNUNZIO. When you go into these banks you have examining teams. When was the last time you were in there, Mr. Kovarik, as a member of a team? Mr. KOVARIK. We performed an examination starting in J u n e 1984. Mr. ANNUNZIO. All right, t h a t is getting close. In what condition did you find the bank in J u n e 1984? Mr. KOVARIK. Sir, I really would rather not answer t h a t question as far as the current status of the bank. I think the bank's circumstances have been highly publicized with the assistance package, the number of loans being bought by the FDIC. Mr. ANNUNZIO. We all know t h a t the bank has been reduced from a $40 billion bank to a $25 billion institution. I thought by having you gentlemen here you could give us some authentic information. But all the mistakes and the ills and the situations t h a t led to the downfall of Continental have been scrutinized closely by the regulators and certain corrections have been made and it looks like Continental will probably come out of it, and instead of being one of the large banks of $40 billion, it is going to be a good $25 billion bank. Mr. WYLIE. Would the gentleman yield on t h a t question? Mr. ANNUNZIO. Yes. Ill Mr. WYLIE. I think maybe t h a t is a question t h a t more appropriately ought to be addressed to the Comptroller of the Currency. I have visited with him about that and I think he is prepared to discuss that, Mr. Annunzio. Mr. ANNUNZIO. Well, I do wish t h a t when the regulators get here they will be able to shed some light. That is one of the reasons I felt t h a t maybe we needed more time as far as the hearings are concerned. Mr. Chairman, you can recall in Oklahoma City when we had the members of the board of that bank there and the regulators, the people in Oklahoma City felt t h a t Penn Square was not an institution t h a t should be closed. And if they were given enough time they would be able to have the necessary capitalization to keep the bank open. There was a great deal of disagreement at t h a t point as to whether the capital raised by the members of the board in Oklahoma City would be able to save the bank, and they accused the regulators of acting too hasty. I am not accusing anybody of acting hasty, but I do think the committee needs a lot more information before we can really make a judgment as to the necessary legislation and procedures we are going to follow in order to correct the situation. This committee, as I see it, is not interested in correcting anything at Continental, but we are interested in tightening up the authority of the regulators to do what they did with Continental and with other multinational corporations. My time has expired. Chairman S T GERMAIN. I assure the gentleman t h a t you will have the opportunity to ask Mr. Conover those questions and Paul Volcker. Paul wants to see you about that, too. Mr. ANNUNZIO. He called me, in fact. Chairman S T GERMAIN. I am sure he did. Mr. Wylie. Mr. WYLIE. Thank you very much. Mr. Kovarik, I was interested in your comment to the chairman a little while ago when he asked you if you had seen this Continental memorandum from Ms. Kenefick and you said t h a t you had and you made the observation t h a t you wished you had seen it 3 months ago. Chairman S T GERMAIN. Had seen it 3 months earlier. Mr. WYLIE. Three months earlier. At the time you read it you said to yourself I wish I had seen it 3 months ago. Chairman S T GERMAIN. Earlier. He said in 1982. Mr. WYLIE. I understand that, but earlier t h a n the time you saw it. What would have been your reaction if you had seen it 3 months earlier? Mr. KOVARIK. Sir, I think after reading the memo it confirmed a lot of our observations and the findings we came to as conclusions in our examination and it would have helped us to focus initially on those instead of having to start on something else and eventually getting to those conclusions. It basically recapped a number of problems t h a t we found in the midcontinent division and especially in the Penn Square loans. Mr. WYLIE. What did you do about it after you read the memorandum? Did they continue the same procedure for making loans? 112 Would you describe—maybe I should ask that of Ms. Kenefick first. Would you descirbe the procedure for making the loans? Ms. KENEFICK. Mr. Congressman, the procedure for making the loans wasn't necessarily the same for every loan. Primarily, the loan requests would come from a variety of sources, either directly from the customer or from Penn Square Bank which would make a request either by phone or by in-person visit to the bank where they would bring representatives from Penn Square Bank, and they would bring with them packages of material relating to various loans that they wanted Continental Bank to participate in. The majority of these conversations involved at some point or another Mr. Lytle, and after some discussion, a decision was made whether or not to partake in the particular credit request. The normal practice in the bank was to write up the credit request in a note sheet form and then circulate it to the appropriate people to get approval signatures on it and if those were not objective, then the loan was, in effect, approved and then input into the loan division operations system and the funds were advanced. Mr. WYLIE. What did it take to get a million dollar loan approved? Ms. KENEFICK. TO get any loan approved the way the bank system ran it took a minimum of two signatures to agree to lend the money to the customer. It was a dual authority system as opposed to a credit committee system in other banks. The individuals themselves, the necessary individuals were defined by memorandum—I can't remember the exact title, I refer to it as sort of an authorization memo, which would specify what level of credit authority was required for a $1 million loan. It may, for instance, vary not only on the amount but also on the length of the loan. Mr. WYLIE. Did anyone keep track of those loans? Ms. KENEFICK. I am sorry. I didn't understand. Mr. WYLIE. Did any one keep track of those loans once they were made? I understand now t h a t one person could authorize a loan, the second person had to approve it if it was a million or more. Did anyone keep track cumulatively, of the number of loans made? I think in your memorandum you suggest there might have been some internal control function t h a t was not there. Ms. KENEFICK. Well, the loans themselves in order to be funded had to, to my understanding, during my time at the bank, had to be entered onto the bank's internal computer system so t h a t the loans themselves were part of the bank's record. Mr. WYLIE. There was some suggestion earlier by one of the witnesses, I thought it was you, t h a t maybe the internal computer system was not all that good, that there was, in fact, some problem with keeping track of the loans, the cumulative impact or effect of the loans and was it possible for somebody to go to that computer and say there are so many loans being made to Penn Square or so many loans being made in this particular area, and then maybe make an evaluation of the impact that t h a t loan may have? Are you in a position to answer that? Ms. KENEFICK. N O , I am not. 113 Mr. WYLIE. Mr. Kovarik, when you read the memorandum what did you do about it? Did you change your procedure for examining these loans? Mr. KOVARIK. If I can clarify, Congressman, I saw the memorandum in August or September 1982 which was a full year after it was written and after Penn Square had failed. Penn Square loans had by t h a t time basically been stopped by the bank so far as any granting of credit to Penn Square borrowers. Mr. WYLIE. HOW about foreign country loans? Ms. OAKAR. Will the gentleman yield on that point just for clarity's sake? I thought the memorandum said 7-29-81: Am I correct Mr. Chairman? Chairman ST GERMAIN. YOU are correct. Ms. OAKAR. Are we talking about two different memos? Mr. KOVARIK. Perhaps I can clarify. The memo did not come to my attention until August or September 1982 during my 1982 examination. Chairman S T GERMAIN. YOU said you wished you had seen it 3 months earlier. Mr. KOVARIK. At the beginning of the examination, it would have helped me focus the examination. Chairman S T GERMAIN. YOU said it reached the same conclusions. Mr. KOVARIK. Yes, we did, but I think if I would have seen it earlier, it would have cut down the amount of work we had to do to reach those same conclusions. Chairman S T GERMAIN. What did you do about it? Mr. WYLIE. That is what I asked him. Mr. KOVARIK. There was not much I could do Chairman S T GERMAIN. YOU say the memo was a good one, right? Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. YOU say you reached the same conclusions, but it took you longer because it took a while for you to focus. Mr. KOVARIK. That is right, sir. Chairman S T GERMAIN. Then what did you do about it? Mr. KOVARIK. That was the conclusions we reached concerning the Penn Square loans, and the midcontinent division were detailed in the report of examination showing the condition of that portfolio. Chairman S T GERMAIN. DO you feel you wrote a strong enough critique at t h a t time? Did you suggest to your superiors t h a t they bring it to the attention of the board of directors and have a decision as to lack of internal controls, and sloppiness of recordkeeping? Mr. KOVARIK. That was brought out in the examination report, sir. Chairman S T GERMAIN. Did you recommend to your superiors that they bring t h a t to the attention of the board of directors and the chairman of the bank? Mr. KOVARIK. Yes, it was. Mr. WYLIE. Thank you very the direction I was headed. much, Mr. Chairman. That is exactly 114 How did you feel about what happened as a result of your recommendation? You had a strong recommendation. Were you happy with it or disappointed or did you go back at it or what? Mr. KOVARIK. I believe t h a t the bank at the time implemented almost every one of our recommendations—all t h a t I can remember. In fact, they were taking steps during the examination starting in August of 1982 to institute certain changes including the formation of a new credit risk evaluation division, they had done an internal—were working on internal review of their policies and procedures at the same time we were conducting the examination, and to my recollection every recommendation t h a t we made to them in that report or with contact with the board of directors was included and was implemented. Mr. WYLIE. Mr. McCarte, did you see the memorandum Ms. Kenefick referred to? Mr. MCCARTE. N O , sir. I did not. I can perhaps help on the timing of this. The July memorandum would have been written or typed, I think, as Ms. Kenefick said, towards the end of the examination t h a t we were conducting in 1981. At t h a t time we had identified or recognized the bank had a relationship with the Penn Square Bank and the credits that we looked at during the examination of 1981 were credits t h a t were primarily secured by standby letters of credit. This memorandum was something t h a t we had just not known about during the 1981 examination. Mr. WYLIE. DO you have an opinion as to the internal control mechanism of the bank, whether there were adequate internal controls as far as ending practices were concerned; do you have an opinion? Mr. MCCARTE. A S to adequacy of the bank's internal controls? Mr. WYLIE. Yes. Mr. MCCARTE. I would say on balance t h a t we were generally reasonably satisfied with internal controls. The internal control deficiencies t h a t we highlighted in the report in the loan area, I think, were well founded and significant and were reported as such. The other internal controls with respect to the authorization of credits as Ms. Kenefick pointed out, the bank did not have a preapproval committee, as some banks will have. They had a process where officers, depending on their grade level, would approve credits. Mr. WYLIE. What did you mean when you say we need to get our own house in order while at the same time potentially changing our procedures, Ms. Kenefick? Mr. Kovarik and Mr. McCarte think they were adequate, internal controls, functioned properly, t h a t there was a way to evaluate the loans. Ms. KENEFICK. I am trying to recall exactly where this was. Mr. WYLIE. It is on page 5, in the conclusion, it says, we need to get our own house in order first while at the same time potentially changing our procedures. This is back in 1981. Ms. KENEFICK. Yes. Congressman, this was just a summary sentence of what I felt. I was describing what were basically changes t h a t I was suggesting 115 in the way t h a t the division, the midcontinent division had been run. I felt if we were to make these changes t h a t would help us better understand where we were with respect to some of our customers. When I say, in order first, I think I was also referencing the fact t h a t we needed to also look to Penn Square Bank to improve t h e information flow to us. Mr. WYLIE. All right. My time is up, Mr. Chairman. Chairman S T GERMAIN. Mr. Barnard. Mr. BARNARD. Thank you very much. Ms. Kenefick, are you presently employed with the bank? Ms. KENEFICK. N O , I am not. Mr. BARNARD. Good. After having worked in such an important phase of the bank operations at Continental, what is your general impression of a bank exmination? Is it good? Is it thorough? Or is it just a hit-and-miss operation? Do you find t h a t it really did uncover anything t h a t was unusual? Did you all learn anything from bank examinations? Ms. KENEFICK. I am afraid, Congressman, t h a t I never was directly involved with any bank examination or read any bank examination reports. So I don't know; I don't have an opinion. Mr. BARNARD. YOU were in loan review capacity at Continental? Ms. KENEFICK. No, I wasn't. Mr. BARNARD. Didn't you review this particular credit and write a memorandum? Ms. KENEFICK. I was a vice president, commercial lending officer, in the midcontinent division for a period of under 6 months time and I worked for John Lytle. I was not in a loan review capacity. I was in a commercial lending capacity. Mr. BARNARD. A bank examiner never talked with you about credits? Ms. KENEFICK. N O , sir. Mr. BARNARD. Not one time? Ms. KENEFICK. N O , sir. Mr. BARNARD. And yet you were in a very critical place in this bank where you could appraise credits. Ms. KENEFICK. Yes. Mr. BARNARD. YOU were. Now, this memorandum Chairman S T GERMAIN. He is our banker in residence. Mr. BARNARD. N O — I really am not. Chairman S T GERMAIN. Excuse me. What I want to point out is that Mr. Barnard does have a good deal of experience in banking. Mr. BARNARD. I had some. I am about to lose it. How far did this memorandum go? Did it just go to Mr. Lytle and then reach file 13? What happened to this memorandum? Did it go into file 13, or did it go into the file of the Penn Square Bank? Ms. KENEFICK. Congressman, I can only testify to what I know with respect to the memo. I had given a copy to Mr. Lytle and I had given a copy to Mr. Rudnick. Mr. BARNARD. Who? Ms. KENEFICK. Mr. Rudnick. Mr. BARNARD. Who is he? 116 Ms. KENEFICK. Mr. Rudnick was at one time my manager in the bank, and at the time I gave him the memo, he was assistant to Mr. Baker. Mr. BARNARD. Mr. Kovarik, where did you find the memorandum? Mr. KOVARIK. Sir, it was included in some work papers t h a t the phase I committee for the bank had pulled together during their review in August 1982. Mr. BARNARD. SO it did get into the file? Mr. KOVARIK. It was in the file of that committee's work papers. Where they got it from, I have no knowledge. Mr. BARNARD. What committee? Mr. KOVARIK. The phase I review committee of the bank. Mr. BARNARD. Was t h a t under t h e jurisdiction of Mr. Lytle? Mr. KOVARIK. That committee, no, sir. That was set up by the board to investigate the occurrences that brought about the Penn Square situation. Mr. BARNARD. SO this was after the fact, 1 year later. Mr. KOVARIK. Yes, sir, it was. Mr. BARNARD. Mr. Meade, I believe you were in on the examina- tion in 1977. Mr. MEADE. Yes, sir—1976, sir. Mr. BARNARD. 1976? Mr. MEADE. Right. Mr. BARNARD. Did you have any inkling at t h a t time of the emerging problems of Penn Square? Mr. MEADE. I never heard of Penn Square until July 1982. Mr. BARNARD. Who was in the bank now in 1978, 1979, 1980, and 1981? Mr. MCCARTE. I was there in t h e years 1979, 1980, and 1981. Mr. BARNARD. Mr. McCarte, were you alerted to the problems of Penn Square in those years? Mr. MCCARTE. I had received no communication from Washington with respect to the situation. Mr. BARNARD. The office in Dallas never alerted the regional office in Chicago t h a t they were having problems with Penn Square? Mr. MCCARTE. Not to my knowledge. Mr. BARNARD. In other words, what happened here is, here we have a situation in Oklahoma where the regional Comptroller of the Currency was having meetings with the board of directors of Penn Square threatening cease and desist, and yet at no time did you know about that? Mr. MCCARTE. That is correct. Mr. BARNARD. OK. In those years, didn't you find it highly unusual that a $400 million bank in a shopping center in Oklahoma City was selling upward of $1 billion worth of loans to Continental Illinois? Mr. MCCARTE. I can speak for the period of time I was at the Continental, and when I left the bank in 1981. In completing the examination at that time, I had been advised that there were approximately $320 million to $330 million of Penn Square-related credits, and a great number of those credits were secured by standby letters of credit. 117 Furthermore, of course, standby letters of credit, in terms of a collateral position, is a rather handsome one; it is nice collateral to have. Notwithstanding the fact t h a t to a $40 billion bank, $300 million of credit is relatively small, we sent people back to look for any kind of concentrations on the banks that may have issued the standby LC's and the message came back t h a t in fact there were no significant—no concentrations. And t h a t is the extent of my knowledge with the Penn Square Bank. Chairman S T GERMAIN. He didn't answer your question. Mr. MCCARTE. Excuse me. The growth of the portfolio occurred subsequent to my departure from Continental. Mr. BARNARD. In other words, what you are saying is, between the time that you left in 1981-82 is when it moved from $300 million to $1 billion? Mr. MCCARTE. Yes, sir. Mr. BARNARD. Who was from the Comptroller's Office in the bank in between t h a t time? Mr. MCCARTE. There was no general examination conducted during that time period. What the Comptroller's staff did was to have a series of visitations, and the visitations would focus on movements of the criticized or classified total and just looked for major type of adversity. Mr. BARNARD. N O bank examination from 1981 to after Penn Square? Mr. MCCARTE. That is correct. Mr. BARNARD. And at which time they built up a portfolio of over $700 million in loans? Mr. MCCARTE. Yes, sir. S T GERMAIN. Mr. BARNARD. Yes, sir. Chairman S T GERMAIN. Chairman Would you yield to me? That should be followed up on. Mr. Kovarik, did the Dallas office ever inform you—because Mr. McCarte wouldn't know this; he left the Comptroller's Office—of the problems at Penn Square? Mr. KOVARIK. NO, sir, they did not. I did not hear of Penn Square until, I believe, prior to the week of J u n e 21, 1982, when I was notified by some of our people in Washington that, first of all, I was going to take over the Continental examination, and then additionally t h a t there were problems with Penn Square. That was the first time I had ever heard that name before. Chairman S T GERMAIN. Mr. McCarte, one more question. You are no longer with the Comptroller's Office, so maybe you can answer this objectively. Would it have helped you if the Dallas office had informed the Chicago Office of the Comptroller of the problems of Penn Square to not react from hindsight but rather have forward vision? Mr. MCCARTE. I would say yes, in retrospect. Chairman S T GERMAIN. Don't you think t h a t should have been done, because they knew t h a t these participations were being sold mainly to three or four large banks and t h a t they were becoming substantial? Don't you think they should have notified the Chicago Comptroller's office rather than keep it a secret from them? Mr. MCCARTE. I would suppose so. Chairman S T GERMAIN. Thank you. 118 I t h a n k the gentleman. Mr. BARNARD. Mr. Kovarik, I believe the staff has given you a copy of the Continental Bank examination findings. On page 11, beginning with the phrase "Our review of credits criticized * * *"—I would like to ask several questions on that. What do you mean by a " B " rated credit? And what is the problem if t h a t credit is criticized by the OCC? Mr. KOVARIK. The phrase " B " credit? Mr. BARNARD. Mr. KOVARIK. Yes. That was in Continental's rating system. They had a credit rating system t h a t ranged from A to D, A being prime quality and D being the worst quality—four gradations in their system. I am sorry; I didn't catch the rest of your question. Mr. BARNARD. That is primarily what it is. It is a rating system t h a t the bank had, and the A is the top rated, and B is second grade. Is t h a t it? Mr. KOVARIK. Yes, sir. Mr. BARNARD. And on Mr. KOVARIK. D. Mr. BARNARD. OK. down to D, E? What is a WLR, a watch loan report? Mr. KOVARIK. That is a report prepared by the account officer on a loan either rated—in Continental's situation—either rated D, where the watch loan reports were required on all loans rated D; and they were required also on some "C" rated credits. So it would be a quarterly report of the problem credit. Mr. BARNARD. In t h a t examination, there are 119 criticized credits t h a t are not on the WLRL, watch loan report list. Why was that? Mr. KOVARIK. They were not recognized as being problems. Mr. BARNARD. By whom? Mr. KOVARIK. By the bank. Mr. BARNARD. Even though the Comptroller of the Currency had brought them to their attention? Mr. KOVARIK. They eventually would have been placed on the watch loan report, but they were not on the watch loan report as of our examination date. In trying to determine whether the bank's loan review function is operating correctly, it doesn't really give them—you can't give them credit for putting something on after you have told them it is a problem. You would hope they get it there before you came in. Mr. BARNARD. Well, 8 months later, how do you review as to whether or not that credit has improved or whether it has gotten on the watch loan report? Mr. KOVARIK. Sir, you say 8 months later, how Mr. BARNARD. Yes. Don't you all keep a record of the loans t h a t you turned? Mr. KOVARIK. Yes, sir. We keep records of the loans we review at each examination. Mr. BARNARD. SO if you had a loan that is criticized and you go back in at the next examination, do you make note of the fact t h a t 119 the criticized loan t h a t you had in there has either improved or asked the bank why it was not on the watch loan report? Mr. KOVARIK. I can't remember any circumstances where we criticized a loan and then came back the next time and criticized it again when it was not on the watch loan report. Mr. BARNARD. Thank you. Chairman S T GERMAIN. M S . Oakar. Ms. OAKAR. Thank you, Mr. Chairman. As a followup, I would like to ask Mr. McCarte a few questions. If you t u r n to page 7 of the staff examination findings report and review the two quotes in the middle of t h a t page—"Our review of the credit administration * * *" and "Several credits which were rated 'B' * * *"—do you have the area I am speaking to? Mr. MCCARTE. Yes, ma'am. Ms. OAKAR. On the third quotation, what is the significance of what is said in the first and second sentences? Mr. MCCARTE. Where we said, "While it is recognized * * *"— bottom of the page there? Ms. OAKAR. Right. Mr. MCCARTE. I think t h a t the paragraph at the bottom deals with the fact t h a t the level of classified or criticized assets in the corporation was above what we consider to be acceptable or traditional standards; in other words, t h a t there was greater dollar amount of credits that we were listing as special mention, substandard doubtful, et cetera. Ms. OAKAR. In relationship to that quote, a third quote, what did you expect and want the board of directors to do in response to your statement that, "A reappraisal of the credit rating process and system is appropriate"? Mr. MCCARTE. A S Mr. Kovarik pointed out, the B credit was normally a credit we would pass, and expect to pass, t h a t credit. The observation I believe t h a t we are making at this time was one that we did pick up and classify or criticize several credits t h a t were rated a " B " t h a t were not on the watch loan reports. That is somewhat subjective in any evaluation of any credit concerned. But what we simply said was t h a t we have traditionally recognized these as sound credits from an examination and evaluation standpoint status. However, we criticized them. And the point of it is t h a t perhaps they deserve watch loan priority. That date—looks like t h a t was 1979, to my recollection—the volume of credits we were picking up as nonwatch loan credits and that we would criticize was not what we would consider to be significant. Part of the thing I think we should recognize is the fact that in a $40 billion bank, with 800 account officers worldwide, there will be differences due to timing differences and other matters. I think what we try to do is put this in perspective as to just how significant is the number of credits and dollar amount we are focusing on in terms of credits t h a t we are criticizing that perhaps have not had watch loan recognition yet. So what we simply said was t h a t we have observed t h a t we had some of these—what we were basically doing is monitoring how the watch loan system worked, how the bank's internal rating system worked. And we were simply going to monitor, during my stay as 120 examiner in charge, what was occurring, what exceptions were we picking up, and that was an exception we picked up. Ms. OAKAR. Let's look at the second quote on that page. What was meant by the last sentence: ' T h e importance of reliability of internal loan evaluation procedures as an early warning mechanism to control credit quality in a growth environment cannot be overemphasized/' Is this an example of a firm warning, or what kind of warning would you say you were trying to give them? Mr. MCCARTE. I think we all recognized, of course, the bank was going to engage in some significant growth. They had stated such in press. And we knew from the internal review that we had Ms. OAKAR. I can't hear you. Sorry. Mr. MCCARTE. I am sorry. We recognized and knew that the bank was embarking upon a growth scenario. And one of the most important things in any kind of growth environment is that the bank be fully aware and appraised of the condition of the portfolio; and since the corporate accounts were targeted for increased loan growth, we simply were reminding the bank t h a t if you are going to engage in this type of activity, it is very important t h a t you identify problems when they become problems. Ms. OAKAR. Right. So to followup this point—was the situation you found in 1979 regarding the loan ratings—rating errors, less serious than the situation you found in 1981 regarding not rating $2.4 billion worth of loans; and, if so, why were the comments to the board more firm in 1979 than in 1981? Mr. MCCARTE. The comments in the 1979 report deals with credits t h a t we rated as criticized or worse—special mention, or more adverse classification—that were not on the watch loan reports. The 1981 report focused not only on the fact that there was an increase in credits that the examiners were criticizing as special mention, substandard, doubtful and loss that were not on the watch loan report—that was part of the 1981 report. Also—and this is an area separate and distinct from the fact there were not watch loans attached to some of these. The $2.4 billion of Ms. OAKAR. $2.4 billion? Mr. MCCARTE. Billion; that is correct, right—of credit that was stale rated meant that perhaps it may have been rated by the bank's internal loan review system, but the timing of such was not within what was prescribed or what was wished by the corporate office and board of directors. Ms. OAKAR. Let me tell you my observation, based on what you said and what Mr. Kovarik said. I don't think you attempted to have any idea of the soundness of what was going on. I want to refer again to Ms. Kenefick's memo, which Mr. Kovarik says if he had received it 3 months before he wrote his report—and according to your testimony, you got it 3 months before you mentioned you received it, in August of 1982, and your report is dated November 15, 1982. Ms. Kenefick report is, if somebody listened to her, pretty devastating, and apparently the bank sat on it. 121 Is that what happened, Ms. Kenefick? Nobody really did anything about your report. Is that pretty much accurate? You talked to Mr. Rudnick, I think you mentioned. Ms. KENEFICK. I said earlier I really can't testify to what happened with the report after I left the bank. Ms. OAKAR. TO your knowledge, nobody did a thing about it; they sat on it? Ms. KENEFICK. I don't have any knowledge. Ms. OAKAR. Mr. Kovarik, how do you reconcile the differences in dates here? She wrote it a year, year and a half, before; you claim you got it almost a year to the day later, in August of 1982. You wrote your report in November. You wish you had had it 3 months before? You had it 3 months before. Mr. KOVARIK. If I could clarify that. Our examinations started, I believe, on May 24, 1984—1982, excuse me. Ms. OAKAR. Yes. Mr. KOVARIK. SO we had people in the bank since May of that year. I arrived at the bank in late J u n e of 1982. My comment of 3 months earlier was, if I would have had it from the time I got into the bank, as I said before, I could have targeted our review and avoided some of the work we did t h a t may have come to a dead end. As I say, eventually we got to the same conclusion. But if I had known what Ms. OAKAR. Your language is not devastating at all. I have read your report and I read Ms. Kenefick's language, and she talks about getting on with it quickly and the accountability. However, your report is mild; essentially it says it is still a great management team even though there are problems. That is what I read into your report. I have, Mr. Chairman, one question for Mr. McCarte. When you were preparing or reviewing the report, or any other report regarding Continental Illinois is t h a t when Continental Illinois approached you about employment? Mr. MCCARTE. N O , they did not. The timing, I think, was rather explicit. What happened was, we had left the bank in August of 1981 and the bank did not come to me until J u n e 10, 1982. Ms. OAKAR. What part of 1981 did you say? Mr. MCCARTE. A S I said, August 1981—approximately 10 months earlier. Ms. OAKAR. Did they ever approach you before that? Mr. MCCARTE. N O , they did not. Ms. OAKAR. Did you have any idea they were interested in you as an employee? Mr. MCCARTE. N O , ma'am. Chairman S T GERMAIN. Would the gentlelady yield? Ms. OAKAR. I would be happy to yield. Chairman S T GERMAIN. YOU said you were considering another employment opportunity outside the areas covered by the Comptroller's Office in Chicago. Mr. MCCARTE. Yes, sir. S T GERMAIN. Chairman where? Had you been seeking employment else- Mr. MCCARTE. N O , sir, I had not. 122 Chairman S T GERMAIN. They just came to you out of the blue? Mr. MCCARTE. Yes, sir. It is not uncommon, I think, t h a t t h a t may occur. Chairman S T GERMAIN. I know. Ms. OAKAR. I want to yield to my friend from Georgia, Mr. Chairman. Mr. BARNARD. I want to ask Mr. Kovarik a question. You say you began the examination in May 1982? Mr. KOVARIK. The examination was begun in May 1982, yes. Mr. BARNARD. And Penn Square failed in February 1982; is t h a t correct? Mr. KOVARIK. July of 1982,1 believe. Ms. OAKAR. July. Mr. BARNARD. We had our hearings Ms. OAKAR. July 5, 1982. Mr. BARNARD. But this was right in the middle of your examination, you know, t h a t all the Penn Square thing came out. You didn't take note of that? Mr. KOVARIK.. Yes, sir. From the time I entered the bank, as I say at the end of June—the week of the 21st or so was the first time I entered Continental, in 1982—I was informed by our staff in Washington, first of all, t h a t I was to do the examination; second, t h a t there were problems with Penn Square. From the time I entered the bank, I was in contact with people in Washington on a very frequent basis, two to three times a day, either gathering information at Continental to help them with the Penn Square examination or with them giving me information to check out at Continental. The period from, say, J u n e 21 to probably July 20 or 30 was a very hectic period at Continental in our examination, and it was constantly during t h a t period, I would say, I was involved almost 100 percent with Penn Square as it related to Continental. Mr. BARNARD. I know my time is expired. Chairman S T GERMAIN. GO ahead. I am being a little more liberal here, and I will use a little more of the chairman's discretion so t h a t we will have a situation where we don't drop a trend or a line of questioning, as too often happens. So I hope the Members will bear with me because they will all be the beneficiaries of it, I assure you. Mr. BARNARD. Mr. Kovarik, in your report on page 4, it says, and I will read: 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 lost. Of these, $1.2 billion were oil and gas loans with Penn Square-related classified loans. So evidently you did pick up the Penn Square situation. Now, the next is what I want you to explain to me. The causes of Continental's problems were explained by Richard Kovarik, author of the 1982 OCC Examiner's Report, in this way: 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 reflection upon management's past deci 123 sions regarding growth and the system of decentralized authority and responsibility/accountability. Chairman S T GERMAIN. What is the date of t h a t one again? Mr. BARNARD. This is on page 4. Chairman S T GERMAIN. The date of it? Mr. BARNARD. The date is September 18, 1984. That is somewhat after the horse is gone. Ms. OAKAR. If the gentleman would yield back Mr. BARNARD. A whole herd. It is the 1982 report. Ms. OAKAR. Excuse me. Mr. BARNARD. What you are saying, Mr. Kovarik, is as early as 1982—and this is 1984 t h a t the Comptroller's Office was alerted to the deficiencies or to some real criticisms in bank management Mr. KOVARIK. Yes, sir. That is from my 1982 report, which covered the period from May to November of t h a t year. It was my findings that, although a number of the credits t h a t were problems at the time were related to the economy, there were still—there were also credits t h a t were related to the systems t h a t had been in place, specifically in relation to the Penn Square loans. Mr. BARNARD. Did this generate any new activity or discussion between the Comptroller's Office and the management of Continental Illinois? Mr. KOVARIK. Yes, sir, it did. Mr. BARNARD. And what kind of discussions? Mr. KOVARIK. There were numerous discussions between myself and the board, between other—from my understanding, staff in Washington. It resulted in actions taken and recommendations made to the bank and actions taken against the bank. Mr. BARNARD. What kind of follow-through did the bank make in regards to those? Mr. KOVARIK. A S I said before, to my recollection they implemented every recommendation we made, including the establishment of a new credit evaluation division; beefing up controls; changing the approval system on loans. A number of items were covered. Chairman S T GERMAIN. That is interesting because I think we are going to have somebody in here. As you know, there were banks t h a t went in and evaluated Continental to determine whether they would like to merge with Continental, and they were not too impressed with some of the things you said were being improved upon. So we better be very cautious there. Ms. Kenefick, let me ask you this: You gave a copy of your memo to Mr. Rudnick and Mr. Lytle? Ms. KENEFICK. Yes, sir. Chairman S T GERMAIN. Anyone Ms. KENEFICK. I left a copy for else? Mr. Goy, who replaced me in my position. But he was out of town at the time, and I don't know whether he actually received it. Chairman S T GERMAIN. YOU say that—in answer to Ms. Oakar— you don't know what, if anything, was ever done as a result of your memo? Ms. KENEFICK. Well, I Chairman S T GERMAIN. Because you left shortly thereafter. 124 Ms. KENEFICK. I interpreted her question as a general, "What did the management of the bank do?" Chairman ST GERMAIN. Correct. Ms. KENEFICK. In that regard, I don't know. Chairman S T GERMAIN. Let me ask you: Once you issued the memo, you gave it to Mr. Lytle and Mr. Rudnick, and subsequently you left it for your successor. How many times did Mr. Lytle or Mr. Rudnick call you to discuss the memo that you wrote and addressed to them? Ms. KENEFICK. Well, I had one meeting with Mr. Lytle regarding the memo. Chairman S T GERMAIN. Did he indicate to you what he thought he would do as a result of the memo? What changes he would implement? Ms. KENEFICK. I don't believe at that initial meeting, but subsequent to my resignation, he did mention that he was looking to add more people to the division. Also, one of my assignments was to work on organizing the accounts to the extent I could, as suggested in the memo, by family of accounts and make recommendations of people in the division to handle those accounts. So I was aware of those two steps being followed. But my general impression from Mr. Lytle was t h a t he didn't share the same view t h a t I did with respect to that. Chairman S T GERMAIN. Let me put the question to you this way: Did you feel that many people got motivated, excited, what-haveyou, as a result of your memorandum? Or do you think t h a t the publisher turned it down? Ms. KENEFICK. Mr. Chairman, I don't believe Mr. Lytle shared the same concerns I did. Chairman S T GERMAIN. OK. Last, you left Continental shortly thereafter. Ms. KENEFICK. Yes. Chairman S T GERMAIN. HOW long after writing the memo? Ms. KENEFICK. I left there in late September. Chairman S T GERMAIN. And the memo was dated August? Ms. KENEFICK. The memo was dated July. Chairman S T GERMAIN. July. Could you tell us what the reasons were for leaving Continental? Are you at liberty to tell us that? Ms. KENEFICK. Well, I was not seeking outside employment, but an opportunity presented itself to me which I felt was a good one and provided different challenges and greater financial rewards. And I was not happy in the division t h a t I was in. I had some difficulty working with Mr. Lytle. Chairman S T GERMAIN. A S expressed in your memorandum? Ms. KENEFICK. Yes, sir. Chairman S T GERMAIN. Thank you. Mr. Leach. Mr. LEACH. Thank you, Mr. Chairman. Ms. Kenefick, you are the most reluctant martyr this committee has ever heard. Whistleblowers in Government are substantially less modest, from our experience on this committee. I would like to go to one question of procedures. You testified a minute ago t h a t two signatures—unlike in other banks t h a t often have commit 125 tees—are enough to authorize a loan. In the Penn Square hearings, we were also informed t h a t Continental had a unique system of offering bonuses to employees to bring in business; t h a t is, you get a bonus if you made a loan. Is t h a t your understanding? Ms. KENEFICK. I don't have t h a t understanding. Mr. LEACH. Second, let me just comment for those of us t h a t follow Chicago banking, from the Midwest, there was kind of a feeling a few years back t h a t the bad guy of Chicago banking was Robert Abboud of First Chicago. As I have listened to this testimony, it appears to me he is talking on almost heroic dimensions as the tough guy who says, "We don't want to follow the procedures of our main competitor." I stress this because, as I review the examination reports, as put together by our staff, there are a lot of comments about peer bank pressures and peer bank analogies. Here, let me just make a couple analogies. First of all, in the securities industry, many firms have many long names to them because they were forced to merge because they didn't get their backrooms in order. It appears t h a t Continental never got its backroom in order. There wasn't even proper accounting after fairly loose standards were used in making a loan. But let me come back to the regulators, because I think this is more regulatory t h a n a banking issue. One of the recommendations that was not made in 1982, because—I stress this because, Mr. Kovarik, you mentioned t h a t the bank met most of the regulations t h a t were made—one of the recommendations t h a t was not made was to increase the capital ratio of the bank. Here, let me stress for the committee t h a t on pages 14 through 16 of the committee staff report, and the two tables t h a t follow, is an excellent summary of the capitalization problem at Continental Bank. I would just like to briefly review one paragraph in summary of the committee report, and t h a t reads: In 1976, Continental's ratio of classified loans to gross capital funds had reached 121 percent. Its ratio of total assets to total capital was 21 percent. Then further on, it says: In the staff interview, Examiner Meade estimated t h a t Continental was between 60 and 70 percent dependent on purchased funds. In comparison, in 1982, the classified loan to gross capital ratio had risen to 172 percent, the degree of asset to capital leverage had risen to 25 percent, and dependence on purchased money was up to 80 percent. But, In 1976, Continental's capital was rated a clear and emphatic "Inadequate." In 1982, the examiners concluded t h a t the capital base of Continental Is presently considered adequate. However, the examiners also noted t h a t an inordinate level of classified assets and loss of confidence by the financial community lent definite reservations to this assessment. The point I would stress is if one is looking for a public rather than private sector bailout of institutions in difficulty, the easy way is to force the institutions to raise more private sector capital. 39-133 0—84 9 126 One of the questions I would just ask is—first of Mr. Meade— Why did you determine in 1976 t h a t t h e bank's capital was inadequate; what happened after t h a t assessment; and why in 1982, in a much deteriorated bank situation was the capital base rated as adequate? Do you think that, first, your report in 1976 made any difference at all? Second, t h a t the 1982 assessment of adequacy was valid? Mr. MEADE. I will speak to t h e 1976 examination, and I will let one of my colleagues speak to the subsequent examinations. In 1976, the classified assets—that is, those assets which were rated substandard, doubtful, and loss—aggregated 121 percent of the bank's gross capital funds. Looking beyond those numbers, I believe there was about $375 million in the doubtful category; t h a t is, those assets which collection in full is highly problematical, $375 million amounted to roughly 35 percent of the bank's capital funds. The 121 percent of capital—the classified assets of 121 percent of capital was the highest I had ever seen up until t h a t time. I will have to point out t h a t t h e bulk of those classified were centered in real estate credits, and this was during the period of high interest rates. The problems in the real estate sector were widely known and experienced by most of t h e multinational banks. Chairman S T GERMAIN. Are you talking about the realty income trusts? Mr. MEADE. Right; t h e REIT's. Chairman S T GERMAIN. Weren't those part of the holding company rather t h a n of the bank? Mr. MEADE. There were loans in t h e bank—the holding company had sponsored a REIT, but t h a t was not the problem. It was loans to REIT's not related to Continental. Chairman S T GERMAIN. Could the gentleman yield for half a second? Mr. LEACH. Of course, of course. Chairman S T GERMAIN. The fact is, t h e bank had lent to t h e holding company REIT. The subsidiary or affiliate—there was a subsidy of the holding company that was an REIT; correct? Mr. MEADE. Right. Chairman S T GERMAIN. And Continental Bank had lent substantial sums to that REIT? Mr. MEADE. That was not the problem, as I understand it. Chairman S T GERMAIN. Had t h a t occurred? Mr. MEADE. It may have occurred, but the primary problem was t h a t it lent—REIT's which had no affiliation with Continental Bank whatsoever. Chairman S T GERMAIN. OK. Mr. MEADE. They were located in New York, Florida, and California. Chairman S T GERMAIN. Thank you. I t h a n k t h e gentleman for yielding. Mr. LEACH. Mr. Kovarik Mr. MEADE. Did I respond to your question? Mr. LEACH. YOU did, to my satisfaction. Why did you conclude t h a t t h e capital was adequate? Wasn't it in better shape than in 1976, Mr. Kovarik? 127 Mr. KOVARIK. The capital increased through retention of earnings, primarily. Mr. LEACH. But not on percentage basis? Mr. KOVARIK. I believe in 1982 the primary capital was well above what it had been in the past. I believe at the time it was in excess of its peer group. The classified assets were very heavy, as I pointed out. Chairman S T GERMAIN. Excuse me. I have to interrupt again. You say in excess of its peer group. If you say that, you will have to discuss the peer group and how adequate t h a t was. Because the Comptroller's Office insisted they improved; right? Mr. KOVARIK. Yes, sir. When I speak of peer group, I speak of multinational banks t h a t we supervise. The classified assets, as I pointed out, were extremely high at t h a t time. But the majority of the doubtful and loss classifications were related to the Penn Square. It was at t h a t point in time Penn Square was, to me, a very isolated portion of the bank. We had criticized, I believe, 80 percent of the loans t h a t they had purchased from Penn Square, in one way or another. Mr. LEACH. Let me just ask another question in t h a t light. How many banks t h a t you have ever examined had 80 percent of their assets dependent upon basically short term large sums of money from other banks or other large institutions? Mr. KOVARIK. I think this is the only one that was 80 percent. Mr. LEACH. The reason I stress that is because it is a warning sign. As anyone who studied economics 101 or beginning theories of banking knows the money supply can grow as banks make loans; and, at the same time, banks can grow if they can find someone to lend to. So t h a t if you have a situation in which banks willy-nilly take on a lot of loans, they will grow a lot. In the 5 years prior to your examination, Continental had grown at almost double the rate of all other banks in the country on the average; and at the same time, Continental had come to be very dependent on shortterm funds. Isn't this situation a warning sign to look at the bank capital adequacy? Mr. KOVARIK. We look at the liquidity of the bank or its ability to fund itself through these short-term markets. First of all, you have to look at it historically. Have they been able to do it? Have they met resistance in the markets? Up to July 1982, with the failure of Penn Square, they had not met resistance in those markets. During the examination, the stability of t h a t funding had come back to a certain extent from what it was immediately after the failure of Penn Square. During July and August, the funding situation was much more critical than it was in September and October and November by the time we had completed our examination, which I think showed to me t h a t the bank had taken steps, gone out into the markets, told their story, and gotten back some of t h a t confidence t h a t they had lost immediately after the failure of Penn Square. Mr. WYLIE. Would the gentleman yield? Mr. LEACH. Yes; of course I will yield. 128 Mr. WYLIE. HOW much confidence do you put in internal controls when you make your examinations? Mr. KOVARIK. How much confidence? Mr. WYLIE. Yes. Mr. KOVARIK. Quite a bit. Mr. WYLIE. Quite a bit. Yes; OK. So if the internal controls were bad enough, then you really don't know where you stand. Mr. KOVARIK. If they are t h a t bad, yes, you wouldn't know where you stood. However, if during an examination or before an examination when we plan it the internal controls are not sufficient, we expand our examination procedures to cover areas where we felt t h a t internal controls were not adequate. Mr. WYLIE. What kind of red flag do you have t h a t internal controls might not be up to standard so t h a t you could place confidence in them? I am not trying to put you on the spot here, but I go back again to my question a little while ago when Ms. Kenefick thought maybe internal controls weren't as good as they should be. And you say, "I wish I had known t h a t 3 months before," and so forth. You really didn't answer my question as to what you might have done about that. Maybe you can answer it. But I am trying to find out now how you can go about ascertaining whether the internal controls are adequate, whether the loans and functions the bank is engaging in are properly evaluated by someone. Mr. KOVARIK. Initially in an examination we would review the internal controls to see what controls were said to be in place. And then during the examination we will check to make sure t h a t they were in fact working. And depending on the area of the bank, we would use audit reports made by internal or external auditors; we would do our own checking as far as testing transactions. The internal control exceptions t h a t Ms. Kenefick brought up, and the ones we were most concerned with at the conclusion of our examination, were the controls that—if I can say—were misutilized in identifying problem loans. Mr. WYLIE. Misutilized by whom? Mr. KOVARIK. By the lending officers who were there to review certain information that, if it would have been reviewed and acted upon, would have said there is a problem in the midcontinent oil division. There were reports of collateral exceptions, reports of nonrated loans, loans t h a t had not even come to the committee for rating over a period of months, which to my recollection at least 50 percent—and I think at times in excess of 65 percent—of all exceptions for the whole bank related to the midcontinent division. Mr. WYLIE. SO the bottom line of all t h a t is t h a t it was just bad judgment on the part of some of the lending officers and some officers of the bank t h a t caused the problem. Mr. KOVARIK. A S far as the exceptions I think it is the people who were responsible for reviewing and ensuring t h a t those exceptions were cleared or t h a t if they couldn't be cleared, find out why and put a stop to it. That wasn't being done. Mr. WYLIE. Thank you. Thank you, Mr. Leach, for yielding. 129 Mr. LEACH. Let me ask one other thing in terms of warning flags. Continental was unique in comparison with other money center banks in t h a t it didn't put as high percentage of its lending abroad but it did put a very high percentage of lending in areas outside its normal areas of jurisdiction, whether they be in Oklahoma for one type of oil lending or Florida for other types of real estate. Was this unusual to you and was this something t h a t was cause for alarm? Mr. KOVARIK. Obviously the Oklahoma section caused me alarm. Mr. LEACH. Surely. Mr. KOVARIK. A S far as the others, I didn't view it as being out of the ordinary to have lending relationships throughout the country. Most banks that I am familiar with—and I include banks t h a t I have either read about or talked about with other examiners from different parts of the country—have offices throughout the country such as Continental did. Mr. LEACH. Let me just conclude, Mr. Chairman, with the observation t h a t while the examiners are largely responsible for the financial well-being of the bank and protecting depositors' money in terms of mandate, but they also have indirect responsibility for money supply growth and the allocation of credit. You are going to have more economic growth in areas where loans are made than not. When you have one type of bank get out front with one type of lending and then be, in effect, protected implicitly by the U.S. Government, we have a serious problem on our hands. One way to approach this problem is to stress capital adequacy as a means of providing evenness in the system. As I look at Continental's capital adequacy, first in comparison with its peer group it comes out less well than otherwise; but secondly, when you compare capital adequacy to problems with the loan portfolio it seems that in 1982, there was reason for a redder flag to be hoisted than was the case. I don't want to criticize one particular examination of the bank in comparison with all others, but I would stress t h a t I think the examiners of all national banks are going to have to apply a little more rigid standards t h a n has been the case. Thank you, Mr. Chairman. Chairman S T GERMAIN. Mr. Kovarik, what did you say about the capital adequacy of Continental in response to Mr. Leach's earlier question relating to its peer group? Mr. KOVARIK. I believe it was comparable and at times exceeded its peer group during t h a t time from 1976 or 1977 through 1982. Chairman S T GERMAIN. I would direct your attention to the chart on the board over there, to your left. You see t h a t first chart, "Capital Adequacy?" Mr. KOVARIK. Yes, sir. S T GERMAIN. YOU see the red Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. That red line is Mr. KOVARIK. Yes, sir. Chairman line? Continental Illinois. 130 Chairman S T GERMAIN. The white line, you know, the up above part t h a t starts between 5.6 and 6, t h a t is 1976, t h a t is the peer group. So where did you see it exceeding the peer group? Mr. KOVARIK. I am sorry, sir; I do not know. Is your peer group the multinational banks? Chairman S T GERMAIN. Yes. That chart was prepared by GAO. Mr. KOVARIK. That chart is not similar to the ones I have seen comparing continental with its peers. Chairman S T GERMAIN. The Comptroller's Office has to get new chart preparers, is t h a t it? Mr. KOVARIK. I am not sure, sir. Chairman S T GERMAIN. NOW, one more and I will go to Mr. Vento. It was noted t h a t the bank was troubled by an outmoded computer system and the bank had commenced a system of design review in 1977. Did you ever criticize the bank's computer system for being inadequate, Mr. Meade, Mr. Kovarik, Mr. McCarte? Now, we are talking about the computer system with respect to loan operations as being inadequate. Lytle was not alone in his perception t h a t the loan operations exceptions reports contained errors. The bank's management generally recognized t h a t loan operations were troubled by an outmoded computer system. Did any of you in your reports ever criticize their computer system for being outmoded? Mr. MEADE. Mr. Chairman, in some of the examinations t h a t I conducted, it was commented on t h a t reports generated by the system were generally not accepted by the people on the line. Chairman S T GERMAIN. Did you point out the fact t h a t the system was outmoded and therefore just couldn't do the job? Mr. MEADE. I am not aware t h a t it was outmoded. Chairman S T GERMAIN. What I am quoting from now is the report of the loan—report of the special litigation committee of the board of directors of Continental Illinois Corp., dated J a n u a r y 7February 8, 1983. But they did a total review and found t h a t back then the computer system was outmoded and just couldn't keep up on installment loans. If it was over, what, 9,999,999.99, they had to split it down because the system couldn't take it. Mr. Kovarik, did you ever criticize the computer system as being outmoded? Mr. KOVARIK. N O , sir. Chairman ST GERMAIN. Mr. McCarte? Mr. MCCARTE. N O , sir. Chairman S T GERMAIN. Thank you. Mr. Vento. Mr. VENTO. Thank you, Mr. Chairman. Let me just ask a general question to the examiners, those chief examiners t h a t are here. When you have a bank t h a t is in an obviously aggressive growth mode as Continental Illinois National Bank pursued, that is knowledge on the part of the examiners, you recognize t h a t particular type of strategy, I assume. Does t h a t type of institution receive any additional attention because of the tremendous number of decisions t h a t are being condensed within any given time? Can any of you comment on that? Mr. McCarte? 131 Mr. MCCARTE. The field examiner as a result of that, I think if you read the reports t h a t we prepared during 1979, 1980, and 1981, observed t h a t t h a t was in fact about to occur. We thought it would occur. As a result, we spent additional time in the actual reviewing of specific credit. Mr. VENTO. SO in other words, you make an analysis of their ability to make credit judgments and the loans they are taking and placing and the type of analogies of the type of deposits they are securing? Mr. MCCARTE. That is correct. Mr. VENTO. In other words, you did give this extra attention. Is that accurate? Mr. MCCARTE. We spent a lot of time during those examinations concentrating on determining the quality of the portfolios and what type of credits were being booked during this growth period. Mr. VENTO. Mr. Kovarik, you agree with that, t h a t a fast-growing institution of this size t h a t is trying to grow is receiving more attention? Mr. KOVARIK. Yes, sir. Mr. VENTO. I assume, Mr. Mr. MEADE. Yes. Mr. VENTO. IS the size of Meade, you agree with that as well? this bank, did that represent special problems, Mr. McCarte? Mr. MCCARTE. Well Mr. VENTO. The size of this financial institution? Mr. MCCARTE. Everything is relative, of course, but I would say t h a t a larger bank requires a greater staffing consideration on our part, but also just putting an entire report together on a larger bank is more difficult t h a n a smaller bank. But in terms of that bank in relation to other banks that I am familiar with it was not any more difficult t h a n other banks. Mr. VENTO. One of the criteria—and I refer you to page 9 of the staff examiner's findings, Mr. McCarte—I would like you to review the first quotation on page 10 of the staff examiner's finding report. It begins, "Review of those internal reports." The first comment is what is the significance of the increase in volume of old credits to $2.4 billion in 1981 from $1.6 billion in 1980? Mr. MCCARTE. What is the significance of that? Mr. VENTO. Yes. Mr. MCCARTE. The significance of t h a t is t h a t the amount of credit exceptions which is, of course, different t h a n a credit problem, has increased. The loan review function had not been able to keep up with the volume of work or, as it was stated earlier in the report or elsewhere in this report, that the line managers had not submitted the appropriate information to loan review to allow them the rating process. The combination of reasons I am sure. Mr. VENTO. It is pretty significant. The bank had not grown by that much. In other words, you have an increase here of almost 50 percent. Mr. MCCARTE. That is correct. Mr. VENTO. YOU know, of the exceptions, in just a single year. Mr. MCCARTE. Yes. I would hasten to point out, of course, t h a t in banking terms and in how examiners view credits there is a significant difference in a credit problem, for example a substandard, 132 doubtful or special mention or loss. But what we pointed out is the amount of exceptions increased dramatically and we were concerned about it and this was part of the rationale Mr. VENTO. One of the statements following is itself evidence no one is monitoring the situation to assure t h a t all credits are receiving timely reviewed as required by the corporate office. So they have this requirement and nobody is doing anything about it. Then you go on, you have the statement in your letter to Continental's board of directors, we find it, the internal rating system, to be functioning well and accurately reporting the more severely rated advances to the board and senior management. In one case you are saying one thing, Mr. McCarte, in the other case it seems to me that there is a problem, you know. It seems you are pursuing serious problems, but you write to the board of directors and you seem to have backed off. What is the reluctance on the part of an examiner to share the unvarnished t r u t h with the board? Mr. MCCARTE. I am glad you bring t h a t up. Let me take a few minutes and expand on that. The $2.4 billion credit exceptions were, in fact, credits t h a t deserved to be rated and it was the wishes of the corporate office t h a t in fact it be done on a timely basis, but it was not being accomplished. As a testing against whether these in fact were credit problems versus credit exceptions, we, in fact, had reviewed approximately 60 to 70 percent of the volume of credit outstanding at the Continental Bank which in terms of what most examiners would do is significantly above what you might expect in a money center bank. And as a result of the testing t h a t we did, the sampling we had done as well as looking at the large credits and scope of the review we had performed in the last several exams, which was to look at credits of $10 million and over, all C and D rated credits, past dues and nonperforming, we also did the sample, sampled credits above the $500,000 threshold where the bank internally rates credits and those below $500,000 looking for exceptions. The results of our sampling reveal that the quality of the assets had not deteriorated other t h a n the credits we had listed in the report and as you will find in t h a t 1981 report we stated t h a t the total criticized had risen to approximately 99 percent of the bank's gross capital funds, a reversal of what had occurred in the past. That statistic, t h a t number was generated from the review by examiners in the various divisions, so in fact while we are talking about a credit exception problem, we are also going through the exercise of testing t h a t and in terms of the comment we made about the internal rating system as functioning, t h a t deals specifically with was the bank being apprised of credits t h a t were troublesome; t h a t is, credit problems. We did not find enough instances other t h a n the ones cited earlier in the report. Mr. VENTO. The point is t h a t these exceptions, you say you are doing testing. I don't know what t h a t means. You are not testing all of the exceptions? In other words, when you say you are testing that, almost by definition t h a t says I am sampling some of these to see what the quality is. But you are not doing all $2.4 billion worth, is t h a t accurate? 133 Mr. MCCARTE. We did not do—I would have to have the work papers, but I am sure we did not look at all the $2.4 billion. But I am confident that a number of the credits came up in the sample. Mr. VENTO. YOU are saying they were selected randomly and you were doing a sample. Mr. MCCARTE. A statistical sample was performed, done in accordance with the guidelines. Mr. VENTO. YOU know, the thing is that that—if that were all by itself and you said the exceptions and that, but if you look at it in relation to some other things like liquidity position of the bank, then I think that problems began to arise. Total loans, income to total assets, is a measure of an institution's liquidity. An analysis of the multinational and regional data reveals that the Continental loans continued to increase and became far and away its major source of assets. During the period of 1976 to 1983, the bank's ratio rose significantly from an average of 58 percent in 1976 to 62 percent in 1979 to 71.6 percent in 1981 to 1983, placing it really in a very poor liquidity position with all these exceptions with regards to its loan portfolio and, of course, forced it very often then into a volatile market to raise these funds. Wasn't that a further warning sign, even compared with its peer group? Its peer group, analysis of both the multinational regional data revealed t h a t the Continental ratio was extremely poor during 1976 to 1983 averaging a minus 45.97 percent, or at least 21 percentage points below its peers in terms of t h a t status. Didn't you point these problems out to the bank? Didn't you address that in any way, especially in light of the fact that you have all this undocumented loans coming in with this weak liquidity position represented by it? Mr. MCCARTE. YOU were reading from some areas I am afraid I couldn't follow you on, where you were coming from. But in terms did we criticize the bank's liquidity, if that is your question Mr. VENTO. Yes. Mr. MCCARTE [continuing]. I think the answer is we did not criticize it. We recognized the fact t h a t the bank had a greater dependence on purchase funds but by the same token so did a number of the peer groups, as was pointed out. With respect to anything beyond that I am afraid I would have to Mr. VENTO. Well, if the peer groups are at some value of 20-some points difference in terms of percentages in terms of what they are raising, an analysis of both the multinational regional data reveals that Continental's ratio was extremely poor during 1976 to 1983 averaging a minus 46 percent or 21 percent below its peers in terms of liquid assets, minus volatile liabilities to total assets. In other words, you are familiar with t h a t term, aren't you? That particular definition is one t h a t I don't work with day in and day out, but it is one, Mr. McCarte, that the examiner must. I guess not. Mr. MCCARTE. I think we understand what liquidity means, yes, sir. Mr. VENTO. Can you share with us, during your period of examination, the amount of foreign bank deposits versus domestic correspondent bank activity? Can you tell us what the volume of corre 134 spondent or foreign bank deposits were at that time in 1981 when you last did the examination, Mr. McCarte? Mr. MCCARTE. I don't have those statistics with me. I would have to defer on that question. Mr. VENTO. Can you provide us with insights into the amount of foreign bank/correspondent deposits with this institution, Mr. Kovarik, during the period t h a t you provided examination work? Mr. KOVARIK. I don't have anything specific on correspondent/ foreign bank deposits. Their relationships to foreign funds did increase after July of 1982, I believe at one point it reached about 50 percent of their total purchased funds. Mr. VENTO. Fifty percent. And of course we all are aware of the fact t h a t they were raising money on a daily basis, but t h a t of course—I am asking about the deposits t h a t were present there and about the correspondent banking relationship. When you began to examine this, how do you treat this as the holding company? Are you just looking at the bank side or at all the other assets, Mr. Kovarik, and all activities in terms of the holding company? How is that relationship worked to the bank examination t h a t you provided? Mr. KOVARIK. We examine the bank, the Federal Reserve Board examines the holding company and holding company subsidiaries. We do work together during the examination and would share our information as far as the quality of the bank, our view to the Federal Reserve, and they supply us with information as far as the quality of the assets and the operations of the holding company and its holding company subsidiaries. Mr. VENTO. What type of communication during the periods t h a t you are doing the examination with the holding company did you receive from the Federal Reserve Board with regards to the holding company? Mr. KOVARIK. The Federal Reserve examiners were in Continental during our examinations. The examinations were conducted as of the same dates although the Federal Reserve examiners in Continental's case were not there as long as we were. Because my recollection is t h a t the holding company and its subsidiaries accounted for 5 or so percent of the total assets of the corporation whereas the bank was 95 or 96 percent of the total assets. Mr. VENTO. Mr. Kovarik, you heard my question of Mr. McCarte, with respect to the liqudity of the bank. Do you have any comments with respect to the significant difference between the liquidity of Continental Illinois and its peers? The ratios, the assets? Mr. KOVARIK. I believe t h a t they historically had been higher t h a n their peers. One of the reasons was t h a t they were—they are located in Illinois whereas a number of their peers are located in States t h a t have the ability to branch and to garner retail deposits throughout a greater location than Continental did. I think if you look at the two multinationals t h a t we have in Chicago their percentage of purchased funds is higher than those banks in California of relatively the same size. Mr. VENTO. YOU think t h a t is the major reason, is the inability to branch t h a t causes their funding Mr. KOVARIK. Yes, and the fact t h a t Continental is a wholesale bank, not concentrating on consumer relationships. If I was a con 135 sumer, I wouldn't put my deposit—you know, if it wasn't convenient for me and if I wasn't assured of getting a loan from that bank when I needed it. Mr. VENTO. In your statement in terms of the record, I forget the date, but you point out that less than 20 percent of the deposits of Continental Illinois were in Penn Square. I guess that was what you were saying. What was the exact percentage? Mr. KOVARIK. I don't understand the question. I don't recall saying anything about deposits in Penn Square. Mr. VENTO. Let us see then, the statement—it says although the Penn Square relationship accounts for a relatively small proportion of the problem loans, less than 30 percent, the publicity surrounding its closing is surely the one event t h a t has done the most damage. In other words, in that case you are talking about what? You are talking about Continental Illinois National Bank having a small portion of the problem loans, or who are you talking about? Mr. KOVARIK. N O , sir. I believe t h a t is talking about the total criticized assets at Continental in my 1982 examination, and that the Penn Square participations accounted for 20 percent of criticized assets. Mr. VENTO. Were they 20 percent or less than 20 percent? Mr. KOVARIK. They were approximately $820 million. Mr. VENTO. In other words, $820 million—in multiplying that out, t h a t indicates there are $4 billion worth of problem loans in 1982. Is that right? Mr. KOVARIK. There were $5.6 billion—according to your page 17, there were $5.6 billion of criticized assets at t h a t examination, so the $820 million would have been less t h a n 20 percent—16 or 17 percent. Mr. VENTO. It shows there were a lot of problems here. It was just not an isolated situation. Mr. KOVARIK. That is right. As I pointed out earlier, though, at that point Penn Square did account for the majority of those doubtful assets and the losses at that examination. Those two categories are the most severe. Mr. VENTO. There is a reluctance on the part of the bank, any bank, to write off any type of bad loan at any time, isn't there? In other words, it is your job to begin to ferret our whether or not some of these loans are collectible. Ultimately, if you go back and look at those loans, the question arises in my mind that it seems like today, after not putting out any more loans, they ended up with 4.5 billion dollars' worth. So these loans looked to me like they are the ones t h a t resulted in the bulk of the $4.5 billion in loans t h a t have been declared as bad loans right now. Is t h a t accurate or not? Mr. KOVARIK. I don't know which $4.5 billion you are referrng to. Mr. VENTO. I mean t h a t there are some assets in the bank right now, today, trying to make a relationship now between what occurs today and what you discovered at that time. They had $5 billion worth of problem loans at that time. Mr. KOVARIK. Yes, sir. Mr. VENTO. Thank you, Mr. Chairman. 136 Chairman ST GERMAIN. Mr. Kovarik and Mr. McCarte, you were scheduled to do the 1982 examination, is that correct? Mr. MCCARTE. That is correct. Chairman S T GERMAIN. Then on what date did you state that you would not do it because you were under consideration by Continental? Mr. MCCARTE. I believe I said I was approached on J u n e 10 and it was a Thursday, and on Friday was a day off for the examiners, I was not in the bank. Just to clear this up, we discussed it with my wife over the weekend and on Monday, the first thing I called Washington to advise them t h a t I had been approached, and at t h a t time I left the bank and joined the regional office. Chairman S T GERMAIN. Mr. Kovarik, you then were given the responsibility for that particular examination, is that right? Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. On what date did you receive t h a t responsibility? Mr. KOVARIK. I entered the bank on J u n e 21 and I think I was notified either Thursday or Friday the week before. Chairman S T GERMAIN. When were you told by the Washington office of the problems at Penn Square? Mr. KOVARIK. I think the name Penn Square came up when I received a call to tell me I was to go to the bank. But it was just—we have got some problems with Penn Square—is my first recollection. It was the following week, the week of J u n e 21, before I got any information about Penn Square. Chairman S T GERMAIN. What type of information did you get? Mr. KOVARIK. What was going on during the examination down there as far as losses at Penn Square, the amount of loans t h a t Continental had purchased from Penn Square, information like that. It had expanded over the next 2 weeks I would say, 3 weeks. Chairman S T GERMAIN. Mr. McCarte, prior to your decision not to conduct that examination were you advised by the Comptroller's Office as to what was occurring at Penn Square? Mr. MCCARTE. NO, sir. Chairman ST GERMAIN. Mr. Schumer. Mr. SCHUMER. Thank you, Mr. Chairman. And my first question is directed at Mr. McCarte. If you would, t u r n to page 10 of the examination findings. The last couple of sentences in the first paragraph you state that no significant problems are evident as noted by the fact t h a t only two oil and gas credits were classified herein. What do you mean by the phrase "no significant"—what you are saying is no significant problems are evident in oil and gas loans. What do you mean by that? Mr. MCCARTE. Well, it means t h a t if we had found a large number of credits t h a t were—that we were reading as special mention or substandard, doubtful and loss, and it was large in relation to the portfolio, we would have considered it to be perhaps a problem. And the observation was t h a t only two credits were cited. One of them was a significant doubtful credit, I believe. Mr. SCHUMER. The basic question is this: You with your team of auditors, probably very experienced auditors, crack auditors, are here in the bank examining the oil and gas loans at the very same time t h a t Ms. Kenefick is issuing her report, and her report is a 137 devastating document and at the same time you are stating no significant problems are evident as noted in the oil and gas area. How did that happen? Mr. MCCARTE. I can't speak to—we obviously did not have Ms. Kenefick's memo during the examination. Mr. SCHUMER. I am not asking did you have her memo. You had her oil and gas loans. That was one of your jurisdictions. Mr. MCCARTE. That is right. The amount of credit t h a t Oklahoma City had generated at t h a t time was in the neighborhood of $300 million, which in a $40 billion bank is relatively insignificant. However, as I said before, we did send examiners back to establish what type of credits they were. The answer came back was they were primarily credits secured by standby letters of credit and that type of collateral is rather good. Mr. SCHUMER. All the things she catalogs in her report, all the many things, do those just completely escape the eyes of auditors? Mr. MCCARTE. I have not read Ms. Kenefick's memo in its entirety. I have not read it at all as a matter of fact. It came to me this morning. Mr. SCHUMER. What she is basically saying is there are hardly even documents for any of the loans. If you are going to take a sample of loans you are not going to find undocumented loans as part of the sample. Mr. MCCARTE. Perhaps we can explain the methodology of how we examine a bank. What happens is during the examination, as Dick Kovarik points out, the examiners will test the internal controls. The examination procedures employed in the large banks allow for the review of the external auditor's report, we try and determine their adequacy and competency. We do the same with the bank's internal audit report. The rationalization is t h a t examiners will not redo good work that has already been done. As a result of the internal control questionnaires that we were using at the front end of the examination, we established that the bank through its internal devices, the bank's internal auditing department, the operation of the bank, had tested and found no significant problems. What we do is review the reports of the auditors and from t h a t basis we make a determination as to how far we are going to go. During the sampling technique t h a t we would employ once we have established up front t h a t the internal controls seem to be adequate. Mr. SCHUMER. Excuse me Mr. MCCARTE. And from Mr. SCHUMER. YOU are past the point I want to be and I don't want to take up the committee's time on that. Mr. MCCARTE. Mr. SCHUMER. OK. Her report makes obvious that the internal auditing mechanism in the bank was atrocious. Mr. MCCARTE. Her report seems to be also dealing with 300 million dollars' worth of credit, And I can't explain anything beyond that, sir. Mr. SCHUMER. I don't understand. You are saying if it was $3 billion you would have caught it? Mr. MCCARTE. If it was $3 billion, I would presume it to be—— 138 Mr. SCHUMER. Most of the bad loans are undocumented is what she said. A lot of them were not there. Would you catch them? Mr. MCCARTE. Yes, I think so. Mr. SCHUMER. Why? You couldn't pick them from the sample? Mr. MCCARTE. The sample did not. Neither the condition of the banks internal controls nor the documentation of the credits would have any bearing on whether they were selected in a sample. The OCC sampled from outstandings and if the loans were booked on the loan system they had the potential of beings selected. Additionally it should be noted t h a t both the number and dollar amount of Penn Square credits was small at April 30, 1981, thus reducing even the potential for selection. Mr. SCHUMER. YOU approved the internal auditing? Mr. MCCARTE. That is right. Mr. SCHUMER. And it is clear it was junky? Mr. MCCARTE. If I can be allowed to finish, I think what we established is the bank's internal devices had done some testing in these specific areas and if they are coming up relatively clean and if we can't challenge the independence and competency of a bank's internal audit department as well as external auditors in the bank, the guidelines require us to go no further, state we should go no further. At the beginning of an examination we visit with the bank's internal audit department and attempt to gauge their independence and competency. If the scope and frequency of their work is acceptable we would shift our emphasis from operational and audit concerns to credit quality matters. Also during the early stages of an examination the competency and independence of the external auditors is also evaluated. It is my recollection t h a t during the 1981 examinaiton there was no grounds for concern from either of these sectors. As such our guidelines would not require us to delve deeply into operational matters. Mr. SCHUMER. Then t h a t leads to my next question. But before I get to t h a t next question which I would like to ask you, Mr. McCarte, I want to say, and I can't speak for the committee, t h a t I think Ms. Kenefick is the good guy in this operation. She is the good gal—excuse me, Ms. Kenefick—and she is here, but I imagine she has to pay a lawyer and all the expenses. It is not going to do you much good, but my apologies. I sympathize with your situation. You did the right thing and you are still in the soup somehow or other. Ms. KENEFICK. Thank you. Mr. SCHUMER. What went wrong, Mr. McCarte? If you were sitting in my chair, what the heck went wrong? Something very badly went wrong. What went wrong? Well, did nothing go wrong? Mr. MCCARTE. Obviously the results of the examinations and what was published Mr. SCHUMER. What went wrong? Mr. MCCARTE. I am afraid I can't give you a very thorough or complete an explanation. Mr. SCHUMER. I am asking you, you have had 22 years' experience both as an officer of Continental Illinois and before t h a t as an auditor. You have to give me some answer—I am asking for your help. 139 Mr. MCCARTE. I would suggest that perhaps it is a combination of factors. In 1981 the Continental Bank seemed to embark upon an agreement with or a relationship with the Penn Square National Bank. The credits t h a t were purchased from that institution I think translated to approximately $1.1 billion. In retrospect, those credits were not very good with very sizable losses and doubtful classifications eventually being rendered on those credits. Also, at that time in late 1981, early 1982, the energy sector began Mr. SCHUMER. Excuse me, Mr. McCarte, I wasn't clear in my question. I don't want to know what went wrong in the energy sector, I want to know what went wrong with the auditing procedures other t h a n t h a t what Ms. Kenefick was able to find out was oblivious to everybody contemporaneously and later? Mr. MCCARTE. I am afraid I can't answer t h a t question. Mr. SCHUMER. YOU can't answer? Mr. MCCARTE. I think what we did was totally appropriate, given the circumstances, and I think we followed the guidelines as prescribed to the letter. Mr. SCHUMER. What you are saying to me is that you can be going through these same guidelines right now with other banks and 2 months from now, we could be hearing about another problem. If there is nothing t h a t went wrong here, and this was the typical procedure, appropriate procedure, for doing bank auditing— right—then it could be that your colleagues, maybe Mr. Kovarik, Mr. Meade, or thousands or hundreds of other auditors around, are not catching the same kinds of problems, maybe not oil and gas, maybe not Penn Square—isn't that an accurate statement? Mr. MCCARTE. It sounds like you are asking me to guess as to what could occur. It is only conjecture and I have been away from the office 2 years now, and I am not thoroughly versed in what they do. Mr. SCHUMER. Well, from what you used to do. Mr. MCCARTE. What we have is a situation where we have a bank who has had sizable problems, and they are a combination of not only Mr. SCHUMER. Those problems are not detected by the auditors. That is my point to you. You know, obviously, the bank has real problems and the banking system has even more serious problems, but all we have is you folks. Mr. MCCARTE. The only observation I would offer is that a lot of the problems t h a t we are discussing are not operational problems, they are problems related to the economy. Mr. SCHUMER. I would ask you the same question. Mr. Kovarik, first comparing Mr. McCarte's memo and Ms. Kenefick's memo. What went wrong? What went wrong with the auditing procedures? Mr. KOVARIK. From Mr. SCHUMER. Why wasn't this problem caught earlier? Mr. KOVARIK. A S I said earlier, the mechanisms that the bank had in place including the collateral reports and rating reports which clearly in my examination of 1982 pointed out that there was a problem in the midcontinent division, and Ms. Kenefick's memo speaks of the Oklahoma portion of that midcontinent divi 140 sion—those exceptions were in my opinion clearly isolated to t h a t one section, that midcontinent division. As I said, my recollection is t h a t during the first 6 months of 1982, those exceptions accounted for more than 50 percent of the total exceptions within the bank and as many as 65 percent of the exceptions within the total bank. So, in my opinion, there was a clearly isolated problem with the Oklahoma portfolio or midcontinent portfolio. Mr. SCHUMER. That was a pretty big portfolio. Mr. KOVARIK. $1.1 billion. Mr. SCHUMER. Yes. Mr. KOVARIK. Again Mr. SCHUMER. What was the capital of the Mr. KOVARIK. Approximately $2.2 billion. Mr. SCHUMER. SO it was 50 percent of the bank at t h a t time? total capital of the bank? Mr. KOVARIK. Yes, sir. But if you Mr. SCHUMER. That is the book value of those loans, not the market value. Mr. KOVARIK. Yes, sir, but if I can go one step further, I think Mr. McCarte said earlier t h a t when he did his examination, those loans amounted to $330 million, and they grew substantially, especially during the last half of 1981, and first half of 1982, a time we were not in the bank examining it. Mr. SCHUMER. YOU wrote in Chairman S T GERMAIN. Chuck, excuse me, do you have perhaps the date of the last participation t h a t was purchased from Penn Square by Continental? Mr. KOVARIK. N O , I don't, sir. Chairman S T GERMAIN. Would you make t h a t available to us? Mr. KOVARIK. We can get it for you. Chairman S T GERMAIN. Everybody knows Penn Square failed, so we don't have a secrecy problem there. Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. Thank you. Mr. SCHUMER. I am afraid maybe some of the people who audited the banks didn't know it failed, even after it failed. But in any case, Mr. Kovarik, in your November 15 memo to William Martin, Deputy Comptroller, you said t h a t quality control problems were endemic throughout the bank. I am trying to find the sentences here. Quality control—it can be said t h a t quality control is useful for the bank. Now, when you see such problems in one area, as you called it the midcontinent area, and you see the quality control problems throughout in the bank, doesn't it lead you to think that problems can occur in the rest of the parts of the bank that you may not be detecting? Mr. KOVARIK. Yes, sir, but we were talking specifically about internal controls and those internal controls which would have pointed out the Oklahoma portfolio is what I was referring to before. Mr. SCHUMER. But they didn't exist for the receipt, did they? Mr. KOVARIK. Yes, sir, they were there, and being observed by other division heads. The fact that 141 Mr. SCHUMER. It says here t h a t quality control is useful for the bank. Internal control and quality control are different? Mr. KOVARIK. Yes, sir. Mr. SCHUMER. In what Mr. KOVARIK. Internal way? control can have an effect on quality, but it is not the only—put it this way, you can make a loan that is very good at the outset, but if you don't document it properly and your internal controls don't catch that, it can t u r n into a problem. You can also make a very good loan at the beginning, document it perfectly and do everything and it can t u r n into a problem loan. The quality control detection is after the loan is booked, are people looking at it to make sure t h a t it is meeting the requirements and if it is not, are steps being taken Mr. SCHUMER. YOU say both are necessary, and neither is sufficient? Mr. KOVARIK. That is true. Mr. WYLIE. Would the gentleman yield on t h a t point? Mr. SCHUMER. Yes, sir. Mr. WYLIE. I think the testimony t h a t you have elicited here is very revealing. From what you have said, it is possible to have as many deficiencies in a loan approval, approval and documentation functions as were later found in the case of Continental Illinois, and still have a sound system of internal controls. Is that a fair observation? Mr. KOVARIK. N O , sir. Mr. MCCARTE. N O . Mr. KOVARIK. N O , I am saying that the unsoundness of their controls was isolated to a certain segment or portfolio. Mr. SCHUMER. Internal, not quality controls? Mr. KOVARIK. Not quality controls, yes, sir. Mr. SCHUMER. J u s t to clarify. Mr. WYLIE. YOU based a lot of your determination on what was going on in the bank on the internal controls within the bank, and what you ascertained from those internal controls. Mr. KOVARIK. Yes, sir. And if I can go one step further? Mr. WYLIE. YOU must have thought those were at the time sound. Mr. KOVARIK. Except as they related to the midcontinent division, strictly internal controls were sound. If I could take just one example of the collateral exceptions. The operations division of the bank t h a t was charged with gathering all the documentation for a loan and making sure it was all there, they would submit reports on a monthly basis to the division heads and their superiors. And it was the division heads' responsibility to clear those exceptions. In the case of divisions outside of the midcontinent those were taken care of on a very timely basis. It was rare to see more than one or two exceptions per month in a division and the next month t h a t exceptions would be cleared and another one, more due to timing than anything else, would appear. However, in the midcontinent division, the exceptions grow over a period of time with the first ones not being corrected, a group of other ones coming on, and then the next month those also not being corrected, so they grew. 39-133 0—84 10 142 The fact that the division head of that midcontinent division was not responding to his responsibility as I stated in my letter to the board, he did not take his responsibility along with the authority he had been granted to make sure these corrections were made. The other breakdown, as I saw it, was t h a t his superiors also did not take their responsibility in overseeing his job. And the other divisions of the bank where we did not find exceptions of any magnitude at all, those division heads and their superiors were taking t h a t responsibility, so t h a t internal control system of reporting an exception to the officer was working in those because those other officers were doing their job and saying here, I have an exception, I have to do something about it and they would correct it. Mr. WYLIE. But it wasn't working in the case of midcontinent. Did you consider doing any additional test or examinations or establishing any different standards so that the internal control system in the case of midcontinent would be adequate? Or is t h a t not your function? Mr. KOVARIK. Yes, sir. Our recommendations to improve the controls started off with, somebody had to be on top of those items to be sure those offices were taking their responsibility along with their authority. Mr. SCHUMER. My colleague, Mr. Barnard, has pointed out something to me. I would like to read two sentences into the record, one from the 1981 report, done by Mr. McCarte, and one for the 1982 report done by Mr. Kovarik. The 1981 report stated t h a t CINB, "Continental Illinois National Bank is adequately staffed with both sound lending officers and scientific engineers, geologists, personnel—scientific personnel to handle current relationships and meet strong continued growth anticipations.' ' 1981. 1982: "It can be said that the lack of quality control is universal for the bank." One has to look at those sentences and say something is rotten in the state of the Comptroller of the Currency's Office and the way they function. I am sure there was not a total revamping from 1981 to 1982. And yet, you are saying complete contradictory things. I would like to ask two more questions. First, have any of the three auditors here been in a situation where you saw a bank in the same kind of shape you saw Continental, where you made your audit and then as a result of your audit, which you quietly and internally passed along to the bank, the situation was corrected so that the bank didn't go bad, although Continental did? Any of the three of you think of an instance of that? The banks will be in good shape now, so you are not revealing any confidences t h a t would lead to problems. Because t h a t is the premise of the question. Can you think of an example, not where each of you were personally involved, but where this happened? Mr. MEADE. Can you repeat the question? Mr. SCHUMER. The question is whether you or another auditor t h a t you know from the Comptroller's Office have ever been involved going to a bank, auditing, discovering reaL internal problems, such as have been touched on in some, though not all, of the 143 reports that we have issued here, you brought t h a t to the attention of the bank's management, and that situation was corrected, so t h a t a Continental did not occur. Mr. KOVARIK. As for myself, I have been invovled in the examination, as examiner in charge or as assistant or assisting examiner in a number of problem banks during my career, and the vast majority of those are still around today. Mr. SCHUMER. That wasn't my question. I know that the vast majority of the banks are still around today. My question was did you examine one of those banks, any one, and find a significant and serious problem, issue a report so, said that, and then management took corrective action? If so, please cite to me the bank and the instance. We want to get an example of when this system ever works. Mr. MEADE. I am not prepared to give you an example. But that is the whole objective of our work, is to identify the problem Mr. SCHUMER. I am aware of that. Mr. MEADE [continuing]. And to prompt management to take corrective action. We have very limited resources to accomplish the job in the 4,500 national banks. We do identify the problems and it is management's responsibility to correct them. Mr. BARNARD. Would the gentleman yield? Let me phrase it a different way. How responsive was the Continental in making the necessary corrections t h a t you recommended over the period of years? I can't ask Mr. McCarte, because he is with the bank. Mr. MCCARTE. I can respond for the period of time I was there, if you like. I can respond for the period of time I was with the Comptroller's Office, if you like. I found the bank to be receptive to the comments and had in the past demonstrated a commitment to make change. Mr. BARNARD. HOW can you respond, then, when there was such a difference in the two reports, where the one you reported shows the bank was adequately staffed, had sound lending, and so forth and so on, and then in the next examination Mr. Kovarik found it in disarray. Mr. MCCARTE. I cannot speak for Mr. Kovarik. Mr. BARNARD. What is your opinion, Mr. Kovarik? Do you feel like the Continental responded aggressively enough to the recommendations for corrections? Mr. KOVARIK. Yes, sir; I think they did. As I said before, I cannot think of any of the recommendations t h a t we made in 1982 that were not responded to positively. If I can get into the other question about the two comments, I think they are related to two different things. Mr. McCarte's comment is specifically to the oil and gas portfolio in 1981, and I am talking about a breakdown in the quality, loan quality control system that not only included Penn Square loans, but other loans on the books at the time in 1982. Mr. SCHUMER. If I might reclaim my time—your comment applies to oil and gas, too. Mr. KOVARIK. Yes, sir. S T GERMAIN. YOU Chairman don't have any to reclaim. 144 Mr. SCHUMER. Sorry, Mr. Chairman. I would just like the record to state, and I will ask this tomorrow as well, instances where we have a real dilemma, to say the least, here. First, three points I would just like to make that I derive from the testimony. As Mr. Barnard elicited, Continental followed all your recommendations. That is No. 1. That means t h a t the procedures set up by the Comptroller can't avoid Continentals, and to me, it implies if other Continentals are blooming, the Comptroller doesn't have any power to stop them. Chairman S T GERMAIN. He has the power. Mr. SCHUMER. Sorry. Any ability under the present way he is working to stop them. The second thing which makes me think that is t h a t nobody can seem to point out an instance where their work was able to discover problems and lead to corrective or prophylactic action so t h a t a debacle didn't occur. And third, which is a separate point, but I think an important one, the contradictions between the various statements made in 1981, 1982, just alone by employees of the Comptroller of the Currency, make me feel t h a t their standards at the very least are flimsy, if not nonexistent. I yield back. Mr. MEADE. May I comment on the period from 1973 to 1976? The classified assets, as you recall, in 1976 were at approximately 120 percent, and I was very impressed with management in terms of the responsive action they took to address those problems. Chairman S T GERMAIN. In 1978, they embarked on their new venture, is t h a t right? Mr. MEADE. I think the study on the high growth scenario, I believe t h a t was undertaken in 1976. But I was very impressed the way management jumped in and recognized problems and effected correction. Chairman S T GERMAIN. Well, gentlemen, Mr. Schumer made a great point. If management did everything the Comptroller's Office told them to do, all along the line, from 1976 to 1983, 1984, and Continental still failed, then maybe the Comptroller's Handbook has to be revisied to determine what it is that is not in the handbook, or whether you should be given more power and more discretion t h a n you have been given to date. Let me ask you this: Mr. McCarte, you were informed about problems at Penn Square when? You resigned J u n e 21, 22, right, from the Comptroller's Office. What did they tell you about Penn Square? Mr. MCCARTE. When I had resigned? Chairman S T GERMAIN. Before you left, when you were still scheduled to be the chief examiner of Continental for the J u n e examination. Mr. MCCARTE. I had no insights on the Penn Square, the condition of the Penn Square portfolio. The conversations that I would have had with the Comptroller of the Currency's Office in Washington was as part of the budgeting process. When we finished the 1981 examination, we had targeted three areas as part of the normal budget to do next time around—which 145 areas, what type of people you want, and the like. We had targeted at that point in time three broad categories. One was real estate, we were in an environment of high interest rates, the bank had problems in the past they had corrected, we wanted to see if they continued as such. The bank had a profit center which was primarily steel scrap dealers, automotive suppliers, related to the Midwest type of economy, which of course we had suspicions might be under some stress, given the recession. And we also had high classified coming out of that particular area. So we concentrated on t h a t one. The third one was the energy area. As part of the scope of the next examination for 1982, we decided that the best way to approach that was to perhaps get some expertise from an area outside of Chicago to help and assist the examiners in the Chicago district. And what we had done Chairman S T GERMAIN. That was in the energy area in general. Mr. MCCARTE. I am sorry. Chairman S T GERMAIN. YOU are talking about the energy area in general, and not Penn Square specifically? Mr. MCCARTE. That is correct. As I said before, we had done a limited amount of testing, tested some of the collateral pieces on the Penn Square related credit, and as we proceeded between August of 1981 and J u n e of 1982, we would have a series of conversations in Washington between myself and the Washington staff, basically fine-tuning the budget, and as part of the program we had decided we were going to ask an examiner to come from the Southwest to assist us. And he was going to go through the Penn Square bank and report back to us. Chairman S T GERMAIN. YOU did that of your own volition and motivation as a result of your 1981 exam? Mr. MCCARTE. Correct. Chairman S T GERMAIN. told you to do it? YOU did not do t h a t because Washington Mr. MCCARTE. N O , sir. Chairman S T GERMAIN. OK. Mr. Kovarik, you took over as the chief examiner for the 1982 exam on J u n e Mr. KOVARIK. J u n e 21, I believe it was. Chairman S T GERMAIN. J u n e 21. All three of you still were in the Chicago office in J u n e of 1982, right? Mr. MEADE. N O . I was in Cleveland at t h a t time. Chairman S T GERMAIN. SO you had departed. Mr. MEADE. Right. Chairman S T GERMAIN. OK. Mr. Kovarik, it is now J u n e 21, 1982. You are now told you are going to be the chief examiner. When did you first receive a call from Washington—obviously, Mr. McCarte, since he did not receive any call from the Comptroller's Office in Washington saying Penn Square is in trouble or might be in trouble. When did you receive that call, Mr. Kovarik? Was it a separate call or what? Mr. KOVARIK. When I was called, the week prior to the 21st, I believe it was either Thursday or Friday of that week, I was called 146 and informed that I would be taking over the examination and the comment was made, we have got some problems with Penn Square, we will talk to you about it next week. I happened to be on vacation at t h a t time, and I think they delayed so I wouldn't get my vacation ruined. Chairman S T GERMAIN. OK. Now, do you know if anyone else in your Chicago office was called and told to do an examination for Penn Square? Mr. KOVARIK. No, I do not. Chairman S T GERMAIN. Would your colleagues in the Chicago office have informed you? Was there a memorandum that came into the Chicago office saying there were problems at Penn Square, or was it merely on the telephone? Mr. KOVARIK. I know of no memorandum. Continental at the time, and still today, is under the Comptroller's supervision—of the Multinational Division here in Washington. So, the region itself, the seventh, the old region, now the central district, does not have responsibility for Continental. Chairman ST GERMAIN. If the Washington Office of the Comptroller were to say they had informed the Chicago office of the Comptroller that there were problems at Penn Square because of the fact they knew t h a t Continental was involved, your division would have been informed also? Mr. KOVARIK. I would assume so. Chairman S T GERMAIN. The multinational, right? There is a reason for this questioning, ladies and gentlemen? I know I have interceded. We heard what Mr. Kovarik said earlier and Mr. McCarte. May 11, 1982. This is from Mr. Conover's testimony on July 15, 1982. April 1982, Penn Square Examination commenced. On May 11, 1982, Regional Administrator notified Washington office of problems being uncovered. May 11, 1982. OK? Now, I asked Mr. Conover on July 15, 1982: "Now, I ask you, was the information that was gleaned from the examination of Penn Square forwarded to your Chicago offices so t h a t the examiners at Continental would have knowledge of the fact t h a t some of these participations in some of those loans which they urged to Penn Square were as you described it in your statement, not too well-collateralized?" He said, "I think I would like to answer the second part first. And then I would ask Mr. Homan if he would deal with the first part involving the transmittal of information to Chicago." All right. We go to Mr. Homan. And I quote him. "During the course of the examination—" t h a t commenced April 19—"as soon as the losses and poor quality loans both in the bank and t h a t portion t h a t was participated with other banks became apparent, we did notify all of our offices effected and particularly our larger regional office that directly supervised the Continental, Chase, and Seattle First and a number of other participants. "We also sent an energy examiner, one of the experts from Oklahoma, to Continental to aid our examiner in the assessment of t h a t portfolio." 147 Now, we hear that Mr. McCarte asked for the examiner to come in from Oklahoma. It is not that the Comptroller's Office decided to do t h a t because of what they were finding in Penn Square. And we find May 11, the Comptroller's Office knew about and had been told, and they told us that on May 11, 12, 13, and 14, they informed the Chicago office of the problems t h a t were occurring in Penn Square. And lo and behold, the reality is t h a t it wasn't until J u n e 17, 18, 21, that Mr. Kovarik was told there might be problems at Penn Square. I think this puts in question some of the testimony we received on July 15, 1982, relative to Penn Square. That is why I wondered when Continental purchased its last participation from Penn Square. Wouldn't it be rather sad if we were to find t h a t they purchased one on the 30th of May, Memorial Day, or 2 days before it, 2 days over? Wouldn't it? That would be, wouldn't it, Mr. Kovarik? Since they had knowledge on May 11 in the Washington Office of the problem, the severity of the situation in Penn Square. You can answer that question, can't you, as an examiner? Mr. KOVARIK. I guess it would. Chairman S T GERMAIN. Wouldn't it be sad to find that out? I know we are supposed to have a veil of secrecy. But my goodness gracious, if there are problems in the audit department discovered by Mr. McCarte, certainly Continental should have been told about the Penn Square situation as soon as possible, because t h a t is in the energy field. Mr. Wortley? Mr. WORTLEY. Thank you, Mr. Chairman. I wonder if we could talk a little bit through the procedure t h a t is followed once you put together a report. Here is 50 to 60 pages in which you have examined the earnings and the capital, reviewed the profit centers, loan portfolio management, liquidity, and assets. I am looking at the December 6, 1982, report, some very damaging language in here. Second paragraph, the letter to the board of directors, says, The examination results show the condition of the institution to be seriously deteriorated. Another sentence in the next paragraph starts out, Current problems can be largely attributed to decentralization of authority without adequate policies, procedures and quality control systems, combined with a management direction that encouraged aggressive growth, but failed to hold managers accountable. It goes on and on with some very critical things. But once this is completed, who do you deliver this report to in the bank? Do you drop it off to a secretary or take it to the president of the bank, or sit down with the board of directors or just what happens to this report? Mr. KOVARIK. The report, after we complete it, is, in this case, submitted to the multinational division in Washington. A transmittal letter is prepared by the Deputy Comptroller for multinational. It is sent to the bank and it is presented to them formally at a board meeting held with the board of directors sometime after they had received t h a t report. 148 Mr. WORTLEY. Do you or anybody from the Office of the Comptroller actually sit down in that board meeting and go through this report with them, or is this something t h a t the officers are supposed to relay to the board of directors and it is part of their big meeting agenda, and it gets 1V2 minutes of comment? Mr. KOVARIK. No, sir. We present the report of examination to them covering the high points or the areas t h a t we want to stress. It includes, I think, in the case of the 1982 report, was probably a 30- to 45-minute formal presentation, and then another half an hour or so, maybe even longer than that, of discussion after t h a t formal presentation. Mr. WORTLEY. SO you spent a good couple of hours with the directors, officers and directors of the bank, is t h a t correct? Mr. KOVARIK. Yes, sir. And t h a t is just at t h a t meeting. Mr. WORTLEY. In all cases, do you do that, or just when you have a very critical report? Mr. KOVARIK. N O . That would be in all cases of course, the length of time would vary. But all reports are presented to the board of directors. Mr. WORTLEY. In person. Mr. KOVARIK. In person. Mr. WORTLEY. Did you present this one to the board yourself? Mr. KOVARIK. Yes, sir, I did. Mr. WORTLEY. Did they have a lot of questions? Mr. KOVARIK. Yes, sir. I might also say that prior to that meeting, I had held, I believe, two and possibly three meetings with the audit committee of the board, starting in September 1982, September, October. Mr. WORTLEY. NOW, once you have made that report to the board, to the officers, is there any sort of a followup procedure t h a t ensues, like in 60 days or 90 days, do you go back and ask them, what have you done to correct this situation, or that situation? Mr. KOVARIK. We do a quarterly visitation at all of our multinational banks, any of them. In this case, there was very frequent conversations between our Washington office, myself, and officers of the bank, even after the examination was presented to them. Mr. WORTLEY. What was their response along the way? Did they say they were pulling up their sox and taking care of this? Mr. KOVARIK. A S I said, to my recollection they instituted every recommendation t h a t we put into the report. Mr. WORTLEY. They instituted all of the recommendations you put into the report. Mr. KOVARIK. Yes, sir. Mr. WORTLEY. And when you went back in 1983, did you find all those situations corrected, or had the ship sprung a leak in another spot? Mr. KOVARIK. A number of the recommendations were, of course, geared toward improvement in the operations and especially the credit review division—the credit quality section of the bank. Those recommendations were implemented. They were reviewing loans more frequently, concentrating on the much more critical problem of the problem loans. In 1983, the condition continued to deteriorate. 149 Mr. WORTLEY. But the condition was still deteriorating. Was this the condition of the old loans that was deteriorating or the new loans. Mr. KOVARIK. No, sir, it was old loans that were on the books, and were feeling the further effects of the downturn in the economy. Mr. WORTLEY. But most of the problem that existed in 1983 and in 1984 you are saying were based upon old loans and not on the current or new loans t h a t had come into the portfolio? Mr. KOVARIK. Yes, sir. Mr. WORTLEY. NOW, do you exchange information in this report with either the Federal Reserve Board or the FDIC? Do you pass on this report of the FDIC—if there is a problem? Mr. KOVARIK. It is my understanding that those reports do go both to the FDIC and to the Federal Reserve Board. As I said before, during the examinations we conducted on Continental, the Federal Reserve was there, and I had at times daily contact with their examiners while they were in the bank. I am sure t h a t they are—the report in its entirety is sent to those two agencies. Mr. WORTLEY. I hope they exchange it more expeditiously than you do within the Office of the Comptroller of Currency, when you don't share information back and forth very well. In your report, you noted t h a t although the lack of quality control is universal for Continental Illinois, this deficiency was most notable within the special industries and real estate groups. In your opinion, what factors contribute to this and why were they not detected sooner? Mr. KOVARIK. Well, in the case of the special industries group, a large majority of those credits were the Penn Square credits in the midcontinent division. The system employed at Continental and in most banks that have loan review systems relies to varying degrees on the account officers initiating any information up through senior management with regard to deterioration in individual credits. I believe in both of those areas, it was a fact that the loan officers were not as fast in putting loans on the bank's watch loan report or bringing them up to management as problems. Mr. WORTLEY. Was this a management problem or a personality problem, would you say? Was the style of management adequate to cope with this or were they just plain inept individuals not paying attention to their business or trying to cover up their tracks, they were hoping for something better to come along. Mr. KOVARIK. I think the answer is all of those, depending on which area you are looking at in Continental. Mr. WORTLEY. But this was essentially in the special industries area, where this problem existed. Mr. KOVARIK. A great deal of those were in the special industries area. Mr. WORTLEY. What about the real estate group? Mr. KOVARIK. I think my recollection is t h a t was the second largest, but it was much lower t h a n the special industries. Mr. WORTLEY. YOU noted the earnings were depressed and would remain so until at least 1985. You also mentioned Continental's 150 heavy loan loss provision, income reductions due to nonperformance as either an increased funding cost all adversely affected the ability of Continental to return to normal profitability. Given these projections, did you recommend any critical supervisory actions be taken at t h a t particular time? Mr. KOVARIK. I recommended t h a t we institute enforcement action against the bank at that time, yes, sir. Mr. WORTLEY. You could foresee the events of 1984 taking place? Mr. KOVARIK. N O , sir, I did not foresee those, but as spelled out in the report, there were a number of areas t h a t needed improvement and it was my recommendation t h a t t h a t be reduced to a formal agreement between the bank and our office. Mr. WORTLEY. Did the bank respond? Mr. KOVARIK. I am sorry. Mr. WORTLEY. Was the bank responsive? You made those recommendations. And did the bank take the next action t h a t you had recommended? Mr. KOVARIK. A S I said, they instituted those recommendations; yes, sir. Mr. WORTLEY. To your satisfaction? Mr. KOVARIK. When we again examined the bank in 1983, yes, they had complied with every aspect of our agreements with them and all of the recommendations t h a t we had made. Mr. WORTLEY. Thank you, Mr. Chairman. Chairman S T GERMAIN. YOU say t h a t you share your reports with the FDIC and the Fed? Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. Does the Fed share their reports with you of the holding company? Mr. KOVARIK. Yes. Chairman S T GERMAIN. YOU have seen Mr. KOVARIK. I have, yes. Chairman S T GERMAIN. DO you know them? when the practice of sharing these reports started? Mr. KOVARIK. N O , I don't. Chairman S T GERMAIN. DO you share them with the FDIC as well? Mr. KOVARIK. Our reports, yes. Yes, sir. Chairman S T GERMAIN. Mr. Patman. Mr. PATMAN. Thank you, Mr. Chairman. Miss Kenefick, were you employed by the Continental Illinois National Bank or the Continental holding company? Ms. KENEFICK. I was, I guess, an employee of the bank directly. Mr. PATMAN. YOU were what? Ms. KENEFICK. I was an employee of the bank. Mr. PATMAN. YOU say you guess? Ms. KENEFICK. I never really thought of it in t h a t distinction. I was an officer of the bank itself, which was a subsidiary of the holding company. Mr. PATMAN. Mr. Kovarik, did you examine all of these other— do you consider this as an entity with many of its other subsidiaries, or do you simply investigate the bank itself, the Continental Illinois National Bank? 151 Mr. KOVARIK. We examined the bank and its operating subsidiaries. The Federal Reserve examines the holding company and its subsidiaries. Mr. PATMAN. IS it your understanding t h a t the extensions of credit t h a t have been made will be guaranteed by the assets of all these other entities t h a t are parts of the holding company? Ms. KENEFICK. That is my understanding. Mr. PATMAN. YOU don't examine at all the holding company itself, the parent company; is t h a t true? Mr. KOVARIK. That is true. Mr. PATMAN. Well, does its financial solvency or prosperity enter into your judgment about the bank itself or do you simply examine it based on its own merits? Mr. KOVARIK. A S I said, we do joint examinations with the Federal Reserve, and the Federal Reserve examines the holding company and its subsidiaries. They pass along their information to us. We examine the bank and its subsidiaries and we pass along t h a t information to them. Mr. PATMAN. In sort of a formal hearing or get together periodically or how often? Mr. KOVARIK. It is between the examiners in charge or other examiners on the teams. We have—I am trying to remember—I think we have been working with the Federal Reserve in Chicago on our two multinationals back into 1977 or 1978, sometime in that period. But I am not sure exactly when it was. Mr. PATMAN. And you have apprised the Federal Reserve of all the problems t h a t have been found in the bank? Mr. KOVARIK. Mr. PATMAN. Yes. From the beginning. Apparently they go back to 1976, if not earlier; is t h a t not true? Is t h a t your recollection in your examination of the bank, your knowledge of its background? Mr. KOVARIK. My knowledge of its background showed t h a t it had problems in the 1975-76 period t h a t were decreasing during my 1977 examination. Mr. PATMAN. M S . Kenefick, did you ever write any memorandum about the Third World loans; did those ever concern you? Ms. KENEFICK. N O , sir. Mr. PATMAN. Did you examine them? Were those a part of your responsibility, or did you have knowledge about their previous nature at all? Ms. KENEFICK. They were not part of my responsibility. Mr. PATMAN. Did you understand t h a t the bank was concerned about those? Ms. KENEFICK. I am trying to recall. During the time I was there, I don't recall t h a t a major topic. Mr. PATMAN. Tell me, did any bank employees, officers or others have an arrangement about which they could take a proprietary interest or an equity interest in any of these businesses to which credit was extended? Ms. KENEFICK. Let me answer the question perhaps a slightly different way. I believe it was either a policy of the bank or a Federal regulation t h a t the employees were—well—the policy of the bank was that you were not to do as you suggest. To the extent that you 152 wanted a waiver, so to speak, you had to in effect get it approved. So it was not practice then to invest in your customers. Mr. PATMAN. But to your knowledge were waivers ever granted? Ms. KENEFICK. I don't have any knowledge. Mr. PATMAN. Well, you have no knowledge of any instances t h a t were called to your attention or about which you heard reports? Ms. KENEFICK. N O , with respect to Continental employees, no. Mr. PATMAN. HOW about Continental Bank itself, did it have the option and did it take advantage of its option to acquire equity interests in businesses to which it extended credit? Ms. KENEFICK. I cannot think of an instance t h a t I was directly involved with Continental. Mr. PATMAN. DO you have knowledge of any instances? Ms. KENEFICK. I have just a general knowledge t h a t in some situations with a problem loan, the bank had occasionally taken warrants, I believe, of stock as part of compensation for reducing interest terms or principal amortization. It was part of the negotiations. Mr. PATMAN. With prospective borrowers? Ms. KENEFICK. In the example that I am thinking of, not specific, but in the general context, it was with loans t h a t were problem accounts and as they were trying to work out of the situation there was a negotiation and give and take. Mr. PATMAN. Were they in business to extend credit in circumstances where it would otherwise be regarded as risky or too risky? Ms. KENEFICK. What I am referring to was credit was already extended and they were trying to work out of the credit. Mr. PATMAN. And as a consideration for continuing the extension of credit or not foreclosing, then these inducements were given, these rewards, as you might say, were given? Were they given to the bank or to the employees? Ms. KENEFICK. It was part of the bank, in effect a collateral, so to speak, security for the loan. It was not directly to the employees of the bank. Mr. PATMAN. Did those occur in any of the loans t h a t were made to Penn Square? Ms. KENEFICK. I am not aware of any. Mr. PATMAN. TO Penn Square credits. Let me ask the other gentleman. You have heard my questions of Ms. Kenefick. Are you familiar with any of those instances during your examinations of the affairs of Continental Bank or any of its subsidiaries? Mr. MCCARTE. I think what Ms. Kenefick is referring to was, if I can try to clarify it a little bit, is a situation where the borrower perhaps is unable to pay the principal and interest owing. It is perhaps an occasion where the borrower will offer shares of stock in lieu of cash or repayment. Quite often, however, those instances were on credits t h a t actually had been charged of and perhaps it was in terms of book value less t h a n what was originally advanced. Mr. PATMAN. Were those standard practices? Were those wholesome practices for the banking industry? Mr. MCCARTE. It is just a matter of trying to recoup moneys t h a t are already out to the borrower. The cases that I would be familiar with are instances where the loan had already been made. Now it 153 is an attempt to recover, the company cannot pay through normal cash flow. It is a matter of how do we recover on our original advances. And at times the corporations will offer stock or warrants in lieu of that. But the examiners would traditionally charge those loans down to the appropriate carrying values. Mr. PATMAN. Let me ask you three gentlemen who have been examiners or have had occasion to examine these affairs at the bank, and its parent holding company—I suppose not the parent holding company. Are you aware of any employee at the Comptroller's Office t h a t has lost his job or been promoted because of inadequacies in his performance, in this instance of the bank's obviously becoming insolvent or reaching the stage of near insolvency and there being some oversights, if not negligence, on the part of the employees of the Comptroller's Office who examined its affairs and failed in some way in their obligations? Mr. MCCARTE. Personally I am not aware of oversights nor people losing their jobs. Mr. PATMAN. YOU are not aware of any oversights or negligence on the part of any of the employees of the Comptroller's Office in their work with respect to Continental Bank. Is t h a t what your statement is? Mr. MCCARTE. It is a very restricted view I could offer, sir. I could not speak for the entire office. I can just speak for Mr. PATMAN. TO your knowledge there were not. Mr. MCCARTE. The answer is no. Mr. PATMAN. IS t h a t what you think, Mr. Kovarik? Mr. KOVARIK. I have no knowledge of anyone. Mr. MEADE. I don't either. Mr. PATMAN. In other words, everything t h a t was done by the Comptroller's Office and its employees was in perfect order and fully adequate to the needs of the instance and the job that they had in this case and in all cases regarding the Continental Bank. Is that what you are saying? Mr. KOVARIK. I don't know of any one. Mr. PATMAN. All three of you? All right. Are you aware of any person or persons in the employ of any person who has been or is currently in political office who contacted the Comptroller's Office or any of its employees with the idea, with the purpose of attempting to get you to modify your approach or your judgment with respect to any matter involving the Continental Bank or its parent company or subsidiaries? Mr. KOVARIK. I am not. Mr. MCCARTE. Nor am I. Mr. MEADE. I am not aware either. Mr. PATMAN. May I continue with one thing. Do we need any statutory changes in your judgment in order to handle matters of this nature, in order to protect the public and insure the public's confidence in the safety and security of our financial institutions? Let's take you in order from the left, Mr. Meade. Yes or no? Mr. MEADE. N O . Mr. PATMAN. If you are aware of any, please provide them. How about you, Mr. Kovarik? 154 Mr. KOVARIK. I am not aware of any and I cannot suggest any at this time. Mr. PATMAN. Mr. McCarte? Mr. MCCARTE. The same. Mr. PATMAN. Where do we draw the line on when you decide whether or not we are going to bail out these depositors with credits above $100,000 or regular deposits with over $100,000? What status, what bank, what status must be achieved by a bank in order to receive that gold-plated assurance from the Federal Government or any branch of the Federal Government, t h a t the depositors will indeed be protected to the full extent of their deposits, whether they are foreign investors, whether they are other banks, whether they are knowledgeable people apparently taking certain risks or what. What is the status, what is the point in the financial status t h a t an institution has to reach in order to provide t h a t guarantee to its depositors? What about it, Mr. Meade? Mr. MEADE. I am really not prepared to comment on that. It seems like the bank lost the confidence of those t h a t were providing it with funds and I am not aware of anything t h a t could have been done to instill confidence. Mr. KOVARIK. I would have to respond almost in the same words. I don't feel qualified to answer a question as to what level t h a t should be. Mr. PATMAN. Were you frankly surprised the Federal Government did intercede in this case, the Fed, and other parts of the Federal Government, and provide that protection for depositors who had in excess of $100,000 on deposit through the FDIC? Mr. KOVARIK. No, I wasn't surprised. I don't think—at the point where it took place, I could see, in my opinion any other course. Mr. PATMAN. It was a decision of historic proportions, wasn't it? Mr. KOVARIK. Yes, sir. Mr. PATMAN. Thank you very much, Mr. Chairman, for your indulgence. Chairman S T GERMAIN. Mr. Hubbard. Wait a minute, Mr. Kovarik—you don't want to be Comptroller? Mr. KOVARIK. Not tomorrow, please. Chairman ST GERMAIN. Mr. Hubbard. Mr. HUBBARD. Thank you, Mr. Chairman. As this hearing nears to a close, let me express my appreciation to the witnesses—Ms. Kenefick, Mr. McCarte, Mr. Kovarik, Mr. Meade, for your testimony and also for your indulgence. We have been here more than 4 hours now. We are grateful to you. This committee referred to Mr. Kovarik's memo which I read with interest—your November 15, 1982, memo to William Martin concerning Continental's condition. In the third paragraph of t h a t memorandum you say, "It is my opinion t h a t there are two interrelated causes of the present situation." Then I read your following sentences. Would you for the record give those two interrelated causes of the problem. Mr. KOVARIK. In my opinion they were the aggressive growth philosophy, that was not tempered by the increased safeguards t h a t obviously were needed, and second, the management style which 155 gave a great deal of authority to officers and did not hold them accountable or ensure that they were taking that—the responsibility along with t h a t authority. Mr. HUBBARD. Again, to Mr. Kovarik, in your last paragraph of your two-page memo to William E. Martin, you say, Some enforcement action to relate our concerns is appropriate. It should, however, be in line with and take note of what they have already done or have instituted. Further, I have made a strong bid towards getting the bank to be much more open with us. We should take this opportunity to get the flow of information we need started. Let me just ask you a few questions. Please share with us some information and please be open with us. How do you require a bank to be open? Do you use the law, for example? Do you take advantage of the law, the cease and desist powers, or, as in this situation, are you saying "please". Mr. KOVARIK. Yes—the cease and desist powers can be used in that instance. My comments here relate to the fact that my prior experiences with the bank had been t h a t although we always did get the information we required, it was not always on a timely basis and at times was after having to go through various levels of management, many people in the bank, especially at the lower levels. What I mean by lower levels is maybe assistant vice presidents type level—would at times when we would ask for certain information defer to their boss who would defer to his boss. During the 1982 examination t h a t changed completely and we were given almost everything and anything we asked for immediately. Mr. HUBBARD. But prior to 1982 Mr. KOVARIK. It was my experience t h a t we got the information, but at times it was slow. Mr. HUBBARD. Is that unique as to Continental Bank? Or is this something you experience in other banks? Mr. KOVARIK. NO; each bank is a little unique. It has been my experience t h a t how the bank treats—that is not the right word— but looks at an examiner and how cooperative outwardly they are is usually a reflection on the people at the top of t h a t bank. In a bank where the chief executive is pleased to see the examiner come in, cooperation is usually full and very timely. At the other extreme is a bank where the president or the chief executive officer does not want the examiners there, they are a bother to him. Continental fell between those two extremes, if I can put it in that vein. I felt, though, when I wrote this t h a t we had made some great strides during 1982. I had tremendous personal contact with a number of officers in getting information, in getting replies to our requests—much more quickly t h a n we had in the past. And I wanted to see that continue because of the situation in the bank, and I didn't think we could afford not to have complete access to them at the time. Mr. HUBBARD. I represent a rural area of Kentucky. If you came to a bank, in, say, Farmington, KY, the Bank of Farmington, your requests of them were not timely taken care of and they continued to pass the buck there at that little bank, wouldn't this give you 156 suspicions that something was wrong there? Or does that just take Mr. KOVARIK. It depends on how it was. As I said, each bank is unique. Some just are very proprietary in all their information. Another thing is in a smaller bank a lot of things t h a t we would ask for in a bank such as Continental, or even banks smaller t h a n that, but still large—in a very small bank we would get ourselves, because the information would be there, it would be very easy to gather ourselves. When we are talking about an institution with 10,000 employees, at times it is just difficult to figure out or to get to which one employee or which two employees you have to see to get that information. Mr. HUBBARD. HOW many employees does Continental Bank have? Mr. KOVARIK. Today I am not sure. At one time it was as high as 12,000. Mr. HUBBARD. A S high as 12,000? Mr. KOVARIK. That is my recollection. Mr. HUBBARD. Quickly, and not wanting to take too much more time, let's talk together about watch loan reports. Who was responsible for putting a loan on the watch loan report? Mr. KOVARIK. The account officer has the responsibility. His superior would have t h a t responsibility if he felt it should be there. The rating committee of the bank, if they rated it a " D " or if it was a "C" rated credit, it could also ask it be placed on a watch loan. Any loan criticized by an examiner during his examination was required to be placed on a watch loan. Mr. HUBBARD. Does it make any sense to have this loan officer who originated the loan responsible for reporting it to senior management if the loan develops a problem? Mr. KOVARIK. Yes, sir. It does. Mr. HUBBARD. What incentives are there for a loan officer to put a loan t h a t he or she objected to on the watch loan report and, therefore, bring the fact that the loan had begun to have problems to top management's attention? Mr. KOVARIK. First of all, it has been our experience t h a t the sooner a loan becomes known as a problem, the better chance there is of working that loan out and maximizing either recovery or repayment on t h a t loan. Second, in a number of banks the fact that a loan officer would not place something on the watch loan report would be a black m a r k against him, as it should be. The loan officer not only has the responsibility of making the loan, but he has the responsibility to the bank to ensure that that loan is of the highest quality he can possibly make it, and if it starts to deteriorate, he should let everybody up above him know as fast as he can so t h a t it can be dealt with quickly. Mr. HUBBARD. Are there any instances where a loan officer was punished for putting a loan on the watch loan lists? Mr. KOVARIK. For putting one on? Not that I am aware of. Mr. HUBBARD. This last question—what is the importance of having all loans reviewed on a timely basis and what was the rela 157 tionship between the loan review process and the watch loan reporting system at Continental? Mr. KOVARIK. The second part of your question, the relationship between the loan review and the watch loan reporting, as I said earlier, the committee, if it rated it a " D " or if they rated it a "C", they could require t h a t it be placed on the watch loan. Excuse me—I forgot the first part. Mr. HUBBARD. What is the importance of having all loans reviewed on a timely basis? Mr. KOVARIK. In order to maintain or to attempt to maintain that quality they should be reviewed—in most places I have seen, and I believe annually is sufficient for a loan that has not deteriorated. And that is the other reason that you need the loan officer to initiate the watch loan report if it is necessary. For instance, if a loan is reviewed by the loan review department in January, and they call for an annual review of t h a t credit by that body, and troubles begin in J u n e of that year, unless that officer puts it on the watch loan report, it won't get reviewed until the next January, and you would have 6 months pass before it may be brought to light that it is a problem. Mr. HUBBARD. Again, t h a n k you for being with us, all four of you. Chairman S T GERMAIN. Ms. Kenefick, I consulted with Mr. Wylie, and he has no further questions of you. Neither do I. But we do want to express our deep appreciation to you. I would ask you not to charge your attorney too much for allowing him the honor and the privilege to come with you to this hearing, because there are not too many attorneys from out of town who are allowed in this room—so he is very fortunate and he should be very grateful to you. But don't charge him too much. Ms. KENEFICK. Thank you. Chairman S T GERMAIN. Thank you very kindly for your assistance. You are a great citizen and a great lady. You can leave. I am going to keep chatting with our friends here. First of all, I would ask unanimous consent to put the charts— capital adequacy, growth of loans, and net chargeoffs to total loans in the record, subsequent to my first round of questioning. Without objection, so ordered. Second, Mr. McCarte, you went with the bank in the latter part of J u n e 1982, as I recall, and are still there now. Mr. MCCARTE. Correct. Chairman S T GERMAIN. At the time you went with the bank was it for an increase in salary, and better benefits, or were there other reasons for your leaving the Comptroller's Office and going into private industry? Mr. MCCARTE. Well, for a variety of reasons, I suppose. I mean there was the incremental increase in my salary. There seemed to be greater opportunities for growth, not only monetarily, but nonmonetarily. Chairman S T GERMAIN. At the time you made t h a t decision, you obviously had another offer from outside the region, so you obviously felt in 1982 when you made t h a t decision as a bank examiner 39-133 0—84 11 158 with the Comptroller's Office that Continental Illinois, as you just stated, would be an opportunity for you to grow in many ways, and, therefore, you must have had confidence in the condition of Continental. Mr. MCCARTE. That is correct. Chairman S T GERMAIN. OK. Mr. Kovarik, you told us about seeing the Kenefick memo in August 1982. Mr. KOVARIK. I believe August or September. Chairman ST GERMAIN. HOW did that come to your attention? She told us she had given a copy to Mr. Lytle, one to Mr. Rudnick, and one to her successor. Did one of those gentlemen give you that memo, or how did it come to your attention? Mr. KOVARIK. NO, sir; I was reviewing the work papers that the phase I review committee of Continental had done, which covered the officers of the bank following Penn Square. Those work papers were made available to me, and that memo was included in them. Chairman S T GERMAIN. NOW, Mr. McCarte, you say significant credit quality and loan documentation deviations. Talking about Penn Square, do I get the impression t h a t in your opinion the loans that proved to be almost worthless at Penn Square were one of the major causes of the problems of the midcontinental division of Continental Illinois? Mr. MCCARTE. Yes, sir. Chairman S T GERMAIN. The reason I ask t h a t question is because I look here and I see t h a t significant credit quality and loan documentation deviations—which were spotlighted by the Penn Square National Bank failure in July 1982. However, these problems were not limited to oil and gas alone. The 1982 Continental examination report classified $3.6 billion in loans as substandard or as loss. Now, let's go back just to energy. Of these, $1.2 billion were oil and gas loans with Penn Square related classified loans totaling $620 million. Now, $620 million to a $40 billion institutional really isn't t h a t much, is it? Mr. KOVARIK. If you look at the portion t h a t was doubtful and loss in t h a t $620 million, it was very significant, though. My recollection is that of the $230 million in total loss, at the 1982 examination, I believe it was approximately $150 million t h a t was related to Penn Square. Chairman S T GERMAIN. This is in the energy field or in the overall exam? Mr. KOVARIK. In the overall examination, $230 million was classified as loss. Chairman S T GERMAIN. HOW much of t h a t was in the energy field? Mr. KOVARIK. I am not sure how much was in the total energy field, but I believe t h a t Penn Square's portion was $150 million, or thereabouts. Chairman S T GERMAIN. But obviously there were oil and gas, $620 million related to Penn Square classified loans out of a total of $6.2 billion, so you have approximately $500 million in energy, oil and gas related loans other t h a n Penn Square that were classified, is t h a t correct? Mr. KOVARIK. Yes. Was the figure used $5.6 million? 159 Chairman S T GERMAIN. N O , $1.2 billion were oil and gas loans with Penn Square related classified loans totaling $620 million, the difference being about $500 million. Mr. KOVARIK. Oh, OK, yes. Chairman S T GERMAIN. SO that $100 million would be other energy related loans t h a t were classified? Mr. KOVARIK. Yes. Chairman S T GERMAIN. Penn Square was unique, let's face it, a lot of banks decided not to buy Penn Square loans, right? Mr. KOVARIK. Yes. Chairman S T GERMAIN. Because they met Wild Bill Patterson? Did you ever meet Wild Bill Patterson in your examinations and meanderings on Continental? Mr. KOVARIK. N O , sir, I have not. Chairman S T GERMAIN. I can't find the testimony, but someone sat at this table and told us they by chance he met Wild Bill Patterson at the water cooler at Continental and decided to do business with him. You know, it seemed so odd t h a t t h a t chance meeting would come about in t h a t way. But it seems as though truthfully—and as you know, we looked at Penn Square thoroughly—that Penn Square loans were pretty much reaching in like a grab bag and hoping you got a bag t h a t had a prize in it t h a t was worthwhile. Does t h a t tell us t h a t the energy lending department of Continental for a period of time was either understaffed or not properly staffed, not technically qualified, technically competent or t h a t they were just not doing the job they were supposed to do as far as examining these loans were concerned? Mr. KOVARIK. If we can just talk about the non-Penn Square loans. Chairman S T GERMAIN. Non-Penn Square, yes. Mr. KOVARIK. Continental had a history of lending on reserves, oil and gas reserves, as most banks had. If you remember between 1981 and 1982, there was a drop in oil prices, so the value of their collateral was reduced, causing first t h a t diminishment of collateral; second, sales of oil and gas products were declining so these companies were facing losses, their balance sheets were deteriorating, so t h a t the loans outside of Penn Square in my opinion were more related to the fact t h a t the price of oil had dropped, sales had dropped, and these companies were experiencing financial difficulty. Chairman S T GERMAIN. Mr. McCarte, you told us t h a t you requested in your budget for the 1982 examination additional moneys, as well as an expert from one of our other regions to look at these energy-related loans in oil and gas, which indicates that you must have had some evidence before you. Was it just because of the decline in the price of oil and gas or did you have other reasons for asking for additional funds to look into the Penn Square loans and for asking for an expert from the Oklahoma area on oil and gas loans? Mr. MCCARTE. The reason we requested additional resources or an expert, to use your term, somebody more familiar with the energy sector, was for a combination of reasons. The energy prices were softening, the bank was a major lender to the energy sector, 160 and the fact t h a t in the Chicago subdistrict, we did not have any examiners with any hands-on experience in t h a t particular side of t h e business. So the combination of all those things just justified or seemed to suggest t h a t as we went forward t h a t we would be better off with some outside help. Chairman S T GERMAIN. Let me ask all three of you this question, let's look at Continental and let's look at Penn Square, but merely as a model or example. You go in and you examine with a peak team of 50 at one point in time and other times, you are down to 12, 10-12 people. How— absent a call from the Washington Office as a result of a call from the Dallas Office, absent t h a t type of red flag waving—how can you discover independently the type of problems t h a t existed at Penn Square? We keep harping on this. It is an unusual situation t h a t these two banks are interrelated with their problems. By the same token, it gives us a model we can look at without having to be fearful of naming Penn Square because we have to be cautious not to name other borrowers who may have been classified or had classified loans as Continental did. So it makes it a little easier for us. First, Mr. McCarte, let me ask you, in your experience as chief examiner, how does the Comptroller's Office discover or arrive at the fact t h a t there might be problems with these loans? We know what happened at Penn Square. Penn Square Bank was paying the interest on nonperforming loans, so they could continue selling new participations to Continental without telling Continental t h a t the previous participations were not performing. Does the Comptroller in an examination have the capacity to discover something like that? Mr. MCCARTE. Well, I think your question was without somebody calling stating t h a t they have this specific problem, how would you do that? Chairman S T GERMAIN. Absent an indication from Penn Square, for example? This could be Penn Square, or it could be the Zippety Doo Dah Machinery Co. t h a t has international sales and is a heavy borrower. Mr. MCCARTE. Right. The primary way I think t h a t examiners establish an asset problem is through direct review of the credits. Now, if the scope of the review t h a t is being performed is not sufficient to encompass those credits, they could go undetected unless the account officers would offer up a watch list report on them. So, in other words, rephrased, in the 1981 examination, the scope of what we did was $10 million and over, C&D rated credits, past due, nonperforming, plus two samples taken totaling 120 outstanding items. If by chance the Penn Square credits did not fall within the sample, over $10 million, past due, or nonperforming, they could go undetected. We just happened to stumble across the fact t h a t there was $300 million in the bank when they were there in June—or in 1981, sorry. Chairman ST GERMAIN. Mr. Kovarik. Mr. KOVARIK. If I could answer through the sampling method, if something like t h a t would go undetected, it would not be significant—I can't say for certain—but even the $300 million t h a t Mr. 161 McCarte looked at in J u n e 1981, I am sure some of t h a t would have come up on the sample just because of the total size of that, so it would have been much less t h a n t h a t for it to slip through our sample when we are looking at somewhere in the neighborhood of 70 percent of the outstanding dollars at a Continental or a bank t h a t size, the majority of the loans t h a t we don't look at are very small in dollar amount. And I am talking about very small, I am talking about less t h a n $1 million for the most part. Chairman S T GERMAIN. YOU fellows Mr. KOVARIK. I agree; that is not small to me personally, but in the scheme of Continental, if you look at capital of $2.2 billion and take a $1 million loan, how many of those $1 million loans does it take to get up there? Chairman S T GERMAIN. Right. Mr. KOVARIK. I think our line cut at $10 million, and sampling techniques gave us great coverage. I think what you are getting at is—maybe what I am interpreting your question to be is, if nobody would have said anything about Penn Square, say it wouldn't have failed, would we have found it? I think we would have, yes. Chairman S T GERMAIN. Mr. Meade? Mr. MEADE. I might add t h a t in addition to those factors that were enumerated before, you know, examiners are expected to be aware of the environment in which we are operating. I mean, a softening of energy prices is something t h a t should prompt a typical examiner to maybe pay greater attention to t h a t sector of the portfolio. Other factors t h a t may be a basis for looking deeper in a particular area are—as if there has been a change in management in t h a t area, we might want to take a little closer look t h a n if, you know, there hasn't been those changes. Another factor may have been to look at the bank's history of chargeoffs or in t h a t area where they generally have difficulty in t h a t area. Another factor would be the sheer growth and volume where you want to look at it a little closer if it was growing real fast as opposed to a department where the outstandings were perhaps running off. It is a lot of those factors, coupled together that—coupled with examiner judgment which we are encouraged to use, utilize, t h a t would probably preclude us from missing, you know, any significant amount of those credits. Chairman S T GERMAIN. NOW the lady whom we allowed to leave pointed to a number of deficiencies in a memorandum—but the fact is t h a t was not news to us because those loans were the subject of a report prepared by the special litigation committee for the board of directors. We know this from the Penn Square hearings as well, that the documentation and the ordinary information t h a t is usually required was not present. The number of people who are supposed to look into particular participations prior to committing themselves to lending the money or making the commitment until after thorough investigation, were not utilized. This is what occurred with the Penn Square loans. In other words, I mean what I said earlier, they were like a grab bag. They reached in blindly. It was more like playing t h a t game 162 where you pin the tail on the donkey. Isn't t h a t a fact, t h a t t h a t is what many of those loans were t h a t Continental bought from Penn Square, that they really didn't know what the quality of the loans were, but they knew the interest rates they were getting on those participations were high, and t h a t was sort of an incentive? The people who made those statements and those conclusions, are they in error, gentlemen? Mr. KOVARIK. I don't think they are in error. Chairman S T GERMAIN. OK. Now, t h a t being the case, absent the Ms. Kenefick memo, which as you said, you wish you had seen before—absent Ms. Kenefick's memo, how, under the procedures you describe for us, do you discover the fact t h a t certain loans and certain procedures t h a t should be followed are not being followed— how do you conclude that? Do you have a methodology for discovering that as well? Mr. KOVARIK. Yes, sir. When we do an examination as we said, we would look at certain loans. If those loans came up in any portion of the loans over our cutoff, they had been listed previously as problem loans by the bank, were past due, nonaccrual, or came up in our sample—and when I get to the sample I am talking about loans below $10 million for Continental; I am talking about a loan t h a t is not perceived by the bank to be a problem, is not past due, is not a nonaccrual, is outwardly a good loan, OK? If a loan would not fall into one of those categories or group of loans would not fall in, it would be a very small portion. Chairman S T GERMAIN. What were the total loans on, participations classified for Penn Central? Wasn't it $300 million? Mr. KOVARIK. From Penn Square, sir? Chairman S T GERMAIN. Yes, sir. Mr. KOVARIK. Classified was $620 million. Chairman S T GERMAIN. $620? Mr. KOVARIK. Right. Chairman S T GERMAIN. Were those loans all under $10 million each? Mr. KOVARIK. N O , sir. In 1982 those would have—a number of those would have been over $10 million. A number of those, assuming t h a t they were not past due and knowing t h a t they were not on the watch loan report, would have turned up in the sample and Chairman S T GERMAIN. Were some of those in the August 1981 examination? Was it August 1981? Mr. MCCARTE. It was April 30. Chairman S T GERMAIN. In the April 30 examination? Mr. KOVARIK. I have no knowledge of the oil loans on April 30, 1981. Chairman S T GERMAIN. Were some of them there, Mr. McCarte? I am not trying to be critical of any of you people. What I am getting at is the procedures t h a t you are armed with—I shouldn't say "armed with,"—that you were supplied with. Let's go back to the 1981 examination; what were the number of classified loans in Penn Square at t h a t point or were there any? Mr. MCCARTE. In 1981 we had no credit from Penn Square t h a t was classified or criticized. Chairman S T GERMAIN. None were classified or criticized? 163 Mr. MCCARTE. Not at t h a t time. Chairman S T GERMAIN. In that sampling, some of the Penn Square loans fall into your sample? Mr. MCCARTE. I just don't recall if there were any Penn Squarerelated credits t h a t came up in the sample. I recall t h a t we had a series of credits that were secured by standby LC's and specifically how large they were or the number of them—I just remember the total. Chairman S T GERMAIN. I will ask my staff to review those examination reports to see if indeed that was the case. Maybe Mr. Conover can explain t h a t to us tomorrow. I am sure he would like to do that. Mr. Kovarik, there was a Mr. Perkins at Continental. Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. M S . Kenefick and Mr. Meade. Mr. MEADE. Mr. Perkins was the president. Chairman ST GERMAIN. And Mr. Anderson? Mr. MEADE. Right. They had just taken over. Chairman S T GERMAIN. Mr. Perkins is the one who testified. He testified on behalf of the ABA, and we were sort of contentious. In fact, one time we had a picture taken together here and it appeared on the front page of the ABA magazine and my next opponent said because of t h a t I was a friend of the big banks. Getting back to Mr. Perkins and Mr. Anderson, Mr. Meade, did you ever go into the office of Mr. Perkins and Mr. Anderson to discuss your examination report with them? Mr. MEADE. I did following each examination with one of them or both of them. Chairman S T GERMAIN. Mr. Kovarick explained to Mr. Wortley the meetings with the board of directors. I didn't want to interrupt Mr. Wortley, but I was wondering in addition to that, did you meet with the chief executive officer ordinarily or one of them, the chairman of the board of the president, to discuss the exam and whatever deficiencies there were? Mr. MEADE. Yes, very definitely. I might point out I did not meet with the board of directors when I did the examinations. That was not our requirement at the time and I did not meet with them. Chairman S T GERMAIN. When did that requirement come in? Mr. KOVARIK. In 1976. Chairman S T GERMAIN. 1976, just after you. Mr. MEADE. Right about then, yes. Chairman S T GERMAIN. Mr. Kovarik, how about you and Mr. Perkins and Mr. Anderson? Mr. KOVARIK. Did we meet? Yes. Chairman S T GERMAIN. Did you meet personally with them to discuss these reports? Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. Was Mr. KOVARIK. Yes, sir. Chairman S T GERMAIN. YOU Mr. KOVARIK. Right at the week of the examination. this after each examination? met with each of them? conclusion probably; within the last 164 Chairman S T GERMAIN. It was part of the examination, is t h a t what you are telling me, or did you met with them to discuss the report of the examination? Mr. KOVARIK. It was both, to discuss the report and also to get their views on the future. Chairman S T GERMAIN. And would they be receptive to your recommendations in t h e areas where you felt changes or improvements should be made? Mr. KOVARIK. Yes, sir; they were. Chairman S T GERMAIN. YOU had no problems with them? Mr. KOVARIK. N O , sir. Chairman S T GERMAIN. YOU said there were three; some, no cooperation; others, cooperation; others, very cooperative. Mr. KOVARIK. N O . Chairman S T GERMAIN. YOU would rate them a 10 on a Bo Derek scale? Mr. KOVARIK. N O , sir. On a Bo Derek scale I would not. Chairman S T GERMAIN. I mean as to cooperation. Mr. KOVARIK. In cooperation? As I said before, they fell somewhere between that. I mean the bank fell somewhere between t h a t full Chairman S T GERMAIN. On a scale of 1 to 10. Mr. KOVARIK. Five. Before 1982. Chairman S T GERMAIN. Right. Subsequently? Mr. KOVARIK. Ten and a half. Chairman S T GERMAIN. They needed you. Mr. McCarte? Did you meet with Mr. Perkins and Mr. Anderson in your capacity as the chief examiner at the bank? Mr. MCCARTE. We would have had meetings, yes. Chairman S T GERMAIN. I asked you if you did? Mr. MCCARTE. Yes. Chairman S T GERMAIN. OK. Mr. MCCARTE. There may have been a meeting—at one point in time, to be perfectly honest, maybe Mr. Perkins may have been out of t h e bank. Chairman S T GERMAIN. If he were not there, did you meet with Mr. Anderson to discuss the report? Mr. MCCARTE. Absolutely, yes. Chairman S T GERMAIN. What was your perception of cooperation? Mr. MCCARTE. Positive. Chairman S T GERMAIN. Mr. Wylie. Mr. WYLIE. Thank you, Mr. Chairman. Our witnesses have been very patient and we t h a n k you very much for your testimony. It has been very revealing to this member. I think you are all to be commended for a job extremely well done. I a m not going to take any more of your time, but I would ask unanimous consent of the Chair to include in the record three pages from the Comptroller of the Currency's report of December 6, 1982, pages 42, 43, and 44, having to do with the internal controls. [The information submitted for the record by Congressman Wylie from the Comptroller of the Currency's report of December 6, 1982, regarding internal controls follows:] 165 INTERNAL CONTROLS Our review of Internal Controls reflects an overall satisfactory condition, with regard to the accounting controls employed. However, as pointed out by recent events, the administrative controls have not functioned properly in the lending area. If the administrative controls had worked, the magnitude of the Penn Square problem could have been greatly lessened. Management, in its review (Phase II) has recommended numerous changes which, if implemented will enhance the bank's administrative control system. These include: increased monitoring of non-possessory collateral; revised collateral deficiency requirements; enforcement of complete collateral documentation on participation loans; reporting of participation concentrations; among many others. Additionally, a number of recommendations were made to review and upgrade the Management Information Systems employed and to design additional systems to aid in monitoring global exposures, exception and past due information, and improve accounting systems to further allocate capital and loan loss reserves to individual lending units. The major recommendation proposes to improve administrative control by establishing a Credit Risk Evaluation Division. This Division would provide management and the Board an independent, internal review of credit quality and be available to pursue special projects for such groups as the Credit Policy Committee. Phase II was a comprehensive review, and the recommendations presented should be implemented wherever feasible. INTERNAL-EXTERNAL AUDIT ACTIVITIES The competence, independence, adequacy, and overall effectiveness of the bank's internal and external auditors were evaluated in order to determine the acceptability of their work. As a result, both the internal and external audit functions are considered fully acceptable. During examination, the management team formed to review the bank's involvement with the failed Penn Square Bank recommended that Executive Vice President William D. Plechaty replace Edwin J. Hlavka as the bank's Auditor. Mr. Plechaty had served as Auditor from 1969 to 1972, and more recently managed the Personal Banking Services Division. In another change recommended by the management team, the Loan Administration Division will report to the Auditor; however, the manner in which this function will operate will be determined after the management team concludes its review of the bank's policies, procedures, internal controls and practices. Aside from the integration of the Loan Administration Division, Mr. Plechaty does not envision any other immediate, significant changes in either the Auditing Division's structure or personnel. 166 The examination of the Auditing Division first focused on the following areas: Cash Accounts, Compliance with 31 CFR 103, Due From Banks, Bank Premises, Other Assets/Other Liabilities, Deposit Accounts, Consigned Items, Employee Benefits, Insurance Coverage and Review of Regulator Reports. Later the scope was expanded to include more audits performed under the supervision of each of the four audit managers. Audit procedures, reports, and supporting workpapers were organized and documented in accordance with divisional standards. The audit reports, which are issued at the conclusion of each audit, are distributed to the management of the a r e a audited. Written responses are required for all exceptions noted, and these responses become part of the permanent audit file. When the scope of the examination was expanded, twenty additional audits were reviewed. In two of these audits, the same or very similar exceptions were noted in each of the last three audit reports. In both instances the corrective action indicated in the management responses to each of the audit reports was not implemented. While it is agreed that the continuation of these particular exceptions is not likely to adversely impact the financial condition of the bank, the failure of management to implement the indicated corrective action detracts from the overall effectiveness of the audit function. In order to insure that audits requiring the attention of management are acted upon in a timely and uniform manner, it is recommended that the Auditing Division clearly identify and label all recurring exceptions, and also consider the development of a ratings system for both individual deficiencies and the overall audit. As part of such a system, it is recommended that management of a higher level be required to respond to deficiencies which exceed a predetermined rating. The implementation of a ratings system that calls for the more direct involvement of senior management would contribute towards increased accountability and a reduction in the number of recurring exceptions. The bank's external audit function continues to be performed by the public accounting firm of Ernst & Whinney. The 1981 audit included a review of the bank's systems for internal control and revealed no significant weaknesses. The firm expressed an unqualified opinion on the bank's year-end 1981 financial statements, and has been retained for the 1982 annual audit. 167 Mr. WYLIE. I would like for your specific comment on the fact t h a t some changes were made in internal controls and were observed and noted there and maybe why changes were noted and recommended, and if t h a t indicated that at that time there was something wrong. You may have noticed this morning I sort of concentrated on this internal control operation at the bank to see if that is a place where we should look to future endeavor, vis-a-vis, the House Banking Committee. So, with that, Mr. Chairman, thank you very much. I have no further questions. Chairman S T GERMAIN. I also want to add my thanks and my congratulations to you. You are all in great physical condition and you did quite well. You were very helpful and we are seriously most appreciative. We do have additional questions which we will submit to you in writing, but t h a t will save you from having to sit here another 2 hours, so I figured you won't mind answering the questions in writing that are referred to you. I would like to make a point here. I read quite a few articles discussing the fact t h a t the hearings were starting today and you read quotes from all kinds of bankers and their opinion as to why you were the leadoff witnesses with the delightful Ms. Kenefick. All of their speculation was so far off target, including the financial press writers using their crystal balls, trying to decide why you were the leadoff witnesses. Very plain and simple, you are the examiners. It makes sense—to start at the beginning and you are the beginning. So, to all those speculators out there and those pundits and whathave-you, gosh, they ought to relax and just look at logic, pure, simple logic, and they wouldn't have to write these ridiculous stories with all kinds of speculations that make me laugh. So, gentlemen, we t h a n k you because you gave us the foundation; you are the beginning, and we go on from here. You have been most helpful. Thank you. The subcommittee stands adjourned until tomorrow morning, when we will have the Comptroller of the Currency as our witness, at 10 o'clock. [Whereupon, at 2:43 p.m., the subcommittee was adjourned, to reconvene at 10 a.m., Wednesday, Sept. 19, 1984.] [A copy of the letter of invitation of witnesses to testify from the Office of the Comptroller follows:] 168 rERNANO J. V <:€RMAIM. «.«.. CHAiflVAN VRANK ANNUNZIO. H.ICARRCLL HU3BARD. JR. KV NOPMAN E. O'AMPURS. N H DOUG 8A3NAR0 JR.. GA JOHN .1. UFALCE. NY. MARY SOSE OAKAR. OM'O BRLI05 ? VEN79. MiNN. ROBERT GAFCIA. H.f CHARLES S. SCHUME*. K.Y. BIU PATMAN. TEX. STEPHEN L. NEAL. N.C. BARNEY FRAN*. MASS. RICHARD H. LEHMAN. CAUF JIMCCOPSR..TENN. BEN EROREiCH. ALA. THOMAS R. CARPER. 061. CHALMERS P V.'YUS. OHIO GEORGE HANSEN. IDAHO JIM LEACH. IOWA ED BETHUNE. ARK. STEWART 8. MCKINNEY. ttN NORMAN D. SHUMWAY. CAL U.S. HOUSE OF REPRESENTATIVES SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE BIL^ERY^ GEORGE C. WORTLEY. NY DAV,D DREIER. CALIF. OF THE COMMITTEE ON BANKING. FINANCE AND URBAN AFFAIRS NINETY-EIGHTH CONGRESS WASHINGTON, D.C. 2 0 5 1 5 September 11, 1984 Honorable C. Todd Conover Comptroller of the Currency 490 L'Enfant Plaza, S.W. Washington, D.C. 20219 Dear Mr. Conover: To assist this Subcommittee in its inquiry regarding why Continental Illinois National Bank came to require federal assistance, you are requested to authorize and arrange for John Meade, Richard Kovarick, and Allan McCarte to appear before this Subcommittee on September 18, 1984, at 10:00 a.m., in Room 2128 of the Rayburn House Office Building. Each individual is requested to provide testimony on the examinations of Continental Illinois National Bank from 1976 to 1983 for which he served as Examiner-in-Charge. If the individuals named have prepared statements, you are asked, as required by Committee rules, to deliver 175 copies of each prepared statement to Room B303 Rayburn before 12:00 p.m. on September 17, 1984. To enable all Subcommittee Members sufficient time for questioning, it is requested that oral testimony be limited to 10 minutes. Each prepared statement will be distributed to all Members of the Subcommittee in advance of the hearing and will be included in its entirety in the hearing record. F3StG:jOe cc: William Ogden Chairman of the Board Continental Illinois National Bank INQUIRY INTO CONTINENTAL ILLINOIS CORP. AND CONTINENTAL ILLINOIS NATIONAL BANK WEDNESDAY, SEPTEMBER 19, 1984 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON F I N A N CIAL INSTITUTIONS, SUPERVISION, REGULATION AND INSURANCE, COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS, Washington, DC. The subcommittee met, pursuant to call, at 10 a.m., in room 2128, Rayburn House Office Building, Hon. Fernand J. St Germain (chairman of the subcommittee) presiding. Present: Representatives St Germain, Annunzio, Hubbard, Barnard, LaFalce, Vento, Patman, Neal, Cooper, Wylie, Leach, McKinney, Shumway, and Wortley. Also present: Representatives Kleczka and Roemer. Chairman S T GERMAIN. There are usually few silver linings around the edges of major bank failures. But, I will admit that failures—and the suggestion that the Congress wants to ask questions—seems to stir the sleeping giants of the Federal bank supervisory bureaucracy. Back in 1973, I was very concerned about the plunder at U.S. National Bank in San Diego, CA, and I announced my intention to have the Financial Institutions Subcommittee look into that failure in detail. No sooner was my announcement on the street than the then Comptroller of the Currency, Jim Smith, came up with a grandiose plan for what he called a retroactive analysis of the OCC. Eventually this analysis was turned over to a consulting firm—Haskin and Sells—at a price. They delivered a hefty document calling for a brandnew system for grading bank performance and what was dubbed—in the very best public relations fashion—an * 'early warning" system. For a long time, that "early warning" system was the centerpiece at OCC. If a problem arose in the supervision of national banks, we were told that the "early warning" system was being developed and that in the future—unspecified, of course—that would take care of the problem. The committee has never been sure just what the early warning system warned the OCC about. * * * These days OCC seldom mentions early warnings in explaining away its problems. Maybe we should be thankful, for the sake of national security, that OCC didn't peddle their system to the Defense Department. (169) 170 In the wake of Continental, we see the OCC stirring once again. At one time the mere thought of an examination report being mentioned in front of a new reporter would send the OCC into apoplexy. But, in recent days, we have been treated to the sight of senior officials discussing the contents of examination with Washington reporters—albeit selected passages. Mimeographed documents discussing the supervisory procedures have been circulated around the city, and the Comptroller, himself, has been out on the hustings talking about strengthening capital, increasing disclosure, improving examination techniques, and strict enforcement policies. Such stirrings. The New York Times has been so lacking in generosity as to suggest that some of this activity is designed to "preempt the congressional hearings." I won't be so unkind. I'm just happy to see the agency talking about better supervision whatever the motivation. But, it is not enough to gin up the supervisory vigor just while the spotlight of congressional oversight and media attention is focussed on OCC. It has to be a full-time, 12 months a year operation. Frankly, I am not sure that either the supervisory bureaucracy or the banks really get the right message out of Washington. We often see Presidents—of both parties—delay and ignore appointments to key posts in the Federal financial supervisory system. The present Comptroller, for example, did not take office until the last days of 1981—7 months after his predecessor had resigned. This kind of delay sends a message down through the ranks and among the industry that OCC regulates. In 1982, right at the height of bank problems nationwide, the number of OCC examiners dropped to 1,835 compared with 2,282 in 1979. Apparently, alarmed by continuing supervisory problems the number crept back up to 2,080 last year. But, these cuts in personnel couldn't have sent a message of vigor and concern to the personnel on the firing line of the examination process. While his staff was being reduced, Mr. Conover became something of the Marco Polo of Comptrollers—appearing coast to coast with a ready speech in hand. Many of these pronouncements seemed less about bank supervision than they did about the big banks' legislative wish lists in the Congress. The big concern, if one followed Mr. Conover's trail from city to city, seemed to be about less regulation, less Government—presumably less OCC—and more power for the banks. At times, Mr. Conover seemed to take on more the role of a cheerleader for the industry than he did that of a regulator. This, too, must filter down through the ranks of the agency. Does the examiner, about to write a sharp directive to a bank's board of directors, hear the echoes of "Get the Government off the backs of the banks" and decide to take the softer line? While I personally dissent, there may be some who feel that the industry does, indeed, need a Government sponsored cheerleader. If so, I don't think it is appropriate that cheerleading and regulating be combined. The highly costly nature of the sweeping bailout of Continental should establish, once and for all time, the fact that every citizen in this Nation has a stake in a solid regulatory system. We should 171 hear fewer arguments t h a t regulatory standards should be based solely on industry needs and desires. Yesterday's testimony did not increase confidence t h a t OCC has gotten its act together. Even when the information was in hand— the problem spotted—OCC seemed paralyzed, unable or unwilling to force remedial action. And communication within the agency— much less between agencies—still seems to be something t h a t predates Alexander Graham Bell. Despite our best efforts in the Penn Square hearings and yesterday's session, we still can't be sure just when, and how thoroughly the message about the disaster in Oklahoma City reached Chicago, Seattle and other points that had been infected by the Penn Square plague. Leaving aside any thought of partisanship, I am firmly convinced that we must start sending a stronger and clearer message about the need for no nonsense, hard-nosed regulation of financial institutions that utilize Government insurance and enjoy other Federal subsidies. The message has to come from the top—the White House and the Congress both. And it must be echoed—with no equivocation and no mixed messages—by the Federal regulatory agencies. Our witness today, C.T. Conover, is an essential link in that communication link—the kind of message he sends to his troops and to the banks has a lot to do with the quality of regulation. The Chair now recognizes Mr. Wylie. Mr. WYLIE. Thank you, Mr. Chairman. I want to thank the Comptroller of the Currency for his appearance here today and for your excellent statement. As I said in my opening statement yesterday, this is an extremely serious matter. It deserves thorough congressional oversight, and it does raise some profound issues for this committee to explore for the future. I am pleased t h a t you, Mr. Conover, have acknowledged these issues up front in your statement where you say t h a t the Continental case deserves a thorough review by both Congress and the public. Let me say t h a t I am hopeful t h a t the administration, Members of Congress, the regulatory agencies and the public will benefit from these hearings. In my view, we need to learn precisely what factors contributed to the deterioration of Continental Illinois to the point where this unique Federal assistance was required. More importantly, perhaps, we need to consider what measures might be taken in the future as to prevent a similar situation from occurring. We should make certain we do not create the expectation that as long as an institution is big enough, there will be no limit to the amount of risk the Federal Government will accommodate. Mr. Conover, I was particularly encouraged by your statement because on page 21 and throughout your testimony, you stress seven key issues which not only are pertinent in Continental's case, but also of a larger meaning for the safety and soundness of the banking system in the United States. I will want to return to these areas in my questions, but you have identified the salient points. (1) supervisory techniques; (2) internal controls; (3) loan loss reserves; (4) capital levels; (5) funding; (6) financial disclosure; and (7) enforcement policy. 172 Mr. Chairman, these hearings are unprecedented since Continental Illinois is an open, ongoing bank which should have an excellent chance to put its own house in order and rid itself of what I am sure is unwanted Federal assistance, as well as Federal intrusion. I am sure t h a t I speak for all Members of my side of the aisle when I say that we hope t h a t Continental prospers and likewise t h a t we do not have to repeat this experiment. Hopefully, these hearings will be the kind of learning process from which we can all benefit. Thank you very much, Mr. Chairman, for affording me the opportunity to make this opening statment. Chairman S T GERMAIN. Chalmers, I want you to know t h a t I and the Members on our side, as well, are hopeful t h a t we need not have another hearing of this type and t h a t we need not have another bailout of the magnitude and of the character we have seen in this instance. So we are in total sync on this. Mr. WYLIE. We are presenting a united front on t h a t score. Thank you, sir. Chairman S T GERMAIN. Would you please rise, Mr. Conover. [Witness sworn.] Chairman S T GERMAIN. Mr. Conover, we will put your entire statement in the record, along with the appendages thereto. You may proceed. TESTIMONY OF HON. C.T. CONOVER, COMPTROLLER OF THE CURRENCY Mr. CONOVER. Thank you, Mr. Chairman. Mr. Chairman, I would like to read excerpts from my written statement as my opening remarks. And because of the importance of this subject, I ask your indulgence as to time this morning. I think this will take about 20 minutes. Chairman S T GERMAIN. We agree wholeheartedly. Mr. CONOVER. Fine. Thank you very much. Mr. Chairman, members of the committee, I am pleased to be here to discuss Continental Illinois National Bank & Trust Co. The serious problems encountered by Continental and the regulators' actions concerning Continental are obviously a matter of public concern and deserve a thorough review by Congress and the public. Today, I will address what happened at Continental by first describing the economic factors t h a t have buffeted Continental—and other banks—since 1980. These include back-to-back recessions as well as a sharply declining energy industry. Second, I will briefly review the internal policies and practices at Continental t h a t rendered it incapable of weathering these adversities. Third, I will discuss what we could have done differently. Finally, I will focus on what we are doing to assure the continued safety and soundness of the banking system. The 1980's have been difficult years for the banking industry. In early 1980, a recession caused real economic growth to drop sharply. By mid-1980 the economy was growing again, but t h a t recovery only lasted 12 months. In mid-1981, the economy fell back into a recession t h a t lasted 17 months. 173 Although the economy as a whole is now experiencing a strong recovery, the pattern of back-to-back recessions was particularly hard on lending institutions. Loan quality typically begins to deteriorate after an economic slowdown begins, and continues to decline well into the recovery. Many loan portfolios thus have continued to deteriorate since 1980, and many banks are still having problems stemming from the recessions. In addition to having to contend with the effects of the two recessions, many banks have also been affected by the severe problems in the energy industry over the last few years. Most U.S. banks have weathered these difficulties with impressive resilience, but almost all have felt some impact. Return on assets and return on equity are down for the industry as a whole. Asset quality is still suffering, with net loan losses rising even faster for large banks t h a n for small. The difficult economic environment had a particularly devastating effect on Continental. Its problems stemmed from management strategies and policies t h a t depended on strong growth in the economy in general and the energy industry in particular. These strategies and their consequences are detailed in the appendix to this testimony. In sum, Continental adopted a policy of rapid growth that was not accompanied by the necessary management controls and policies to maintain adequate asset quality in the face of an economic slowdown and a declining energy industry. In implementing this goal, Continental adopted a strategy of decentralized lending t h a t permitted its account officers to respond to customers and make loans more quickly and competitively. Although this approach required fewer controls and levels of review, management believed the potential rewards of such a strategy outweighed the associated risk. Continental's management targeted the energy sector for its most aggressive lending expansion. During the latter half of the 1970's, the United States was attempting to develop a program for energy self-sufficiency in the face of uncertainty about actions of the OPEC nations. At that time, some economic analysts were projecting the price of oil to increase to some $60 a barrel. Continental's management strategy of rapid growth with a specialty in energy was quite successful for several years. During the late 1970's, Continental outperformed its peers in growth, earnings, and market perception, and its loan loss record was excellent. In 1978, "Dun's Review" described Continental as one of the five best managed companies in America. In 1981, the very strategy t h a t generated praise began to turn against the bank. A slowing economy meant t h a t the quality of available lending opportunities was deteriorating at the same time t h a t Continental was increasing its corporate lending, inevitably resulting in the making of loans to weak borrowers. By 1982, it became clear t h a t the bank's rapid growth had been achieved at the expense of asset quality. The declining energy industry in late 1981 dealt a particularly serious blow to Continental for two reasons. First, it had a heavy concentration in oil and gas loans t h a t left the bank extremely vulnerable to the industry's sudden decline. Second, from 1980 to 1982, the bank had purchased a large volume of energy loans from Penn 39-133 0—84 12 174 Square Bank, N.A. The quality of these loans proved to be very poor, particularly those loans that were purchased in late 1981 and early 1982 when Continental's growth was peaking. Considering the disproportionate contribution that Penn Square loans made to Continental's losses, it is important to analyze how such a questionable relationship could develop in a bank that had been a top performer for so many years. It now appears that Continental's purchase of problem loans from Penn Square involved significant misconduct on the part of officers of both institutions. However, the problem extends beyond employee misconduct. Management processes should be in place to guard against, and detect, employee misconduct as well as other risks. Continental's management controls were the subject of considerable attention in our examinations over the past 6 to 10 years. Although we judged the bank's system of loan controls to be generally satisfactory, we directed a number of specific improvements. For example, we cited, at various times during the period from 1974 to 1981, problems with the past-due loan report, the completeness of credit files, the identification and rating of problem loans, and collateral deficiencies. Bank management was generally responsive to our concerns and made a number of improvements in its systems for controlling and detecting risk in the loan portfolio. These improvements were not enough. In retrospect, it is clear t h a t there was not sufficient management support for the control systems. Top management had created an environment where aggressive lending was not only condoned but encouraged. In this atmosphere, a high quality system of controls was secondary. Moreover, those warning signals t h a t the existing system did generate were ignored by senior lending officers. In the final analysis, the bank's internal controls did not prevent the purchase of massive amounts of bad loans from Penn Square. With the benefit of hindsight, it is clear that our generally favorable assessment of Continental's internal controls was overly influenced by the bank's outstanding performance during the years 1974 through 1981. It became clear, during our examination t h a t began in May 1982, t h a t Continental's management practices and policies had led to serious loan problems. We responded to this in a number of ways. We extended our examination through November. During the course of the examination, we directed Continental to begin a number of corrective measures, which were immediately initiated by the bank. We informed management of our intention to formalize these directives by placing the bank under a formal agreement, enforceable under our cease-and-desist authority. The agreement required improvements in numerous areas, including loan policies and procedures, asset and liability management, and funding. It also required regular reports by a board committee on the bank's compliance with the agreement. Bank management complied with the terms of the action and took significant steps to revamp its operations. However, the loans t h a t crippled Continental were already on the books. Market confidence had begun to turn against the bank in July 1982 when its Penn Square loan problems surfaced publicly. Despite nearly constant OCC supervision and presence in the bank 175 over the next 2 years, and the efforts by bank management and the board of directors, Continental was unable to fully regain market confidence. In May of this year, the market reacted adversely to rumors of further problems at Continental, and large depositors began withdrawing funds. The bank was unable to stem the run, and Federal intervention was required to prevent the bank's collapse. An obvious question t h a t we and others have asked is whether there was anything that the OCC should have done differently in the course of Continental's deterioration. In addressing this question, it is important first to clarify the role of the bank supervisor. Our charge is to maintain the safety and soundness of the national banking system. To do so requires sufficient oversight of and interaction with bank management to minimize the likelihood of bank failure. We do not take over and manage institutions; we cannot substitute for private management in making lending or any other decisions. The primary responsibility for any bank's performance rests with its management and board of directors. However, as supervisors we do monitor risk exposure, work to see that policies and controls are appropriate to t h a t level of risk, and enforce compliance with the law. When we identify major weaknesses, we institute corrective measures, and follow up on their implementation. This results in significant improvement in the vast majority of institutions t h a t we identify as having problems. For some institutions, even prompt and stringent corrective measures are unsuccessful. The safety and soundness of the banking system also requires allowing such poorly managed, financially weak institutions to disappear from the system in an orderly manner. In an important sense, this is what has happened to Continental. The doors are still open, but the officers who allowed the bank's deterioration are no longer part of Continental. Moreover, those that bear responsibility for approving management policies have paid a price. The shareholders face substantial, if not total, loss, and the directors and former management face potential legal liability. Chairman S T GERMAIN. Mr. Conover, I am constrained to interrupt you at this point, because your timing is excellent because we have a quorum call. So I am interrupting you at this point to clarify something. I think every one should be aware of the full import of your comment about Continental management paying the price for their mistakes. I will quote from page 17 which you just read. "The doors are still open, but the officers who allowed tne bank's deterioration are no longer a part of Continental. Moreover, those that bear responsibility for approving management policies have paid a price." Now, Mr. Conover, again I say all should know that the full price being paid by Continental's former management may not be as heart rendering as you might imply. Let's take a look at the facts. Mr. Anderson, former chairman of Continental, retired, now, let's keep in mind, is the fellow who was the go-go-banker, the aggressive banker that really took over the reins of this institution and decided he would make it big, and we will get to t h a t issue of bigness again later in these proceedings—but he is the fellow who 176 said, "Well, we will let lower management be responsible for making the loans." And very frankly, I think one of the big problems here is that the top-level management just disassociated itself and insulated itself from responsibility for many of the mistakes t h a t were made at the lower level. But let's look at what poor Mr. Anderson is undergoing. And I think we should all take out our crying towels. What did he end up with? A one-time lump sum pension supplement of $269,792. And then a monthly consulting fee of $12,212 through July 1986. When cited, they gave it on a monthly basis, but t h a t works out to $145,000 a year. He received a cash payment of $77,000, reflecting the value of forfeited shares of certain stock, about which we have no idea what the value might be. Then certain financial advisory services from 1 year after retirement and payment of dues to certain clubs. Now, Mr. Perkins and Mr. Miller also received handsome separation packages when they retired from Continental. A full explanation of the termination benefits Continental's top management received are discussed in an OCC memorandum dated July 3, 1984. If there is no objection, I shall place t h a t memorandum in the record at this point. Is there objection? The Chair hears none. [The OCC memorandum of July 3, 1984, referred to by Chairman St Germain and the Continental Illinois Corp. proxy statement, dated August 24, 1984, follow:] 177 o ©iMMoy Comptroller of the Currency Administrator of National Banks Washington, D.C. 20219 Andrea Salloom, Attorney Enforcement and Compliance Division Ronald Goldberg, Law Clerk\h^2£Enforcement and Compliance Division July 3, 1984 Possible OCC Action Against "Golden Parachutes" at Continental Illinois Issue Would the OCC be authorized to institute an enforcement action against Continental Illinois Corporation (ClC^or its former officers with respect to the "golden parachute" retirement/termination contracts granted to three former top officers and if so, on what basis could such an action be sustained? Short Conclusion Under a different factual situation it might be possible to compel the non-enforcement of bank employment contracts containing unreasonably excessive compensation through a cease and desist order under 12 U.S.C. §1818(b), alleging that such contracts constitute an unsafe or unsound banking practice. However, given the moderate amount of the contracts in comparison with Continental's asset size and the industry-wide practice with respect to such termination agreements it will be difficult to establish a violation of either §1818 or our interpretative ruling on the subject contained in 12 C.F.R. §7.5220. Scope of this Memo This memo will discuss the validity of employment contracts entered into by national banks and their officers or employees. The rise of "golden parachute" contracts, industry-wide compensation standards and the facts of CIC s retirement settlements with three former officers will be examined, focusing on the Comptroller's statutory authority to act against excessive remuneration or benefits in banks employment or termination agreements. The discussion will 178 fccus on the interaction of 12 U.S.C. §§24(5) and 1818(b) and 12 C.F.R. §§7.5220 and 563.39(a) as construed in recent cases. The more general question of reasonableness in executive compensation, the standards for establishing violations by directors and officers of their fiduciary duties and the business judgment rule will also be addressed in connection with excessively generous compensation schemes. The Termination Agreements at CIC Effective April 30, 1984 Roger E. Anderson, Chairman of the Board of Directors and Chief Executive Officer at CIC, Donald C. Miller, Vice-chairman of the Board and John H. Perkins, President, voluntarily entered early retirement. According to an executive vice president at the bank, two factors led to the decision of Miller and Perkins to retire early: (1) the opinion of the Board of Directors that the bank's corporate office organizational structure had not functioned as it should have, necessitating a concentration of power in one CEO, ar>d 2) the need to accelerate the bank's management succession process. Negotiations for their retirement were initiated in May 1983 and it was decided that in order to avoid the appearance of penalizing them in any way their termination agreements were to treat them as if they had completed their full careers. Originally, Anderson was to remain as CEO, but in late December 1983 and early January 1984 it had become clear to the Board of Directors that the bank's earnings were not rebounding as expected; visible action needed to be taken to retain confidence in the corporation's recovery from the Penn Square failure. After discussions with members of the Board's Compensation and Nominating Committee, it was mutually agreed that Anderson would also retire early. The Board felt it was appropriate to offer Anderson terms similar to those given Miller and Perkins since the retirement was not punitive in nature and the Board did not wish to create more notoriety for the corporation. At its meeting on August 15, 1983, the Board approved the termination packages arranged for Miller and Perkins and on February 27, 1984, the Compensation Committee approved Anderson's retirement agreement. According to inside sources at the Bank, at the times these three retirement plans were developed and approved there was no premonition of the devastating effects of the rumors of May 1984 and no reason to assess personal penalties against the three former officers. 179 A. Terms of the Agreements General Terms Length of Service 37 years 25 years Amount of annual Pension Supplement Consulting fees (monthly) $38,150 $12,500 5/1/84-7/1/86 $12,212; 8/1/86-6/30/88 $1500 Lump sum payment to reflect orfeited restricted shares $77,000 Membership payments to be made by bank One country club and one luncheon club for five years Office with secretarial support Eligibility forcorporation's professional services in the year of retirement and and the year following retirement Reimbursement for all legitimate business expenses incurred on behalf of the bank years 5/1/84-3/85 $15,375 $51,000 3 7 years "121,500 9/1/84-8/30/t $12,682 (to rise by $1,850 if nc elected to Board in 1984 or 196 $57,000 One country club and one tennis club for five years One country c one luncheon club for 5 ye and Old Elm club for life 5 years 5 years 180 B. Industry Standards on Termination Agreements and the Rise of "Golden Parachute" Contracts Negotiated termination settlements such as those obtained by Anderson, Miller and Perkins have become a standard practice in almost all corporations. A 1983 survey conducted for The THinc. Consulting Group International revealed the following "standard" severance settlements for three levels of executives in banking, insurance and service industries: Below Mid-Range Executives; - Average of 6 months severance; Benefits continuance, often structured as "Bridging Pay" whereby the financial commitment ceases upon relocation; Out-placement; Off-site office with secretarial assistance when, feasible; sometimes short-term travel/lodging allowance. Mid-Range Executives: - Plus/minus 1 year of severance or 1 week per year of service, infrequently spaced over additional years; Benefits continuance, sometimes structured as "Bridging Pay" whereby financial commitment ceases upon relocation; Key executive level out-placement; Off-site office with secretarial assistance; Short-term travel/lodging allowance. Above Mid-Range Executives: Usually negotiated settlements; Over 1 and up to 3 years of severance, sometimes spread over 1 to 5 years; Benefits continuance, up to 5 years bridging to early or full retirement; Key executive level out-placement; Off-site office with secretarial assistanceSubstantial travel/lodging allowance. In comparison to the "standard" termination package for top-level executives, it would not seen that the packages obtained by the CIC officers are unduly excessive. According to a 1982 survey conducted by Ward Howell Infl., Inc. approximately 40% of U.S. corporations on the Fortune 1000 list provide employment contracts for top officers. The rise of so-called "golden parachute" contracts are symptomatic of the accelerating merger trend and are normally intended to both minimize the ramifications of hostile tender offers by protecting both the positions and responsibilities of key 181 officers, and discourage hostile tender offers through the disincentive of large management payoffs to current officers in the event of a takeover. Haggerty, Golden Parachute Agreements: Cushioning Executive Bailouts in the Wake of a Tender Offer, 57 S. John L.Rev. 516 (1983). Although normally golden parachutes are negotiated shortly before or during the tender offer, many corporations have given their top executives golden parachutes despite the present threat of a takeover. Id. at 577. Generally, "golden parachutes" have the following characteristics: the contracts are usually given to 2-5 top executives; the contracts normally extend from 1-7 years; benefits range from salary incentives to health, pension and stock purchase plans; over 50% of the contracts are valued at $1-5 million; some provide for lump-sum payments, others for periodic payments. Cooper, "The Spread of Golden Parachutes", August 19 . . Institutional Investor at 65; Haggerty at 529. Given these general characteristics of "golden parachutes" it is unlikely one would describe the contacts obtained by Anderson, Miller and Perkins as "golden parachutes." C. The Validity of Employment Contracts Entered into by National Banks Among the corporate powers granted to national banking associations dating back to the National Bank Act of 1864 is the power to "[e3lect or appoint directors...and other officers...[and] dismiss such officers or any of them at pleasure." 12 U.S.C.A. §24 Fifth (West Supp. 1983). Courts have consistently interpreted this provision to allow the board of directors of a national bank to dismiss an officer without liability for breach of any employment agreement that the bank might have entered into with the employee. In re Paramount Publix Corp., 90 F.2d 441, 443 (2d Cir. 1937); Mahoney v. Crocker National Bank, 571 F.Supp. 287, 289 (N.D. Cal. 1983); Kozlowsky v. Westminster National Bank, et al., 6 Cal. App. 3d Supp. 573, 86 Cal. Rptr. 52 (Cal. Dist. Ct. App. 1970). As stated in 7A Michie on Banks and Banking, §127: "Under the federal statute providing that a national bank shall have power by its board of directors to appoint the president, vice-president, cashier and other officers and to dismiss such officers or any of them at pleasure, the board may dismiss an officer without liability for breach of an agreement to employ." The Comptroller, in an interpretative ruling contained in 12 C.F.R. §7.5220 gave the boards of directors of nations' banks 182 the power to enter into employment contracts with their officers pursuant to 12 U.S.C. §24 Fifth. However, the ability of banks to contract for employment is qualified in that the contracts must be entered into "upon reasonable terms and conditions." 12 C.F.R. §7.5220 (1984). In a leading case examining the interrelationship between 12 U.S.C. §24 Fifth and 12 C.F.R. §7.5220, a former bank president unsuccessfully sought damages for wrongful discharge. The court held that the power to contract for a definite term given to banks in 12 C.F.R. §7.5220 is consistent with the power to discharge an employee before the end of that term. Kemper v. First National Bank in Newton, 94 111. App.3d 169, 418 N.E.2d 819, 821 (111. App. Ct. 1981). The court interpreted the various cases dealing with both the statute and regulation and concluded that "[ajlthough a national bank may contract to employ an officer for a definite period of time, it may not bargain away its right, granted by statute, to discharge those officers at pleasure". Id. Therefore, it would appear that employment contracts whTch are otherwise valid and enforceable may be di^ owed by national banks without liability for wrongful discharge. However, the decision to actively seek avoidance or disaffirmance must be made by the board of directors. D. Proving a Violation of 12 C.F.R. §7.5220 — Factors Determining the Reasonableness of Executive Compensation Although no cases have defined the term "reasonable" as used in 12 C.F.R. §7.5220, a 1976 memorandum from Charles F. Byrd, Assistant Director, LASD, to John E. Shockey, Deputy Chief Counsel, concluded that unless an employment contract "is blatantly unreasonable," an effort to prove the contract is not within the terms of I.R. 7.5220 "would be extremely difficult." The task of proving the unreasonableness of employment contracts was not made easier by the defeat of a 1976 proposal to add to I.R. 7.5220 illustrations of provisions in employment contracts that OCC would consider unreasonable. Nevertheless, courts have had to develop guidelines for determining the reasonableness of executive compensation in other contexts. As noted in an American Law Reports Annotation, the reasonableness of compensation involves a question of fact and although generally within the exercise of the board of directors* business discretion, courts have looked to the actual services rendered by the officer, the financial condition of the corporation and have made comparisons with other officers' salaries in the same company or other firms in similar businesses. See Annot. 53 A.L.R. 358 (1973). A federal district court explicitly held that the reasonableness of an officer's compensation, as approved by the board of directors of which he was a member, may be determined in light of the corporation's financial condition. Irwin v. West End Deve' -^pment Co., 342 F.Supp. 687 (D.Colo. 1972), modified, 481 183 F.2d 34 (1973). As noted by another court, the salaries of officers of an efficiently managed corporation must bear a reasonable relation to the services rendered and the income of the business since corporate directors and officials must have regard for the financial condition of the corporation. Baker v. Cohn, 42 N.Y.S.2d 159 (N.Y Sup. Ct. 1942), modified, 266 A.D. 715, 40 N.Y.S.2d 623 (N.Y. App. Div. 1943), a f F I 292 N.Y. 570, 54 N.E.2d 689 (1944). A reviewing court may look at compensation paid by other corporations in similar businesses. Backus v. Finkelstein, 23 F.2d 531, 536-37 (D.C. Minn. 1924). A general guideline for determining the reasonableness of compensation is that the remuneration must be in proportion to the officer's ability, services and time devoted, corporate earnings and other circumstances. Glenmore Distilleries Co. v. Seidman, F.Supp. 915, 919 (E.D.N.Y. 1967). The Seidman court went on to stress that "[sjalaries of officers in an efficiently managed corporation must bear a reasonable relation not only to the services rendered but to the income of the business." Id. Given the inherent vagueness in a term such as "reasonable", the preceding material is offered merely as an indication of the types of factors a reviewing court might consider in a determination of the reasonableness of executive compensation agreements. E. Unreasonable or Excessive Executive Compensation as an Unsafe or Unsound Banking Practice Within 12 U.S.C. 1T818 Although it would.prove difficult to establish a violation of I.R. §7.5220 due to the ambiguity of the term reasonable, there is substantial authority that given the proper circumstances, excessive or unreasonable employment or termination agreements could constitute unsafe or unsound banking practices within 12 U.S.C. §1818. Bank Circular No. 115 dated August 30, 1978, stated that practices OCC views as unsafe or unsound include excessive salaries and bonuses, excessive director fees and fees paid where there is no corresponding benefit to the bank. The legislative history of 12 U.S.C. §1818 reveals the breadth of the term unsafe or unsound. As John F. H o m e , Chairman of the Federal Home Loan Bank Board testified before Congress: [d]espite the fact that the term "unsafe or unsound practices" has been used in the statutes governing financial institutions for many years, the Board is not aware of any statute, either Federal or state, which attempts to enumerate all the specific acts which could constitute such practices. The concept of "unsafe or unsound practices" is one of general application which touches upon the entire field of the 184 operations of a financial institution. For this reason, it would be virtually impossible to attempt to catalogue within a single all-inclusive or rigid definition the broad spectrum of activities which are embraced by the term. The very formulation of such a definition would probably operate to exclude those practices not set out in the definition, even though they might be highly injurious to an institution under a given set of facts or circumstances or a scheme developed by unscrupulous operators to avoid the reach of the law. Contributing to the difficulty of framing a comprehensive definition is the fact that particular activity not necessarily unsafe or unsound in every instance may be so when considered in the light of all relevant facts. Thus, what may be an acceptable practice for an institution with a strong reserve position, such as concentration in high risk lending may well be unsafe or unsound for a marginal operation. Hearings on S. 3158 Before the House Comm. on Banking and Currency, 89th Cong., 2d Sess., at 49-52 (Sept. 15-22, 1966). An early case treating this question at a different bank found that excessive bonuses and salaries to bank officers constituted an unsafe and unsound practice and upheld the Comptroller's Cease and Desist Order given the poor financial performance of the bank. First National Bank at Eden, South Dakota v. Department of the Treasury, Office of the Comptroller of the Currency, 568 F.2d 610, 611 (8th Cir. 1978). The court adopted the Comptroller's defintiion of unsafe and unsound practices as encompassing "[w]hat may be generally viewed as conduct deemed contrary to accepted standards of banking operations which might result in abnormal risk or loss to a banking institution or shareholder." Id. In the most significant case on point the Seventh Circuit upheld the determination of the District Court for the Northern District of Illinois that employment agreements entered into by a federally-insured savings association with two of its officer-directors were null and void because they constituted an unsafe and unsound banking practice. Federal Savings and Loan Insurance Corporation v. Bass, 576 F.Supp. 848 (N.D. 111. 1983), app. dismissed, No. 83-3305 (7th Cir. April 28, 1984). The agreements involved large termination payments voted by the board of directors of Unity Savings Association at a time when the institution was experiencing serious financial difficulties; several board members were contract beneficiaries. Eventually Unity became insolvent and the FSLIC 185 took over as its receiver. The court relied heavily on a Federal Home Loan Bank Board regulation requiring that an insured institution "[n]ot enter into an employment contract with any of its officers or other employees if such contract would contitute an unsafe or unsound practice." 12 C.F.R. §563.39(a)(1983). The court also applied a Fifth Circuit holding that restricted the breadth of the unsafe or unsound practice formula to practices with a reasonably direct effect on an association's financial soundness. Bass, 576 F. Supp. at 852 (quoting Gulf Federal Savings and Loan v. Federal Home Loan Bank Board, 651 F.2d 259, 264 (5th Cir. 1981), cert, denied, 458 U.S. 1121 (1982)). The court found that "[UlnTty could ill afford to part with $200,000 for even the best of reasons," and certainly not to disburse funds for this "[b]latent attempt to secure...[the officer-directors'] position at Unity's expense." Id. The FSLIC in its briefs before the court, argued that the employment contracts threatened a loss of public confidence in the entire t 'ings and loan industry by allowing officers to remove substantial amounts of cash from an instituion as a result of its failure. More basically, the FSLIC contended that the agreements were inconsistent with sound financial practices which would involve reduction rather than increase of expenses for a financially troubled institution. What may be more significant for future litigation involving the OCC is the fact that the court agreed with the FSLIC that judicial deference to bank regulators would be "particularly appropriate" in a factual situation such as that presented by Bass. When faced with a question of statutory construction, the Supreme Court has mandated that federal courts accord "CgJreat deference to the interpretation given the statute by the officers or agency charged with its administration." Ford Motor Credit Co. v. Milhollin, 444 U.S. 555, 566, (1980) (quoting Udall v. Tallman, 380 U.S. 1, 16 (1965)). With respect to the deference which has been accorded the OCC in its interpretation of 12 U.S.C. §1818 the D.C. Circuit has held that the Comptroller's discretionary authority to define and eliminate 'unsafe and unsound1 conduct is to be liberally construed. Independent Bankers' Association of America v. Hermann, 613 F.2d 1164, 1168-69 (D.C. Cir. 1979), cert, denied, 449 U.S. 823 (1980). The Fifth Circuit has held that the exercise of the Comptroller's discretion will not be disturbed unless it is arbitrary, capricious or contrary to law; so long as the Comptroller can substantiate his actions in a reasonable manner, a reviewing court will defer to the agency's judgment. First National Bank of Bellaire v. Comptroller of the Currency, 697 F.2d 674, 680 (5th Cir. 1983). In light of Bass and the series of decisions stressing judicial deference to 7ministrative agency interpretations, there is clearly a lege, basis upon which to argue that in certain 186 circumstances, employment or termination agreements can constitute unsafe or unsound banking practices within 12 U.S.C. §1818. In order for a court to uphold a Cease and Desist Order, several requirements would probably have to be met. First, the bank's financial condition would have to be precarious enough that the compensation would have a "reasonably direct effect" on the institution's financial soundness. Additionally, the contracts themselves must be "unreasonable" in some manner. A violation of the guidelines enumerated in Banking Circular No. 115, a financially unsound decision to reward poor managerial performance or a contract of the "golden parachute" genre could all fall within this prohibition. However, when one examines the three termination agreements for Anderson, Miller and Perkins at CIC, it is unlikely that any action under §1818 would succeed. The contracts were relatively meager in terms of industry standards. Additionally, the lengths of service of the former officers was very long while the duration of the payments was fairly short. The net'present value of each agreement constituted only the amount each officer would have received in salary and benefits if he had not retired early. More significant is the fact that a plausible argument could not be made, given Continental's size, that the payments would have a direct and detrimental effect on the institution's financial soundness. In a smaller and more "insolvent" or "illiquid" institution and under a more egregious set of facts such as those presented by Bass, the Comptroller would have a much better chance of sucessfully arguing that the contracts were null and void as an unsafe or unsound banking practice. F. Potential Arguments that Bank Boards or Officers Might Raise to an Action Under 12 U.S.C. §1818 Seeking a Cease & Desist Order Any action brought under 12 U.S.C. §1818 attempting to nullify an employment or termination agreement will be subject, as a first defense, to the claim that the agreement was entered into in accordance with 12 C.F.R. §7.5000. This interpretative ruling reads, in pertinent part: A national bank may adopt any reasonable bonus or profit-sharing plan designed to insure adequate remuneration of bank officers and employees. 12 C.F.R. §7.500 (1984) (emphasis supplied). Given the representative standard compensation/termination practices described in Section B, it might be difficult to argue that a contract which is typical of those in the industry is "unreasonable." However, a bank's challenge to an §1818 action on this ground would probably be unsuccessful as the Comptroller need prove only that the agreement constitutes an unsafe or unsound practice, not that it is "unreasonable." 187 A bank board's next argument would probably focus on the deference courts give to directors' decisions as a result of the business judgment rule. Under the business judgment rule, corporate directors are presumed to have acted properly and in good faith and are called to account for their actions only when they have acted in bad faith. Treadway Companies, Inc. v. Care Corporation, 638 F.2d 357,382 (2d Cir. 1980). As one court has stated, directors will be held to a standard which requires them to exercise honest business judgment, defined as the exercise of "[t]hat care which businessmen of ordinary prudence use in managing their own affairs." Northwest Industries, Inc. v. B.F. Goodrich Company, 301 F.Supp. 706, 711 (N.D. Ill. 1969) . While corporate management has a high fiduciary duty of honesty and fair dealing with shareholders, and it will be given wide discretion in decision-making under the business judgment rule, Berraan v. Gerber Products Company, 454 F.Supp. 1310, 1319 (W.D. Mich. 1978), the business judgment rule does not apply to situations involving self-dealing, where there is a conflict of interest. Lewis v. S.L.& E., Inc., 629 F.2d, 764, 769 (2d Cir. 1980). In an action brought under the Labor-Management Reporting and Disclosure Act, 29 U.S.C. §501 et seq. (1976), the Second Circuit held that corporate officers could be liable for breach of their fiduciary duties by authorizing and receiving excessive compensation for themselves. Morrissey v. Curran, 650 F.2d 1267 (2d Cir. 1981). Similarly, if bank director-officers were to vote themselves large employment or termination agreements, the business judgment rule would not apply. Although the Comptroller would probably not have standing to assert an action for breech of fiduciary duty, any action under 12 U.S.C. §1818 to have the contracts rescinded as unsafe or unsound banking practices would not be subject to the business judgment rule defense. As fiduciaries, directors and officers are obligated to act solely to benefit the corporation and must forego any personal advantage that may result from their position. Pepper v. Litton, 308 U.S. 295, 311 (1939); Burden v. Sinskey, 530 F. 2d 478, 489-90 (3d Cir. 1976). Conclusion It is unlikely that the Comptroller would be successful in an enforcement action against Continental and/or Anderson, Miller and Perkins given the nature of their contracts, the bank's size and financial condition, and industry practices with respect to termination agreements. As Eugene Katz, Assistant Director, Litigation, stated in a memo to Robert Serino, Deputy Chief Counsel, it might be advisable for the FDIC, considering the leverage it now has over Continental, to "suggest" that these contracts should be rescinded as they are not in the bank'8 best interest. It is clear, however, that given a more blatant use of insider advantage as is the case with true "golden parachutes" at a financially troubled bank, the Comptroller could successfully bring an action against such agreements, alleging them to be unsafe or unsound banking practices. cc: Ralph Sharpe Robert Davis Stacy Powers 188 FROM CONTINENTAL ILLINOIS CORPORATION'S PROXY STATEMENT DATED AUGUST 24, 1984 Bank in the ordinary course of business during 1983. All loans and commitments included in such transactions were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and did not involve more than normal risk of collectibility or present other unfavorable features. The following table sets forth all 1983 cash compensation for services rendered to CI Corp and its subsidiaries by (i) the five most highly compensated executive officers of CI Corp and (ii) all executive officers of CI Corp, as a group, while they held such positions. Name and Capacities in Which Served Salary Roger E. Anderson (3) Former Chairman of the Board of Directors of CI Corp and the Bank John H. Perkins (3) : Former President of CI Corp and the Bank Donald C. Miller (3) Former Vice Chairman of CI Corp and the Bank David G. Taylor (3) Former Vice Chairman of CI Corp and the Bank Edward M. Cummings (3) For.ner Executi/e Vice President of CI Corp and the Bank until December 31, 1983 All executive officers as a group (18 in number) S 515,000 Profit Sharing (1) Incentive Compensation (2) 514,909 ' S - 0 - 430,000 12,448 -0- 325,000 9,409 -0- 269,455 7,801 -0- 207,500 6,007 -0- 3,838,574 115,404 -O- (1) The figures in this column represents amounts paid in 1984 for 1983 pursuant to CI Corp's cash and deferred profit -sharing plan/ (2) The Board of Directors has determined that no awards for 1983 will be made pursuant to CI Corp's incentive compensation plan. (3) All of the executive officers named in the table above have resigned from CI Corp and the Bank, except for David G. Taylor. Mr. Taylor, who served as Chairman of the Board of Directors of CI Corp and the Bank from April 23, 1984 to August 13, 1984, now serves as a Vice Chairman of the Bank. For a description of certain of CI Corp's benefit plans, see "Stock Options, Stock Appreciation Rights and Restricted Stock" and "Other Employee Benefit Plans". In addition to the amounts set forth in the table above, Mr. Perkins received during 1983 other compensation of $31,294 in the form of dues paid by CI Corp for certain associations and clubs and the value of financial advisory services provided by the Bank. Mr. Cummings received during 1983 other compensation of $ 131,786 in the form of reimbursement for various expenses incurred in connection with duties overseas during 1982, for moving expenses incurred in returning to the United States and for dues paid by CI Corp for certain clubs. During 1983 no other executive officer named in the table received any other compensation in an amount in excess of 525,000 and all executive officers as a group did not receive other compensation in excess of 10% of the compensation for that group as reported in the table. In connection with Mr. Anderson's retirement, he received (i) a one time lump sum pension supplement of 5269,792; (ii) a monthly consulting fee of S12.212 through July 1986 and Sl,500 thereafter through June 1988; (iii) a cash payment of S77.000 reflecting the value of forfeited shares of restricted stock to which he would have been entitled if he had retired at the age of 65; (iv) certain financial advisory services until one year after retirement and (v) payment of dues for certain clubs. In connection with Mr. Perkins' retirement, he received (i) an annual pension supplement of S19,720; (ii) a monthly consulting fee of S14,532 through August, 1986; (iii) a cash payment of 557,000 reflecting the value of forfeited shares of restricted stock to which he would have been entitled 68 189 if he had retired at the age of 65; (iv) certain financial advisory services until one year after retirement and (v) payment of dues for certain clubs. In connection with Mr. Miller's retirement, he received (i) an annual pension supplement of SI2,500; (ii) a monthly consulting fee of $15,375 through March, 1985; (iii) a cash payment of 551,000 reflecting the value.of forfeited shares of restricted stock to which he would have been entitled if he had retired at the age of 65; (iv) certain financial advisory services until one year after retirement and (v) payment of dues for certain clubs. CI Corp directors who are not regular salaried officers of CI Corp or its subsidiaries receive an annual retainer of $15,000, a fee of S600 for each board meeting attended, a fee of S500 for each committee meeting attended, and an annual fee for service on committees as specified below. The Chairman and each other member of the Audit Committee receive an annual fee of S7,500 and 54,000, respectively. The Chairman and each other member of the Compensation and Nominating Committee receive an annual fee of 55,000 and 53,000, respectively. Each member of the Board Credit Committee and each member of the Bank's board's Committee on Private Banking, Trust and Investment Services receives an annual fee of 53,000. Directors may elect to defer payment of any of their director fees, which then accrue earnings at a rate determined from time to tims by the Compensation and Nominating Committee. Deferred fees are paid in a lump sum or in installments, generally commencing after a director ceases to be a director of CI Corp and the Bank. Stock Ownership of CI Corp CI Corp has been advised by Dean LeBaron, doing business as Bat.urymarch Financial Management ("Batterymarch"), 600 Atlantic Avenue, Boston, Massachusetts 02210, that as of June 30, 1984, Batterymarch was the beneficial owner (as defined by the Securities and Exchange Commission) of 2,057,050 shares, representing 5.1% of the outstanding shares of Common Stock of CI Corp. Batterymarch has sole voting power with respect to 623,500 shares and has sole investment power with respect to 2,057,050 shares. CI Corp does not know of any other person who is the beneficial owner of more than 5% of its Common Stock. The following table sets foi.h the beneficial ownership of Common Stock of CI Corp and directors' qualifying shares of the Bank as of August 20, 1984 (i) by each director, and (ii) by all directors and officers of CI Corp as a group. As of that date, each director of CI Corp beneficially owned less than .1%, and all directors and officers as a group owned less than 1%, of the outstanding shares of Common Stock of CI Corp. CI Corp John E. Swearingen William S. Ogden.... Raymond C. Baumhart, SJ James F. Bere Weston R. Christopherson William B. Johnson 7 Jewel S. Lafontant Vernon R. Loucks, Jr Frank W. Luerssen Robert H. Malott Marvin G. Mitchell John M. Richman Paul J. Rizzo Thomas H. Roberts, Jr William L. Weiss Blaine J. Yarrington All directors and officers as a group (33 in number) *.". . 69 39-133 0—84 13 100 100 .. None 1,000 200 1,220 400 200 200 1,000 1,000 200 200 200 248 1,000 356,484(1) (2) Bank 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 190 Chairman S T GERMAIN. I simply want the record to reflect that, yes, Mr. Anderson has paid a price since he no longer earns $515,000 a year. But the man has apparently not been left to pauperism, or destitute since his departure from Continental. The subcommittee will be in recess for 10 minutes in order to allow the Members to answer the quorum call. Then we will resume Mr. Conover's testimony. [Recess.] Chairman S T GERMAIN. The subcommittee will come to order. Mr. Conover, you may proceed. Mr. CONOVER. Thank you, Mr. Chairman. The demise of Continental was clearly not desirable. It would have been far better if management had made better decisions and taken actions that would have been more appropriate for the ensuing circumstances. It would also have been preferable if we as supervisors could have done something to change the course of Continental. As we review the history of Continental, it is possible to identify several points in time and ask whether it would have been appropriate for the supervisors to step in forcefully to change the course of the bank's direction. We did this, of course, after our 1982 examination when we took a formal enforcement action against the bank. Most banks, including Continental, respond to this type of corrective measure. What made Continental different from most of these cases was that the market did not wait for the bank's recovery plan to restore it to health. I am persuaded t h a t since mid-1982, there was nothing more t h a t we could have done to speed Continental's recovery and thereby increase market confidence. We have asked ourselves whether we should have taken action as early as 1976 to prevent Continental from embarking on a course of rapidly becoming a top lender to corporate America. In my view, it would have been inappropriate to have done so. It is not the proper function of regulators to decide what business strategy an individual bank should undertake. The regulator's role is to see t h a t whichever business strategy a bank chooses, it has the mechanisms in place to implement t h a t strategy in a safe and sound manner. In retrospect, it is clear t h a t management, buoyant with the bank's years of financial success, placed too little value on risk control mechanisms in the implementation of its strategy. If there is anything t h a t OCC could have done differently, I believe it would have been to place more emphasis on our evaluation and criticism of Continental's overall management processes. Had we done so, we might have been alerted to management's lack of commitment to controlling risk sooner than 1982. Had we been less swayed by management's successful track record from the early 1970's through 1981 and its previous responsiveness to our supervision, we might have been able to see more clearly the risks inherent in its rapid growth strategy. Continental's demise has highlighted the need for banks and supervisors to continue to work to maintain the public's confidence in individual banks and the banking system as a whole. 191 Supervisory techniques continue to be improved. The OCC's supervisory process has continued to improve as technological innovations have been made and industry conditions have changed. Our supervision of banks of all sizes has been enhanced by the establishment of an Industry Review Program. This program includes a computerized information system to collect data on industry concentrations in individual bank portfolios and the banking system as a whole. Our examiners will use the information in their analyses of individual banks to identify concentrations and to help position banks to withstand problems emerging from them. The near-complete development of two additional computer systems will provide us with a much improved ability to respond to examination needs and follow up on examination results. We have also taken steps to ensure communication within the OCC of examination findings on individual banks t h a t may affect other banks in the system. These steps include changes in OCC internal procedures, examination manuals, and training. Our multinational bank program has been expanded, and we are examining multinational banks more frequently t h a n in the past. Our examinations are targeted on the areas of supervisory concern and take place two to three times a year, rather t h a n annually. Moreover, we have reorganized and significantly increased our resources committed exclusively to the supervision of our largest banks. In addition to the more frequent examinations we have undertaken, the examiners will also monitor trends and developments in the banks between examinations. This new approach results in near-constant supervision of each of our large banks. Second, internal controls must be emphasized. The OCC is placing more emphasis in the examination process on banks' internal controls and systems. This includes increased testing of control procedures and their application and more stringent follow-ups to ensure t h a t internal control deficiencies are corrected. In addition, we have issued specific procedures t h a t banks must follow when they purchase loan participations. Three, loan loss reserves are being evaluated. Since the allowance for possible loan losses [APLL] is the first line of defense against loan deterioration, we are taking additional steps to assess the adequacy of a bank's APLL relative to the total risk in its portfolio. We are concerned t h a t for some banks, increases in the APLL have not kept pace with increases in nonperforming and classified loans. We are addressing this concern by developing more specific criteria for use by our examiners in evaluating the adequacy of reserves and by focusing our examinations of large banks to make sure t h a t reserves are adequate. Four, capital levels are being increased. Congress reemphasized the critical role of capital in maintaining the safety and soundness of the banking system when it enacted in 1983 the International Lending Supervision Act t h a t authorizes the banking agencies to enforce capital requirements. Under regulations proposed by the OCC and the FDIC, all banks, regardless of size, would be required to maintain a minimum ratio of primary capital to total assets of 5.5 percent and a total capital ratio of 6 percent. The implementation of this standard would not replace our supervisory evaluation of capital adequacy. Banks of all sizes will be 192 encouraged to maintain higher capital levels. Furthermore, the OCC retains the right to impose higher ratios for banks whose circumstances necessitate a stronger capital base. Five, sources and uses of funds are being scrutinized. The OCC is devoting more resources to monitoring regional and multinational banks' global funding. Banks will be placed under special surveillance if they are especially vulnerable to eroding market confidence or reliance on particular funding markets is deemed to be excessive. Where we find a high volume of volatile liabilities, we will require a larger percentage of liquid assets. Six, increased financial disclosure is being promoted. The market's evaluation of the banking system depends, in large part, on the information t h a t is publicly available. To enhance the credibility of bank financial statements and reduce the likelihood t h a t the market will overreact to incomplete information, the OCC is considering requiring increased disclosure of information about banks. To t h a t end, it is seeking public comment on increasing the disclosure requirements for banks via an advance notice of proposed rulemaking. Chairman S T GERMAIN. If I may for a moment, Mr. Conover, I want to encourage you in t h a t area. Unfortunately, we had thought we would see t h a t earlier, as you recall, right after or during Penn Square I made the point t h a t increased disclosure was very, very essential. I got the impression that the FDIC was going to really move in t h a t direction. But the movement has been very slow. So I really encourage and commend you on t h a t point, because I think it is most important, and on capital adequacy, you do recall that, as I think you stated, the International Lending Supervision Act as a result of this committee's insistence, required this increase in capital. Mr. CONOVER. Correct. On the subject of increased disclosure, we have been pushing for t h a t for some time. I think the action we are taking now is significant because it is not jawboning. It is not a voluntary thing. We are talking about putting a firm regulation in place. Chairman S T GERMAIN. Well, that is very gratifying. Mr. CONOVER. The seventh area we have been focusing on is maintaining a strict enforcement policy. We have been utilizing our enforcement power more vigorously to correct violations of law and imprudent banking practices. For instance, last year we took 274 formal actions against national banks compared to 156 for the previous year and only 65 in 1978. The total for the first 8 months of this year is 250 formal actions. These actions have been taken against banks of all sizes. We have outstanding enforcement actions against 17 percent of the banks with assets over $1 billion and 12 percent of the banks with under $1 billion in assets. Last year, we also imposed civil money penalties against 127 bank officials. To put t h a t into perspective, in 1981 we imposed only 19. In summary, Continental pursued a growth strategy without adequate controls t h a t proved to be its downfall in adverse economic circumstances. Management has been removed, and shareholders have incurred substantial losses. At the same time, we have avoided major disruption to the financial system. Upon implementation of the long-term solution, Continental will be well capitalized and 193 have stronger assets and management. It will be returned to private ownership at the earliest possible date. We continue to focus our supervisory efforts on enhancing the ability of banks to remain sound even under difficult circumstances. Such action will strengthen the banking system and assure the continuing confidence of depositors. Mr. Chairman, that concludes my prepared remarks. I will be happy to answer questions. [Mr. Conover's prepared statement follows:] 194 Statement of C. T. Conover Comptroller of the Currency Before the Committee on Banking, Finance, and Urban Affairs U. S. House of Representatives September 19, 1984 Mr. Chairman, members of the Committee, I am pleased to be here to discuss Continental Illinois National Bank and Trust Company (Continental)• The serious problems encountered by Continental and the regulators1 actions concerning Continental are obviously a matter of public concern and deserve a thorough review by Congress and the public. It is my hope that these hearings will generate a broader understanding of the bank regulatory process, and the events surrounding the financial deterioration of Continental and the ensuing federal assistance, I would like to express my appreciation to the members of the Office of the Comptroller of the Currency (OCC) staff as well as the other financial regulatory agencies who have devoted countless hours in working toward a resolution of Continental's difficulties. 195 -2- In the Spring of 1984, Continental began experiencing liquidity problems that reached crisis proportions in May. The liquidity problems resulted from a rapid decline in market confidence brought about by severe deterioration in the quality of Continental's loans. On May 17, a temporary assistance program was implemented by the federal regulators to allow time to work out a solution while minimizing any adverse impact on global financial markets. The long-term solution, which was announced July 26 and on which shareholders will vote on September 26, is intended to restore Continental to health and allow it to continue to serve its marketplace without interruption. I fully appreciate the Committee's need to receive full and complete information on this Office's supervision of Continental. For that reason, we have provided the Committee's staff complete access to all OCC documents relating to the condition of Continental and our supervision of the bank. At the same time, we have been careful to protect the legitimate rights to privacy of bank customers and other third parties. I hope that these hearings will also contribute to the Committee's understanding of what happened at Continental. 196 There are many important aspects to the Continental situation that need to be aired at these hearings. I can best contribute to the process by focusing on the bank itself, and this Office's supervision of it. I understand the FDIC will discuss the temporary assistance plan and subsequent long-term solution. Similarly, the holding company/ Continental Illinois Corporation, and certain aspects of the federal assistance plan are more appropriately discussed by the Federal Reserve. Today, I will address what happened at Continental by first describing the economic factors that have buffeted Continental — and other banks — since 1980. These include back-to-back recessions as well as a sharply declining energy industry. Second, I will briefly review the internal policies and practices at Continental that rendered it incapable of weathering these adversities. Fundamentally, the bank undertook an aggressive growth strategy without adequate safeguards against the ensuing adverse events. Third, I will discuss what we could have done differently. Finally, I will focus on what we are doing to assure the continued safety and soundness of the banking system. The Appendix includes a ten-year chronology of Continental's internal 197 policies, strategies, and decisions; describes the prevailing economic environment; and details this Office's supervisory involvement with the bank. ECONOMIC PROBLEMS HAVE IMPAIRED BANK PERFORMANCE The 1980s have been difficult years for the banking industry. In early 1980, a recession caused real economic growth to drop sharply. By mid-1980 the economy was growing again, but that recovery only lasted 12 months. In mid-1981, the economy fell back into a recession that lasted 17 months. This latter recession proved to be deep and pervasive, with virtually no sector of the economy left untouched. It was a particularly difficult recession because unlike most, it was not accompanied by declining real interest rates. Although the economy as a whole is now experiencing a strong recovery, the pattern of back-to-back recessions was particularly hard on lending institutions. Loan quality typically begins to deteriorate after an economic slowdown begins, and continues to decline well into the recovery. When the 1981 downturn occurred, banks were still dealing with increasing loan losses from the 1980 recession. The 198 second downturn not only added new problem loans, but hindered attempts to work out existing problem loans. Many loan portfolios, thus, have continued to deteriorate since 1980, and many banks are still having problems stemming from the recessions. In addition to having to contend with the effects of the two recessions, many banks have also been affected by the severe problems in the energy industry over the last few years. Oil prices began to drop sharply in early 1980. Although they rose again during the last half of 1980, by 1981 oil prices were clearly on a downward spiral. This caused a sudden and unexpected decline in the profitability of energy exploration and production in late 19"81. Banks that had lent money to a booming industry suddenly found many of their customers facing severe financial difficulty, and in many cases, bankruptcy. The energy sector continues to be a problem area for lenders today, as oil prices continue to soften. These economic factors have posed challenges to all bankers. In an earlier era of strong domestic and international economic growth and relatively stable interest rates, bank managements1 abilities were not sorely tested. However, over the last few years, the margin for error in banking has shrunk dramatically. 199 Most U.S. banks have weathered these difficulties with impressive resilience, but almost all have felt some impact. Return on assets and return on equity are down for the industry as a whole. Asset quality is still suffering, with net loan losses rising even faster for large banks than for small. One important consequence of the industry's problems has been a heightened public concern about the condition of U.S. banks. Market confidence is an unpredictable but crucial element in the stability of individual banks and the banking system as a whole. Whether a bank survives adverse circumstances is often a matter of whether the market allows it the needed time to work out problems. In the case of Continental, the market didn't provide this needed time. WHAT HAPPENED AT CONTINENTAL? The difficult economic environment had a particularly devastating effect on Continental. Its problems stemmed from management strategies and policies that depended on strong growth in the economy in general and the energy industry in particular. These strategies and their 200 consequences are detailed in the Appendix to this testimony. In sum, Continental adopted a policy of rapid growth that was not accompanied by the necessary management controls and policies to maintain adequate asset quality in the face of an economic slowdown and a declining energy industry. Management Strategy Showed Early Signs of Success Continental management announced its decision in 1976 to become one of the top three banks lending to "Corporate America". Located in the heart of industrial America, Continental was already the leading commercial lender in the Midwest. Moreover, because it could not establish a significant retail customer base due to state restrictions on branching, the bank's corporate lending function was a natural area for expansion. Continental set out to quickly become a major lender to corporate customers. In implementing this goal, Continental adopted a strategy of decentralized lending that permitted its account officers to respond to customers and make loans more quickly and competitively. Although this approach required fewer controls and levels of review, management believed the potential rewards of such a strategy outweighed the associated risk. Management felt confident about the depth and experience of the bank's staff and its analysis of the direction of the economy. Obviously, this judgment proved to be incorrect. 201 Continental's management targeted the energy sector for its most aggressive lending expansion. During the latter half of the 1970s, the United States was attempting to develop a program for energy self-sufficiency in the face of uncertainty about actions of the OPEC nations. The 1973 oil embargo had propelled energy independence to the forefront of our national goals. Prices were skyrocketing and gas lines forming when Continental targeted energy lending as an area for growth. The federal government was giving serious consideration to gas rationing and even printed a million rationing coupons. The Administration and Congress in 1977 emphasized the critical nature of energy to the United States by establishing a separate Department of Energy. At that time, some economic analysts were projecting the price of oil to increase to some $60 a barrel. In June 1980, Congress enacted the Energy Security Act establishing the Synfuels Corporation and authorizing $20 billion for synthetic fuels development. Continental's management strategy of rapid growth with a specialty in energy was quite successful for several years. During the late 1970s, Continental outperformed its peers in growth, earnings, and market perception, and its loan loss record was excellent. In 1978, Dun's Review described Continental as one of the five best managed companies in America. 202 Asset Quality Ultimately Deteriorated In 1981, the very strategy that generated praise began to turn against Continental. A slowing economy meant that the quality of available lending opportunities was deteriorating at the same time that Continental was increasing its corporate lending, inevitably resulting in the making of loans to weak borrowers. In addition, many of Continental's existing corporate borrowers were seriously affected by the back-to-back recessions; existing loans to these companies became problems. By 1982, it became clear that the bank's rapid growth had been achieved at the expense of asset quality. The declining energy industry in late 1981 dealt a particularly serious blow to Continental. The end of the energy boom put a severe strain on the bank's energy-producing borrowers. Many of Continental's energy loans, which had been performing well and had been extremely profitable, suddenly turned into serious collection problems. Continental's problems in the energy area were two-fold. First, it had a heavy concentration in oil and gas loans that left the bank extremely vulnerable to the industry's sudden decline. Since July 1982, oil and gas loans have accounted for approximately two-thirds of the bank's losses, although those loans have averaged only about 20 percent of the total loan portfolio. 203 Second, from 1980 to 1982, the bank had purchased a large volume of energy loans from Penn Square Bank, N.A. The quality of these loans proved to be very poor, particularly those loans that were purchased in late 1981 and early 1982 when Continental's growth was peaking. Loans purchased from Penn Square constitute a disproportionate amount of Continental's losses. During our May - November 1982 examination, for example, Penn Square loans accounted for approximately 3 percent of all Continental's loans. However, they accounted for 16 percent of classified loans and 65 percent of the charge-offs directed by our examiners. Inadequate Management Controls Permitted Huge Losses Considering the disproportionate contribution that Penn Square loans made to Continental's losses, it is important to analyze how such a questionable relationship could develop in a bank that had been a top performer for so many years. It now appears that Continental's purchase of problem loans from Penn Square involved significant misconduct on the part of officers of both institutions. There are also indications that criminal fraud may have been involved. In fact, on September 10, 1984, William G. Patterson, the former head of Penn Square's energy lending division, was brought to trial on a 34-count indictment that charged, among other things, that he engaged in deceitful and fraudulent conduct 204 to conceal his illegal banking practices from OCC examiners and the banks that purchased loans from Penn Square, However, the problem extends beyond employee misconduct. Management processes should be in place to guard against, and detect, employee misconduct as well as other risks. These include policies and controls governing loan approval, review, and classification; mechanisms for determining provisions for losses; loan workout functions; management information systems; and loan officer compensation systems. For banks such as Continental that undertake aggressive growth strategies, top quality controls are essential. Continental's management controls were the subject of considerable attention in our examinations over the past eight to ten years. Although we judged the bank's system of loan controls to be generally satisfactory, we directed a number of specific improvements. For example, we cited, at various times during the period from 1974 to 1981, problems with the past-due loan report, the completeness of credit files, the identification and rating of problem loans, and collateral deficiencies. Bank management was generally responsive to our concerns and made a number of improvements in its systems for controlling and detecting risk in the loan portfolio. 205 These improvements were not enough. In retrospect, it is clear that there was not sufficient management support for the control systems. Top management had created an environment where aggressive lending was not only condoned but encouraged. In this atmosphere, a high quality system of controls was secondary. Moreover, those warning signals that the existing system did generate were ignored by senior lending officers. In the final analysis, the bank's internal controls did not prevent the purchase of massive amounts of bad loans from Penn Square. With the benefit of hindsight, it is clear that our generally favorable assessment of Continental's internal controls was overly influenced by the bank's outstanding performance during the years 1974 through 1981. Continental Was Dependent on Volatile Funds Although Continental was weakened by asset deterioration, its losses never exceeded capital, and thus it never reached book insolvency. funding problems. Rather, its near-collapse was triggered by Beginning in the second half of 1982, the bank was forced to rely increasingly on foreign funding, as federal funds and certificates of deposit rapidly eroded. 39-133 0—84 14 For 206 almost two years, the overseas funding provided Continental with relatively stable, much needed liquidity. It also made the bank vulnerable to the liquidity problems that occurred in May 1984 when uncertainty about Continental's condition caused the overseas markets to close completely. Clearly Continental's reliance on uninsured, short-term funds meant that it was particularly vulnerable to a loss of confidence. However, Continental's earlier decision to become a major corporate lender made the wholesale market a natural funding source. The wholesale market was practically a necessity given the restrictive branching statutes in Illinois that made establishment of a broad retail customer base difficult. Although reliance on uninsured, short-term funds makes a bank sensitive to market perceptions, it is not by itself an imprudent banking practice. If a bank maintains sufficient liquidity and asset quality, periodic shortfalls in funding can be readily accommodated. In Continental's case, the heavy reliance on wholesale funds was not accompanied by enough liquidity to sustain it through funding shortages. The bank's aggressive lending 207 strategy was pursued to the exclusion of sufficient liquidity, resulting in a higher proportion of loans relative to assets than any of its peers. Even an extremely conservative liquidity position would not have protected Continental from the major funding crisis it experienced last spring. Nevertheless, it is an area we could have paid more critical attention to; we are doing so in large banks now. Continental Never Regained Lost Confidence It became clear, during our examination that began in May 1982, that Continental's management practices and policies had led to serious loan problems. a number of ways. November. We responded to this in We extended our examination through During the course of the examination, we directed Continental to begin a number of corrective measures, which were immediately initiated by the bank. We informed management of our intention to formalize these directives by placing the bank under a Formal Agreement, enforceable under the cease and desist authority of 12 U.S.C. 1818. My staff and I met several times with senior management and board members over the next few months to discuss the bank's condition and the impending Agreement. 208 The Agreement required improvements in numerous areas, including loan policies and procedures, asset and liability management, and funding. It also required regular reports by a board committee on the bank's compliance with the Agreement. Bank management complied with the terms of the action and took significant steps to revamp its operations. However, the loans that crippled Continental were already on the books. Market confidence had begun to turn against the bank in July 1982 when its Penn Square loan problems surfaced publicly. Despite nearly constant OCC supervision and presence in the bank over the next two years, and the efforts by bank management and the board of directors, Continental was unable to fully regain market confidence. In May of this year, the market reacted adversely to rumors of further problems at Continental, and large depositors began withdrawing funds. The bank was unable to stem the run, and federal intervention was required to prevent the bank's collapse. WHAT COULD HAVE BEEN DONE DIFFERENTLY? An obvious question that we and others have asked is whether there was anything that the OCC should have done 209 differently in the course of Continental's deterioration. In addressing this question, it is important first to clarify the role of the bank supervisor. The Supervisor's Role is to Maintain Systemic Soundness Short of nationalizing the banking system, no bank regulatory system can prevent all bank failures. I do not believe that the American public would support either the cost or the kind and degree of regulation and supervision that would eliminate all possibility of failure. To do so would require removing all risk-taking from banks, and would make banks unable to carry out their role as financial intermediaries in fueling the nation's economic growth. At the same time, however, it is clear that the nation is not well-served by a banking industry where the potential for failure is unrestricted. Our charge is to maintain the safety and soundness of the national banking system. To do so requires sufficient oversight of and interaction with bank management to minimize the likelihood of bank failure. We do not take over and manage institutions; we cannot substitute for private management in making lending or any other decisions. The 210 primary responsibility for any bank's performance rests with its management and board of directors. However, as supervisors we do monitor risk exposure, work to see that policies and controls are appropriate to that level of risk, and enforce compliance with the law. When we identify major weaknesses, we institute corrective measures, and follow up on their implementation. This results in significant improvement in the vast majority of institutions that we identify as having problems. For some institutions, even prompt and stringent corrective measures are unsuccesful. The safety and soundness of the banking system also requires allowing such poorly managed, financially weak institutions to disappear from the system in an orderly manner. In an important sense, this is what has happened to Continental. The doors are still open, but the officers who allowed the bank's deterioration are no longer part of Continental. Moreover, those that bear responsibility for approving management policies have paid a price. The shareholders face substantial if not total loss, and the directors and former management face potential legal liability. Could OCC Have Taken Other Actions? The demise of Continental was clearly not desirable. It would have been far better if management had made better decisions and taken actions that would have been more appropriate 211 for the ensuing circumstances. It would also have been preferable if we as supervisors could have done something to change the course of Continental. As we review the history of Continental, it is possible to identify several points in time and ask whether it would have been appropriate for the supervisors to step in forcefully to change the course of the bank's direction. We did this, of course, after our 1982 examination when we took a formal enforcement action against the bank. Most banks, including Continental, respond to this type of corrective measure. What made Continental different from most of these cases was that the market did not wait for the bank's recovery plan to restore it to health. I am persuaded that since mid-1982, there was nothing more that we could have done to speed Continental's recovery and thereby increase market confidence. One possible action was to force out top management in addition to those dismissed following the failure of Penn Square. this, for several reasons. We decided not to do First, existing management had proven more capable than most at bringing the bank out of the serious difficulties that many large banks faced following the REIT problems of 1975 and 1976. Second, management recognized the bank's problems in 1982 and put a program in place to 212 identify and correct them. Finally, a thorough, independent management review undertaken by the board of directors in mid-1982 had indicated which officers had been directly responsible for the Penn Square loans, and those officers were removed. One other possibility would have been to force the bank to curtail dividend payments. However, management and the board of directors felt that maintaining dividend payments was crucial to regaining market confidence and to raising additional capital. Moreover, the amount of money involved would not have added appreciably to capital. In all, once the bad loans were on the books, OCC -- and the bank -- took every action that could have been reasonably expected to restore Continental to health. We have asked ourselves whether we should have taken action as early as 1976 to prevent Continental from embarking on a course of rapidly become a top lender to Corporate America. In my view, it would have been inappropriate to have done so. It is not the proper function of regulators to decide what business strategy an individual bank should undertake. The regulator's role is to see that whichever 213 business strategy a bank chooses, it has the mechanisms in place to implement that strategy in a safe and sound manner. In retrospect, it is clear that management, buoyant with the bank's years of financial success, placed too little value on risk control mechanisms in the implementation of its strategy. Continental's record shows that neither financial success nor the esteem of the financial community that flows from that success can substitute for sound and effectively enforced controls. If there is anything that OCC could have done differently, I believe it would have been to place more emphasis on our evaluation and criticism of Continental's overall management processes. Had we done so, we might have been alerted to management's lack of commitment to controlling risk sooner than 1982. Had we been less swayed by management's successful track record from the early 1970s through 1981 and its previous responsiveness to our supervision, we might have been able to see more clearly the risks inherent in its rapid growth strategy. 214 SAFETY AND SOUNDNESS MUST BE MAINTAINED Continental's demise has highlighted the need for banks and supervisors to continue to work to maintain the public's confidence in individual banks and the banking system as a whole. All reasonable steps must be taken to strengthen the ability of banks to weather adverse circumstances and thereby earn the continuing confidence of depositors. I would like to focus briefly on seven areas where the OCC has taken steps to enhance its examination and supervision and to strengthen the banking system. 1. Supervisory Techniques Continue to be Improved The OCC's supervisory process has continued to improve as technological innovations have been made and industry conditions have changed. In the aftermath of Penn Square's failure and the problems experienced since mid-1982 by Continental and other banks, we have made a number of improvements in our supervision of national banks generally, and of large banks in particular. Our supervision of banks of all sizes has been enhanced by the establishment of an Industry Review Program. This program includes a computerized information system to collect data on industry concentrations in individual bank portfolios 215 and the banking system as a whole. Through the use of outside information sources we are monitoring significant industries in an attempt to better anticipate developments that might result in problems for banks. Our examiners will use the information in their analyses of individual banks to identify concentrations and to help position banks to withstand problems emerging from them. Industry analyses and developments will be available to each examining team through its own portable microcomputer. Each team is being provided with extensive training in the full range of analytical techniques and will be equipped to perform more sophisticated analyses of banks1 activities than were possible previously. The near-complete development of two additional computer systems will provide us with a much improved ability to respond to examination needs and follow up on examination results. The first will facilitate examination scheduling by establishing system priorities. The second is our Supervisory Monitoring System, an automated tracking system that provides our examiners with access to all supervisory information sources, particularly examination findings and recommended actions. This will require a more orderly tracking and efficient follow-up of important supervisory concerns. 216 We have also taken steps to ensure communication within the OCC of examination findings on individual banks that may affect other banks in the system. These steps include changes in OCC internal procedures, examination manuals, and training. A newly developed course for evaluation of problem banks, in particular, addresses this concern. Our multinational bank program has been expanded and we are examining multinational banks more frequently than in the past. Our examinations are targeted on the areas of supervisory concern and take place 2 to 3 times a year, rather than annually. Moreover, we have reorganized and significantly increased our resources committed exclusively to the supervision of our largest banks. A corps of our best and most senior examiners has been devoted solely to supervision of the multinational banks. In addition to the more frequent examinations we have undertaken, the examiners will also monitor trends and developments in the banks between examinations. This new approach results in near-constant supervision of each of our large banks. We are now better able to identify and devote attention to items of supervisory concern in individual large banks and significant practices emerging in the large bank population as 217 a whole. We are committed to continually improve our supervisory process and to maintaining an examination force that, in its training, support systems and overall quality is of the highest caliber. 2. Internal Controls Must be Emphasized The OCC is placing more emphasis in the examination process on banks1 internal controls and systems. This includes increased testing of control procedures and their application, and more stringent follow-ups to ensure that internal control deficiencies are corrected. To accomplish this, we are focusing our examiners1 attention to four basic control questions: o What systems are in place to permit early detection of actions or trends that, if continued, might seriously affect the bank's condition; o What actions are taken by senior management once adverse trends and deficiencies are disclosed; o What individuals in the bank are in a position to materially affect the accurate recording of transactions; and, 218 o What safeguards are in place to mitigate the chance that individuals could conceal irregularities from their superiors, bank auditors, and examiners. These questions are particularly important in the area of problem loan identification systems and will receive greatest attention in that area. In 1983, the OCC issued specific procedures that banks must follow when they purchase loan participations. The circular spells out that the purchase of loans and participations in loans may constitute an unsafe and unsound banking practice in the absence of documentation, credit analysis, and other controls over risk. The circular also warns banks that the absence of satisfactory controls over risk is unacceptable and may cause the OCC to seek appropriate corrective action through enforcement actions. 3. Loan Loss Reserves Are Being Evaluated Since the allowance for possible loan losses (APLL) is the first line of defense against loan deterioration, we are taking additional steps to assess the adequacy of a bank's APLL relative to the total risk in its portfolio. We are 219 concerned that for some banks, increases in the APLL have not kept pace with increases in nonperforming and classified loans. We are addressing this concern by developing more specific criteria for use by our examiners in evaluating the adequacy of reserves and by focusing our examinations of large banks to make sure that reserves are adequate. 4. Capital Levels Are Being Increased Congress reemphasized the critical role of capital in maintaining the safety and soundness of the banking system when it enacted in 1983 the International Lending Supervision Act that authorizes the banking agencies to enforce capital requirements. Under regulations proposed by the OCC and the FDIC, all banks, regardless of size, would be required to maintain a minimum ratio of primary capital to total assets of 5.5 percent. The implementation of this regulation will require over 200 national banks to raise a total of over $5 billion in new capital. The Federal Reserve has proposed similar guidelines on capital. Stricter regulatory capital requirements will strengthen the trend towards stronger capitalization of the nation's largest banks. For example, in the first quarter of 1984 the average ratio of primary capital to total assets stood at 5.67 220 percent for the holding companies of the 11 multinational banks supervised by the OCC. This is almost 16 percent higher than the average level at those banks two years ago. Adoption of this standard would not replace our supervisory evaluation of capital adequacy. Banks of all sizes will be encouraged to maintain higher capital levels. Furthermore, the OCC retains the right to impose higher ratios for banks whose circumstances necessitate a stronger capital base. As another means of ensuring adequate capital, OCC will be scrutinizing each bank's dividend payout policies in light of its overall capital structure. We will not hesitate to restrict dividend payments when necessary. 5. Sources and Uses of Funds are Being Scrutinized The OCC is devoting more resources to monitoring regional and multinational banks1 global funding. Banks will be placed under special surveillance if they are especially vulnerable to eroding market confidence or reliance on particular funding markets is deemed to be excessive. A key element in our 221 increased supervision of funding is constant monitoring of the attitudes and concerns of market participants. Supervisory actions on individual banks will vary but, at a minimum, they are expected to include the development of alternative funding plans. In some cases, supervisory actions could also constrain growth. Finally, where we find a high volume of volatile liabilities, we will require a larger percentage of liquid assets. 6. Increased Financial Disclosure is Being Promoted The market's evaluation of the banking system depends, in large part, on the information that is publicly available. To enhance the credibility of bank financial statements and reduce the likelihood that the market will overreact to incomplete information, the OCC is considering requiring increased disclosure of information about banks. To that end, it is seeking public comment on increasing the disclosure requirements for banks via an advance notice of proposed rulemaking (ANPR). The ANPR highlights questions such as what additional information is needed; who should have the responsibility of making information public; and how the integrity of financial statements used for disclosure should be maintained. 39-133 0—84 15 222 The OCC has also taken steps to enhance the accuracy of information that is already disclosed. Recently OCC took enforcement actions against six major banks and required them to restate some of their financial information to eliminate "window dressing" that could mislead depositors, investors, and the regulatory agencies. In addition, along with the Federal Reserve Board, the OCC issued a statement on June 11, 1984 reaffirming its policy on nonaccrual loans. Such loans must be placed on nonaccrual status (by virtue of being more than 90 days past due) on contractual dates and must be brought current before being returned to accrual status. Finally, we are continuing to work with other federal banking agencies and the Securities and Exchange Commission to review additional means of improving bank disclosure. 7. Strict Enforcement Policy is Being Maintained We have been utilizing our enforcement power more vigorously to correct violations of law and imprudent banking practices. For instance, last year we took 274 formal actions against national banks compared to 156 for the previous year and only 65 in 1978. These actions have been taken against 223 banks of all sizes. We have outstanding enforcement actions against 17 percent of the banks with assets over $1 billion and 12 percent of the banks with under $1 billion in assets. Last year, we also imposed civil money penalties against 127 bank officials. To put that into perspective, in 1981 we imposed only 19. Over the last several years our enforcement actions have covered a wide variety of banking activities. In the large banks alone, we have recently taken a number of enforcement actions following targeted examinations that found inadequate loan losses reserves. In one instance, we took formal enforcement actions against some 21 national bank subsidiaries of a regional company to prevent improper transactions among affiliates. In addition to numerous cases addressing problem assets, lending controls, capital and management, actions against large banks have also been directed at inadequate procedures governing banks1 securities activities. Moreover, we have worked jointly in enforcement actions with the SEC and have made referrals to the SEC when it appeared that holding companies failed to make adequate disclosure of OCC's enforcement actions on a subsidiary bank. 224 CONCLUSION In summary, Continental pursued a growth strategy without adequate controls that proved to be its downfall in adverse economic circumstances. consequences. The bank has suffered the Management has been removed, and shareholders have incurred substantial losses. At the same time, we have avoided major disruption to the financial system. Upon implementation of the long-term solution, Continental will be well-capitalized and have stronger assets and management. It will be returned to private ownership at the earliest possible date. We continue to focus our supervisory efforts on enhancing the ability of banks to remain sound even under difficult circumstances. Such action will strengthen the banking system and assure the continuing confidence of depositors. * * * Mr. Chairman, that concludes my prepared remarks. be happy to answer questions. I will 225 Appendix to Statement of C. T. Conover Comptroller of the Currency Before the Committee on Banking, Finance, and Urban Affairs U. S. House of Representatives September 19, 1984 CONTINENTAL ILLINOIS NATIONAL BANK AND TRUST COMPANY TEN-YEAR REVIEW This Appendix provides a ten-year historical overview of the principal events leading up to the federal rescue of Continental Illinois National Bank and Trust Company. Continental's history, for this purpose, falls naturally into two distinct time periods: the period from 1974 through 1981 when Continental grew rapidly and acquired many loans that ultimately turned into losses, and the period from the beginning of 1982 until July 1984 in the aftermath of the discovery of significant loan problems. This Appendix reviews the effects of the U.S. economy on the bank, significant actions taken by the bank, and OCC's supervisory involvement. The discussion and accompanying charts relate to the bank and 226 not the bank holding company. Unless otherwise indicated, the peer group referred to in the charts and analysis is composed of eight wholesale money center banks.* CONTINENTAL; 1974 - 1981 Located in America's industrial heartland, Continental historically focused on domestic corporate lending. Because state restrictions on branching limited the establishment of a significant retail customer base, corporate lending was a natural area for Continental to emphasize. As the U.S. emerged from the 1974 - 1975 recession, economic growth was strong and many new lending opportunities emerged. Roger E. Anderson became Chairman and Chief Executive Officer in 1973. He and his new management team set ambitious strategic business goals to make Continental a world class bank. In describing those goals, a bank executive was quoted in a 1980 Institutional Investor article: We're a country bank. . . What we would like to do is demonstrate that a Midwestern country bank can become the most magnificent force in the banking world. *The eight wholesale money center banks included in the peer group are Bankers Trust, Chase Manhattan Bank, Citibank, First National Bank of Boston, First National Bank of Chicago, Irving Trust Co., Manufacturers Hanover Trust Co., and Morgan Guaranty Trust Co. 227 Between 1974 and 1981, Continental's assets grew an average of over 13% per year. Its $45.1 billion in total assets at year-end 1981 made it the sixth largest bank in the nation, up from the eighth largest in 1974. Continental's Year-end Total Assets $ Billioni 50 T $45.1 45 $40.3 40 PI $34.3 35 $29.9 30 20 $19.1 $19.8 10 5 w Source: Call Reports $21.4 H 15 0 • 1 111 • 1i i i i $25.0 25 ^ • • W-M • I ^ 3 MO.; ll If 11 I 228 As illustrated in the following chart, Continental generally grew faster than other wholesale money center banks during this period. Growth in Sotal Assets Index of Total Assets (1974-100) 250 1 225 CONTINENTAL / ' ^--. / 200 / ^*~— PEER 175 / 150- / / 125 i s, /, S, — r ^ L ^ ?> 1O0 75 J • 74 —•- 75 -— » 76 ' « 77 * I 78 79 I • I 80 81 i 82 | 83 Source: Coll R e p o r t • . OCC Beginning in 1973, Continental embarked on an aggressive assault on selected segments of the banking market. rapidly built up its consumer loan portfolio. The bank A private placement unit was created that secured a foothold in the market by arranging placements of debt for small companies. Its international effort was expanded by structuring i 229 syndicated Eurodollar loans, making advances in direct lending to European multinational companies, and becoming active in project financing. Like most banks, Continental suffered during the collapse of the real estate investment trust industry in the mid-1970s. Continental's management, however, handled this problem well; recovered the bank from its real estate problems more successfully than most other large banks with similar problems. As a result, Continental continued to remain active in real estate lending throughout the 1970s. Its mortgage and real estate portfolio grew from $997 million at the end of 1977 to approximately $2.3 billion at the end of 1979. Continental emerged from the 1974 - 1975 recession with one of the best loan loss records among its peer group, reflecting management's ability to steer the bank through economic downturns. Financial problems at some of Continental's prime competitors in the late 1970s also provided the bank with a competitive opportunity to increase its market share and become the "premier bank in the Midwest." OCC's assessment of Continental's management and the bank's performance during the eight examinations conducted by 230 this Office in the 1974 - 1981 period was favorable. The bank was particularly strong as it emerged from the 1974 - 1975 recession. Earnings were rising and the bank's handling of its problem loans following that recession was superior to that of most other wholesale money center banks. In 1972, the bank expanded individual lending officers' authority and removed the loan approval process from a committee framework. Continental revamped its organization in 1976 and eliminated more of the "red tape" in its lending procedures. Major responsibility was delegated to lending officers in the field, resulting in fewer controls and levels of review, in order to provide lending officers with the flexibility to rapidly take advantage of lending opportunities as they arose. While decentralized lending operations were common among money center and large regional banks, Continental was a leader in this approach. Management believed that this organizational structure would enable Continental to expand its market share and eventually meet its goal of becoming "one of the top three banks lending to corporate America." 231 In light of Continental's rapid growth, OCC examiners stressed the importance of adequate controls, especially in the loan area. Certain internal control problems within the bank were noted by examiners. In particular, exceptions were noted in the timeliness of putting problem loans on the bank's internal watch list. In reaction to these criticisms, management implemented new control features, including computer-generated past due reports and a system to track exceptions in the internal rating process. Given the bank's historical loan loss experience and proven ability to deal with problem situations, supervisory concerns were not of a serious nature. During the period from 1974 - 1981, Continental sought to spur loan growth by courting companies in profitable, although sometimes high risk businesses. Lending officers were encouraged to move fast, offer more innovative packages, and take on more loans. This aggressive lending strategy worked well for the bank; Continental's commercial and industrial (C&I) loans expanded from $4.9 billion in 1974 to $14.3 billion in 1981. Moreover, it was able to expand its market share during a period in the late 1970s when many other major U.S. banks experienced declining market shares because of 232 increasing competition from foreign banks, the commercial paper market, and other nontraditional lenders. By adding numerous multinational and m : '"die-market companies that previously did no business wiuh the bank, Continental's share of the domestic C&I loan market rose from 3.9% at the end of 1974 to 4.4% at year-end 1981. Commercial and Industrial Loan Growth Index of CSc\ Loans (1974-100) 325 T 300 + 275 + 250 + 225 + 200 + 175 + 150 + 125 | 100 + 75 - L 82 Source: Call Reports, OCC 233 As part of its corporate expansion, Continental became particularly aggressive in the energy area. The bank created a special oil-lending unit in the early 1950s — reportedly the first major bank to have petroleum engineers and other energy specialists on staff. The economic consequences of the 1973 oil embargo and the resulting four-fold increase in world oil prices pushed energy self-sufficiency to the forefront of our national goals. A number of actions were taken by various Administrations and Congress following the first embargo and subsequent oil price hikes to both reduce U.S. energy consumption and to increase domestic production. The Department of Energy, created in 1977, sought to develop ways of encouraging higher investments in U.S. exploration, development, production, and refining capacity. Cultivation of this niche had made Continental a premier energy lending bank and contributed significantly to its rapid, and profitable, expansion. 234 Continental's C&I loans, including its energy loans, produced high returns for the bank. Average yields were consistently higher than those of other wholesale money center banks. Average Annual yield on C&I Loans Percent 20 i 18.5 18 f CONTINENTAL 16 14 + 14.9 14.0 17.5 15.2 I i L i % 14.4 12.3 10.9 11.3 12 f 10 8 6 4 2t 79 80 Peer group includes only national banks. Source: Coll Reports The financial markets reacted favorably to Continental's aggressive growth strategy. In 1978, Dun's Review described Continental as one of the five best managed companies in America. Many analysts regarded it as a preeminent wholesale 235 money center bank, citing its stable asset and earnings growth, its excellent record in loan losses, and its expertise in energy lending. Continental Illinois Corporation's ratio of market price to book value, which had lagged behind other money center bank holding companies in the early 1970s, began rising in 1976. Market Price/Book Value Ratio 2.0 T O J—•—I—I—•—I—I—I—I—I—I—I—I—l-H—I—•—I—l-Hh-H—I—I—I—I—I 74Q4 75Q4 76Q4 77Q4 78Q4 79Q4 I t — I » I I- < I I I t 80Q4 8104 I I 82Q4 I—»—I 83Q4 SOURCE: D a t a R a a o u r c a s . Inc. With limited access to retail banking markets and core deposit funding because of restrictive branching statutes in Illinois, Continental funded its rapid growth through 236 purchased wholesale money such as federal funds, negotiable certificates of deposit, and the interbank market. Its reliance on purchased funds, approximately 70% of total liabilities, was much higher tnan its peer group average. Continental's Liability Distribution 76 77 78 79 80 81 82 83 Source: Call Reports Concerns were raised by OCC examiners in the 1976 examination over the bank's liquidity and its reliance on Fed Funds, foreign deposits, and negotiable CDs. By the time of the summer 1977 examination, Continental had improved its liquidity position and had enhanced its monitoring systems. 237 OCC examiners concluded that the Office's funding and control concerns were being adequately monitored by the bank. The bank was requested, however, to submit quarterly status reports on classified assets over $5 million and monthly financial statements. Continental's heavy reliance over this period on purchased money, which had a higher interest cost than retail deposits, offset much of the gain that accrued from Continental's higher loan yields. High funding costs reduced Continental's net interest margin to a level well below its peer group. Net Interest Margin Percent * T PEER 3+ CONTINENTAL 82 Net Interest Margin — Net Interest Income (TE) to Average Earning Assets Source: Call Reports 39-133 0—84 238 Continental was, nevertheless, able to maintain its superior earnings growth because of low overhead and non-interest expenses. The absence of domestic branches and relatively few foreign branches, compared to other money center banks, held down Continental's overhead expenses and, therefore, compensated for some of its high funding costs. As illustrated in the following chart, Continental's ratio of non-interest expenses to average assets was far below its peer group average. Non-Interest Expenses/Average Assets Percent 3.0 i PEER CONTINENTAL 74 75 Sourct: Coll Reports 76 78 79 80 81 239 As a consequence, through 1980, Continental was able to achieve one of the best and most consistent performance records among money center banks. Its ROA was consistently above the average of other wholesale money center banks. Return on Average Assets Percent .8 i .6 + •5 t .4 .3 CONTINENTAL . .2 .1 83 Source: Call Reports 240 The bank showed record earnings while its assets grew to a high of $45.1 billion in 1981. As shown in the following chart, net income rose rapidly before peaking at $236 million at year-end 1981. Continental's Net Income $ MILLIONS 300T 74 75 76 77 78 79 80 81 82 83 Net Income After Tax, Before Securities Transactions and Extraordinary Itens Source: Coll Raports As noted earlier, in the examinations conducted by this Office in the 1974 - 1981 period, Continental's overall condition was found to be good and it generally compared well with other multinational banks under our supervision. In addition to liquidity and internal controls, our concerns during this time period centered on capital adequacy and asset quality. 241 While Continental's capital to asset ratio compared favorably to other money center banks, OCC examiners expressed concern throughout the late 1970s about the bank's ability to generate sufficient capital to keep pace with its rapid expansion. Primary Capital to Total Assets Percent 7- ii 5+ 2 T I Source: Coll Reports 75 I 76 PEER CONTINENTAL 77 I i [ i 83 242 During the 1976 examination, the Office pointed out that unlike most other large national banks, Continental had no definite capital growth plan. As a result, the bank prepared a three year capital plan and took immediate measures to increase capital, including cutting the size of its 1976 dividends to the holding company, by $15 million, to $45.6 million. In addition, the bank holding company issued debt and used the proceeds to inject $62 million into the bank's surplus account. Despite these efforts, capital failed to keep pace with asset growth and continued to decline through 1980. Continental had an excellent loan loss experience, with one of the lowest percentages of nonperforming assets and net loan losses in the industry. Asset quality, which was a major concern at most money center banks in the 1975 - 1976 period, showed steady improvement at Continental throughout the late 1970s. Its classified assets decreased dramatically following the recession, demonstrating management's ability to deal effectively with problem assets. By the end of 1977, Continental had classified assets representing 86% of gross capital, down from 121% of capital the previous year. In the 243 1975 - 1977 period, Continental's ratio of net loan losses to average total loans and leases was 25% lower than the average of other wholesale money center banks. Net Loan Losses/Average Total Loans and Leases 74 75 76 77 78 79 80 81 Source: Call Reports OCC's 1979 examination of Continental noted continuing improvement in asset quality. Classified assets had declined from 86% to 80% of gross capital funds. considered adequate at this time. Liquidity was also Some problems, however, 244 were noted in the bank's internal credit review system. Deficiencies were cited in the identification and rating of problem loans and the completeness of credit files. In light of the bank's rapid asset growth, OCC examiners once again emphasized the importance of building a strong capital base. Similar conclusions were drawn during the 1980 examination. Liquidity was still considered acceptable. Asset quality continued to improve; classified assets as a percent of gross capital funds declined to 61%. Management was encouraged to perform some type of on-site review of information submitted to the loan review committee, such as periodic visits to foreign offices and other loan origination sites. Although not keeping pace with asset growth, capital was considered adequate. The bank was thought to have sufficient capability to meet external pressures and to fund projected growth. In its response to the 1980 examination, Continental management indicated that although they believed the bank's present internal credit review system had been successful, some type of on-site review might be appropriate, particularly in light of the bank's expansion. Accordingly, management had been exploring various methods of accomplishing this shift in 245 a cost-effective manner. An experimental field review was subsequently conducted. During the 1981 examination, the OCC placed special emphasis on the review of Continental's energy and real estate lending, since the bank was targeting these areas for additional growth. Continental's energy portfolio nearly doubled between 1979 and 1980 and increased by an additional 50% the following year. By 1981, energy loans represented 20% of Continental's total loans and leases and 47% of its total C&I loans. With energy prices skyrocketing and drilling and exploration activity booming, Continental was well-positioned to meet the burgeoning credit demands for development of energy sources. Continental historically had made loans to energy producers that were secured by "proven reserves" or by properties surrounded by producing wells that were almost guaranteed to produce oil and gas. As part of management's intensified commitment to energy lending in the late 1970s, the bank had begun expanding its energy portfolio, including 246 making loans secured by leases on undeveloped properties with uncertain production potential. The bank also became particularly aggressive in extending loans to small, independent drillers and refiners. Energy Share of Continental's C&I Loans $ Billions 20 i 18 $16.2 16 $14.3 $14.3 14 + 12 $11.0 $9.3 10 -J8 OTHER C6c\ wx 532 642 591 6 f 4 742 Mm 412 mm 2 26% E$2.4 \ m $6.7 $4.5 4 f $5.8 362 | »5.2 OILdcGAS 36Z 1979 Source: OCC In 1981, Continental had over $6.7 billion in oil and gas loans outstanding. Despite this high commitment to a single sector of the economy, Continental's management felt confident about the strength of the energy industry and its knowledge of specific oil fields and companies. Losses from Continental's 247 energy loans had consistently averaged less than half the net loan losses from its non-energy loans. According to Gerald Bergman, former head of Continental's Special Industries lending department, the bank was simply demonstrating "a reasonable way to leverage [its] expertise in the oil industry" (American Banker, August 25, 1981). While conducting the 1981 examination, which used information as of April 30, 1981, OCC examiners noted a significant level of participations from Penn Square that were backed up by standby letters of credit. Recognizing that the amount of these loans was large in comparison with Penn Square's size, additional time was spent examining them. The OCC's review determined that these standby letters of credit were issued by banks other than Penn Square, including several money center banks, alleviating our concerns. Moreover, since the energy industry still appeared strong and the energy loans were continuing to perform, we saw no cause for concern at that time. In all, only two oil and gas loans, totaling $85 million were classified. Neither loan had been purchased from Penn Square. As part of the 1981 examination, OCC examiners sampled new account relationships, in particular, and devoted further efforts to judging the quality of the credit rating system. Classified assets as a percent of gross capital had increased 248 from 61% at the previous examination to 67%. The trend, which was also noted at other large banks, however, was attributed by OCC examiners to deteriorating economic conditions rather than a relaxation of credit standards, OCC examiners again reviewed Continental's internal loan review systems during the 1981 examination. Although examiners did classify several loans for which watch loan reports had not been prepared, each of these loans had been internally rated in accordance with bank policy. Neither the dollar amount nor the number of these loans was considered significant. However, it was noted that approximately 375 loans, totaling $2.4 billion, had not been reviewed by the bank's rating committee within one year; 55 of these had not been reviewed within two years. Management was aware of these exceptions and was in the process of reassessing its loan review system. Continental's quality and consistency of earnings were considered good at the time of the 1981 examination. Examiners noted that a program of holding down dividends had resulted in a steady source of capital augmentation, but that capital still needed to be brought in line with asset growth. Liquidity was considered sufficient to meet any external pressures. Suitable systems for managing funding and rate sensitivity were found to be in place. 249 In response to the 1981 examination, Continental's management indicated that they did not feel there was a problem with the loan portfolio quality, in light of the economic environment at that time. In fact, management expressed surprise that more difficulty had not surfaced, given the prolonged period of record high interest rates and the state of the economy. Nevertheless, they stated that close, continued attention would be provided to the quality of the portfolio. Management further stated that the issue of loans not being reviewed on schedule for rating purposes was receiving attention and that improvement was expected. Through most of 1981, the majority of Wall Street analysts believed that Continental would continue to experience superior growth due to its position as a prime lender to the energy industry, its potential for improved return on assets, and its record of loan losses. The Wall Street Transcript gave its silver runnerup award for outstanding money center bank CEOs to Roger Anderson in June of 1981. Bank analysts strongly supported the selection, with one analyst noting: I give Continental credit for doing what they do best, and that is lending money. They've been able to pick out certain niches. I'm continually amazed by their reception as energy lenders. They positioned themselves well early on, and they have been reaping the benefits of that. I used to be skeptical that they could manage their costs when things slowed down, but they've shown me recently that they've done a good job of managing people and costs and pushing employees toward productive areas. 250 Another analyst commented that: With Continental possessing one of the best loan loss records among money center banks, one can assume it is carrying the same credit standards into the current period of economic weakness as it did in the prior period and will not suffer large loan losses. CONTINENTAL: JANUARY 1982 - JULY 1984 To fully understand the demise of Continental, it is first necessary to review the history of Penn Square Bank's involvement with Continental. Penn Square was one of the most aggressive lenders in one of the hottest energy drilling areas of the country. Because its loan generating ability exceeded its legal lending limit as well as its funding ability, Penn Square would originate loans and then sell them to other banks, including Continental and Seattle First National Bank. Although Continental began purchasing loans from Penn Square as early as 1978, significant growth in loan purchases did not occur until the beginning of 1981. For example, as of the end of 1980, Continental had purchased energy loans from Penn Square totaling only $167 million. By the conclusion of this Office's 1981 examination of Continental in August, loans purchased from Penn Square were in excess of $500 million. From that time period until the start of the 1982 examination, another $600 million in participations from Penn Square loans 251 were booked at Continental, bringing the total amount to $1.1 billion. At their peak in the Spring of 1982, Penn Square loans represented 3% of Continental's total loans and leases and 17% of its total oil and gas loan portfolio. Major Purchases of Penn Square Loans Occurred Between Examinations Growth in Purchased Penn 81Q1 81Q2 81Q3 81Q4 Square Loans 82Q1 82Q2 82Q3 82Q4 Source: OCC In a quarterly visit with Continental management in March of 1982 prior to the general examination, OCC examiners 252 discussed the general health of the energy industry. Since the end of 1981, the energy industry, as represented in the following chart showing drilling activity, had declined significantly. Drilling Rigs Operating in the U.S. jg 3000 + O 2000 -t 1 — — I 1 t i t * 1 1 2 3 4 1 2 3 4 1 2 1973 1079 K—I 3 1980 H- -H 1 » » — -I 1 1 1—I 1 1- 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 1981 1982 1983 1984 SOURCE: STANDARD & POOR'S In spite of this decline, bank officials said they felt comfortable with their expertise in the energy area and planned to continue to stress it. Notwith- standing the thorough review of the energy portfolio in 253 the 1981 examination, the intervening decline in the oil and gas industry made energy a principal focus of the OCC's 1982 examination scheduled to begin in May. At the request of the examiner-in-charge of the Continental examination, an energy lending specialist from the OCC's Southwestern District was assigned to assist in the 1982 examination of Continental. Our concerns became serious when OCC examiners in Penn Square learned that Continental had purchased a significant quantity of bad loans from Penn Square. An examination of Continental was underway and OCC examiners in that bank were immediately informed of irregularities in the Penn Square loans. The OCC responded to this in a number of ways. After informing Continental's management in June of the serious condition of Penn Square and its implications for Continental's loan portfolio, the OCC extended its examination through November and worked closely with Continental's internal auditors and independent accountants to assess the damage. On July 5, 1982, Penn Square Bank failed. Continental's serious condition prompted the OCC to direct a number of corrective measures, which were immediately initiated by the bank. 3 - 3 0-84 913 17 The OCC informed management in August 254 of its intention to formalize these directives by placing the bank under a Formal Agreement, enforceable under the cease and desist authority of 12 U.S.C. 1818. The Comptroller and his staff met several times with senior management and board members over the next few months to discuss the bank's condition and the impending Agreement. Continental moved quickly to determine the extent of its exposure in loans originated by Penn Square, to get a fix on the size of the loan loss provision necessary for the second quarter, and to stabilize funding. OCC examiners also reviewed all of the loans Continental had purchased from Penn Square and evaluated their effect on Continental's loan portfolio and provision for loan losses. Our examiners held numerous meetings with Continental's Board of Directors to discuss the bank's provision for loan losses and its recovery effort. OCC's 1982 examination determined that many of the loans purchased from Penn Square, particularly in the months just prior to Penn Square's failure, had failed to meet Continental's typical energy-lending standards. Many were also poorly documented and were, therefore, not being internally rated in a timely manner. Accordingly, increasing numbers of these loans appeared on Continental's late rating reports. In addition, numerous loans had appeared on 255 Continental's internally-generated collateral exception report. The reliability of Continental's internal reporting systems, however, had been spotty in previous years. As a consequence, officers in the Special Industries Division who were purchasing the loans from Penn Square were able to persuade senior lending officers to disregard the internal reports. Early internal warning signals were, therefore, largely ignored. During the office's 1982 examination, OCC examiners also learned that a team of internal auditors had been sent twice in 1981 by Executive Vice President Bergman, head of Continental's Special Industries Group, to review the Penn Square loans Continental was purchasing. The auditors' report on their first visit in September 1981 noted several items that they felt merited "special attention", including: incomplete and inaccurate records, questionable security interests, and a high level of loans to parties related to Penn Square. The Special Litigation Report of the Board of Directors issued in 1984 concluded that this audit report, although submitted to Bergman, was not seen by senior Continental management prior to the collapse of Penn Square. The written report of the bank auditors' findings of their second visit to Penn Square in December 1981 expressed 256 concern with loans secured by Penn Square-issued standby letters of credit (representing approximately one-third of that bank's equity), questionable lien positions, and several loans in which the bank had purchased more than Penn Square's current outstanding balance. This audit also uncovered $565,000 in personal loans from Penn Square to John R. Lytle, manager of Continental's Mid-Continent Division of the Oil and Gas Group, and the officer responsible for acquiring the Penn Square loans. The Special Litigation Report once again indicated that while senior Continental management did receive news of these loans to Mr. Lytle, they once again did not receive the full auditors' report from the December review of the Penn Square lending operations. No action was taken by Continental to remove or discipline Mr. Lytle until May of 1982. In July of 1982, following the collapse of Penn Square, Continental sent a staff of experienced energy lenders to Oklahoma City to review Penn Square's records and assess the dimensions of the problem. Each of the loans Continental purchased from Penn Square were reviewed during the first two weeks of July. After analyzing the probable risk associated with each credit, senior Continental officers recommended an addition to loan loss reserves of $220 million. This Office, 257 as well as the bank's accounting firm of Ernst & Whinney, reviewed this figure and concluded that it was supported by the information available at that time. This figure was then published on July 21 along with a full statement of Continental's second-quarter results. Continental auditors, supported by accountants from Ernst & Whinney, remained in Oklahoma City reconciling Continental's records with Penn Square data, assisting in the Penn Square portfolio assessment program, and preparing the loan workouts. OCC examiners also reviewed in late August and early September each loan purchased from Penn Square and discussed their findings with senior Continental management before release of third quarter earnings. That review resulted in an additional $81 million being added to the bank's provision for loan losses in the third quarter, as reported in Continental Illinois Corporation's October 14 press release. The holding company also indicated that its nonperforming assets had reached $2 billion as of September 30, 1982, up $700 million from the previous quarter. Simultaneously with the credit review, Continental undertook an extensive review of the people involved in the Penn Square relationship and the lending policies, procedures, and practices which might have contributed to the crisis. In 258 its first phase, an independent review committee appointed by Continental's Board of Directors recommended a series of major staff changes beginning with the July 14 suspension of John R. Lytle. Mr. Lytle was permanently released from the bank on August 30. Resignations and early retirements, including those of Executive Vice President Bergman and his superior, Executive Vice President George Baker, soon followed. In addtion, various other bank personnel were reassigned. In its second phase, the internal review committee assessed bank policy and recommended: o codification of bank lending policies and procedures; o enhancement of secured lending and related support systems; o improvement in cooperation between loan operations and the line; o revision of loan operations activity to improve its reliability and productivity; and o formulation of a Credit Risk Evaluation Division, as had been recommended by the OCC, to strengthen the bank's credit rating system and enhance credit risk identification, evaluation, reporting, and monitoring. Following the Penn Square collapse, the domestic money market's confidence in Continental was seriously weakened. 259 The bank's access to the Fed Funds and domestic CD markets quickly dried up. As illustrated below, Continental lost 40% of its purchased domestic funding in 1982. Continental's Domestic Purchased Funds 76 S o u r c e : Call 77 78 79 80 81 82 83 Reports Continental moved quickly to stabilize and restore its funding. Meetings were held with major funds providers, rating agencies, and members of the financial community. Public disclosures were periodically issued to correct misinformation. In the fall of 1982, liquid assets were sold or allowed to mature. As the domestic funds market dried up, 260 Continental shifted to the European interbank market for funding. Foreign liabilities soon began to approach 50% of the bank's total liability structure. Continental's Foreign Liabilities/Total Liabilities Poreont of Total Liabilities 50 1 46% 45 + 40 I 35% 35 30 111 2755 25 + 20 + 15 + 10 5 0 I i • H 75 40% i 37% 34% 1i 1 1I • m H m Iim W74 362 1 1i I m • n 78 ^ I Source: Colt Reports 48% 1 ^ ^ 1 1 I Continental's parent holding company maintained its $0.50 per share dividend on common stock in August 1982. While the dividend may not have been merited by the earnings level, holding company management felt it was a necessary step in attempting to restore the confidence of the financial markets and to raising capital in the marketplace. 261 Despite these actions, Continental's condition deteriorated throughout 1982. Many of its energy loans that had performed well and been extremely profitable in the 1970s and well into 1981 were now serious collection problems. Nonperforming assets at the holding company level, which totaled $653 million at the end of 1981, grew to $844 million at the end of the first quarter of 1982. While most of these nonperforming assets were concentrated in real estate loans and nonenergy-related corporate loans through the first quarter of 1982, this changed dramatically in the following quarters when a number of energy loans were nonperforming. the end of 1982, close to half (over $900 million) of Continental's nonperforming assets were energy-related. $ Mnos iin Nonperforming Assets by Industry 2000 T . 1 800 J 1600 J | 1400 + I I 1200 { i 1979 Sourca: O C C 1980 1981 1982 0,L*GAS I I I ! I I 1983 By 262 In all, $1.2 billion in nonperforming assets were added in 1982, bringing them up to nearly 6% of the total loan portfolio. Continental's Nonperforming Assets 10 9t 8 7 6.6 5 6t -9 ,7 IN • 5 4 3 2 3.7 Kg ^ ill i i 1 i i ill -° ill^ H ill 111 2+ 1 | 80Q4 Source: OCC 111 61 6.6 HI II III i m v& « ^ ^ 1 nil 263 Continental's net loan losses reached $371 million by December 1982, nearly a five-fold increase over the previous year's losses. Despite an improving economy in 1983, many of Continental's borrowers continued to experience difficulties and Continental's losses remained high. Continental's Net Loan Losses 74 75 76 77 78 79 80 81 82 83 Source: Call Reports Energy-related loans represented a disproportionate share of Continental's loan losses. While oil and gas loans comprised approximately 20% of Continental's average total 264 loan portfolio in 1982 and 1983, they represented approximately 67% of its June 1982 through June 1984 loan losses. Composition of Continental's June 1982 through June 1984 Loan Losses SHIPPING 5% T%Vv»n RE 4% PENN SQUARE OTHER 0 * G NOTE: OCC estimate baaed on a review of losses in excess of $2 million per loan taken between June 30, 1982 and June 30, 1984 Most of Continental's oil and gas loan losses were a direct result of its purchase of loans from Penn Square. Although loans purchased from Penn Square averaged less than 3% of Continental's total loans over the past 2 1/2 years, 265 they accounted for 41% of the bank's losses between June 1982 and June 1984. Penn Square loans have thus far resulted in nearly $500 million in loan losses for Continental. Continental's Losses Since June 30, 1982 Compared to Average Outstandings OTHER LOANS OTHER C&l LOANS LOANS - Annual Average 1 9 8 2 - 1 9 6 3 LOSSES — Losses since June 1 9 8 2 Source: OCC 266 As illustrated in the following chart, most of Continental's loan losses since June 1982, including those purchased from Penn Square, were from loans that originated in 1980 and 1981. Origination Date of Continental's Post-June 1982 Loan Losses OTHER LOANS OTHER C8c\ OTHER OIL Sc GAS PENN SQUARE PRE-/8 Source: OCC 78 267 These loan quality problems caused Continentalfs earnings to collapse. The bank's provision for loan losses consumed 93% of its 1982 operating income, reaching $476.8 million. Resulting net income fell from $236 million in 1981 to $72 million at year-end 1982. Continental's Loan Loss Provision Percent of Operating Income 100 T 74 75 76 77 78 79 80 81 82 83 Source: Cnll Reports The collapse of Penn Square and the energy industry forced Continental's management in 1982 to reassess the bank's 268 overall direction. Continental's Credit Risk Evaluation Division, which had been created at the urging of the OCC in the fall of 1982r was strengthened in early 1983 to provide improved risk evaluation and to report regularly to the Board of Directors and senior bank management. The Division also monitored the effectiveness of Continental's early warning credit quality systems and served as an important check on corporate lending activities. The Formal Agreement, signed on March 14, 1983, primarily covered asset and liability management, loan administration, and funding. It required the bank to continue to implement and maintain stronger policies and procedures designed to improve performance. In addition to quarterly progress reports regarding compliance with the terms of the Agreement, Continental was also required to report periodically to this Office on its criticized assets, funding, and earnings. In April 1983, OCC examiners visited Continental to review the first quarter financial results. Nonperforming assets, at $2.02 billion, were higher than anticipated by the bank, but market acceptance had improved and premiums on funding instruments had declined. 269 Continental submitted the first quarterly compliance report required by the Formal Agreement to this office in May 1983. It indicated that appropriate actions required by the Agreement were being taken by the bank. Continental's 1983 recovery plan called for a reduction in assets and staff and a more conservative lending policy. Two executive officers, David Taylor and Edward Bottum, were appointed to Continental's Board of Directors in August of 1983. Immediately after their appointment, they instituted key management and organizational changes to further lay the groundwork for recovery. External market conditions during the second half of 1983, however, slowed Continental's recovery. margins. Increasing interest rates squeezed net interest Loan demand was weak. Nonperforming energy loans rose further as the energy industry continued to decline. The general sentiment of bank analysts toward Continental in 1982 was negative following Penn Square. It had become apparent to bank analysts by early 1983 that Penn Square wasn't Continental's only problem. Few analysts felt that Continental stock had any short-term turnaround potential. 39-133 0-84 18 270 Robert Albertson of Smith, Barney, Harris, Upham & Co. in the March 28, 1983 Wall Street Transcript summarized these opinions: Continental Illinois1 problems are something that, in retrospect, we perhaps should have been better prepared for than we were. Recognizing how fast they grew should have alerted us to the fact that at least the potential for unusual problems was definitely there . . . The most disconcerting thing about [Continental's difficulties] is the fact that the worst hit occurred in its principal area of expertise. Therefore, I have to remain uncertain as to where Continental will be going in the near term. The 1983 examination of the bank's condition as of June 30, focused on energy and real estate credit, overseas exposure, funding, earnings, capital adequacy, and compliance with the Formal Agreement. The overall condition of the bank had further deteriorated since the 1982 examination. quality and earnings remained poor. Asset Capital was adequate on a ratio basis, but under pressure due to asset and earnings problems. Funding had improved, but was still acutely sensitive to poor performance and other negative developments. The bank was found to be in compliance with the 271 provisions of the Formal Agreement. Following completion of the examination in December 1983, the Comptroller and senior OCC staff met with Continental's Board of Directors on January 23, 1984 to discuss these findings. A revised recovery plan for 1984 called for a further reduction in assets, enhanced capital-raising efforts, and a reduction in non-interest expenses and staff. Non-essential businesses, such as real estate and the bank's credit card operation, would be sold to improve capital and refocus the bank on wholesale banking. Merger alternatives would be pursued wih the assistance of Goldman, Sachs & Co. which had been retained in September 1983. Plans were also accelerated to transfer additional responsibilities to Taylor and Bottum. On January 31, 1984, OCC staff met with Continental's Vice Chairman and its Controller to review the bank's 1983 performance, the 1984 recovery plan, and contingency planning. Part of the discussion concerned the bank's own strategy for a "good bank/bad bank" separation, similar to that eventually provided for in the long-term assistance program. David Taylor replaced Roger Anderson as Continental's CEO in February of 1984 and Edward Bottum was elected President. External events in the first quarter of 1984, however, 272 produced further problems for this new management team. Asset quality continued to deteriorate and Continental recorded an operating loss for the first quarter of 1984. Continental's condition as of March 31, 1984 remained poor. An OCC examination begun March 19 and targeted at asset quality and funding, concluded that continued operating losses and funding problems could be anticipated unless the bank's contingency plan to sell nonperforming assets was successful. Details of this plan were not, however, available at the close of the examination on April 20. The Comptroller and his staff met with Continental's Chairman/CEO and President on May 2 to discuss the bank's dividend policy and contingency plan for selling nonperforming assets. It was the Comptroller's conclusion following the meeting that our approval of the payment of the bank's second quarter dividend to the holding company, in part, depended on the successful implementation of the provisions contained in the contingency plan, specifically the sale of nonperforming assets. Later that month, market confidence in Continental slipped even further as rumors about the bank's impending bankruptcy were fueled by two erroneous press reports on May 8 that 273 concerned the purchase of or investment in the bank. Prom that point onf the Office was in constant contact with the bank and other bank regulatory agencies, particularly the FDIC. On May 10, the OCC issued a news release stating that the Office had not requested assistance for or even discussed Continental with any bank or securities firm and that the Office was unaware of any significant changes in the bank's operations that would serve as the basis for rumors concerning the bank's fate. OCC examiners established an onsite presence in Continental's trading rooms in Chicago and London on May 10 to more closely monitor the bank's rapidly deteriorating funding situation. Initial reports from OCC examiners indicated that major providers of overnight and term funds were failing to renew their holdings of the liabilities of the bank and Continental Illinois Corp. The bank was forced to prepay the deposits in Eurodollar and domestic markets and seek replacement of the CD funding in the domestic market. Because other funding sources were not available, the bank resorted to borrowings from the Federal Reserve Bank of Chicago. From May 12 - 14, a safety net of 16 banks put together a $4.5 million line of credit for Continental. But, by May 15, the safety net began to unwind due to a heightened lack of 274 confidence. The Comptroller and staff held meetings on May 16 and 17 with Continental, other money center banks, and regulatory agencies in Chicago, New York, and Washington to consider alternatives. These meetings resulted in the formation of the "temporary assistance package". Under the temporary assistance plan publicly announced on May 17, Continental received a $2 billion subordinated loan for the period necessary to develop permanent sources of funds. The loan was evidenced by a demand subordinated note; $1.5 billion was provided by the FDIC, with the balance provided by a group of seven major U.S. banks. In addition, a consortium of 28 banks provided Continental with a $5.5 billion standby line of credit. By virtue of this capital injection, the FDIC in effect provided assurance that Continental's problems would not be resolved through a pay-off of insured depositors. It, therefore, also provided assurance that the funds of all depositors, both insured and uninsured, were thereby fully protected. During the next two months, the regulators held meetings with both domestic and foreign financial institutions and other parties interested in merging with or investing in Continental. It became apparent fairly early on in these discussions, however, that it would be difficult to arrange a 275 completely private sector solution. private sector/government-assisted Furthermore, proposed transactions were likely to be too costly to the FDIC. The regulators' efforts were, therefore, directed toward devising a permanent solution to Continental's problems that was not dependent on private sector investment. Small working groups comprised of representatives from all three bank regulatory agencies met on a daily basis to develop and refine a long-term solution. At the same time, a search began to find new management for the bank. The Comptroller and other senior officials met at least weekly with the FDIC to discuss planning details; telephone contact between the principals occurred frequently. Continental's financial situation, while stable for most of June, began to deteriorate again in July. Despite FDIC assurances, there was unease about just how the FDIC "assurances" would be honored if Continental failed. As a result, many large depositors began to again withdraw their funds as they matured. During the 60 days after the erroneous press reports, Continental's deposits, Fed Funds, and repos had fallen nearly $10 billion. By July, Continental had borrowed $4 billion 276 from 28 banks, another $3.55 billion from the Federal Reserve Bank of Chicago, and $2 billion more from the FDIC and the seven banks holding subordinated notes. Throughout this period, OCC held several meetings with senior bank management and with various members of the bank's Board of Directors. Numerous meetings were held internally to analyze and refine the proposed plan. Intensive monitoring of the bank's funding continued and a joint OCC/FDIC review of the loan portfolio was conducted. The long-term solution, announced on July 26 and subject to shareholder approval on September 26, is intended to restore Continental to health and allow it to continue to serve its marketplace without interruption. It entailed two key elements: top management changes and substantial financial assistance. The solution will result in the creation of a smaller and more viable Continental. Management has been removed, and shareholders have incurred substantial losses. At the same time, major disruption to the financial system has been avoided. Upon implementation of the long-term solution, Continental will be well-capitalized and have stronger assets and management. It will be returned to private ownership at the earliest possible date. 277 Chairman S T GERMAIN. Thank you, Mr. Conover. Now, Mr. Conover, immediately after the Penn Square failure, Continental's management began an in-depth review of its operations. And in 1983, the Office of the Comptroller of the Currency required Continental to enter into a supervisory agreement. Almost 2 years after Penn Square, and a year after the supervisory agreement was signed, banks t h a t went into Continental to evaluate its merger potential, last May, found conditions t h a t surprised them. What they reported to the FDIC is recorded in two FDIC memoranda. To preserve the identity of the banks whose officials commented to the FDIC, I will refer to them simply, all of them rather simply as the "X-Y-Z" bank. Let me cite two of the recorded comments. And I quote: X-Y-Z banks compared their internal loan rating system on a scale of 1 to 9 against the rating system at Continental, 1 to 9, on 21 borrowers who were common to both banks. Only 6 of the 21 credits were given the same rating by both banks. On another situation, Continental's rating was one better than the rating at X-YZ. On another five, Continental's was two better t h a n X-Y-Z, and on another four, Continental's rating was three or more better t h a n X-Y-Z. Based on this review, X-Y-Z indicated t h a t Continental's internal loan review process was very lenient and that the volume of classified loans was really much higher than presented or contended by Continental. On some of the common loans at the two banks, X-Y-Z bank has taken at least partial chargeoffs while Continental continues to carry them at full value and in performing status. Continental also makes new loans to customers in order to keep the interest rate payments current. X-Y-Z people estimate t h a t there is an additional $650 to $700 million in loans that should be classified as nonperforming. They also estimate an additional $1.6 billion in nonperforming loans within 12 months. Now, from the information developed yesterday, it is clear that examining and supervising a large money center bank is a difficult task. From the evidence reflected in the FDIC memos from which I have just quoted, it appears it takes a long time for a large bank to correct its problems. And I believe you sort of indicated that in your testimony as well. I am confident t h a t with its new management, Continental will quickly become a strong bank once again and its problems will be solved. However, we need to know whether the length of the time Continental is taking to correct its operating practices is normal. How long does it usually take for a large money center bank to correct the problems cited by your examiners? And would you please provide the subcommittee with a tabulation of the length of time it takes national banks to move from the lowest soundness category to one we view as acceptable? On the second, naturally, I expect you to submit t h a t for the record. May I just add t h a t in regard to this issue of bigness, in 1976, management determined t h a t they would become very aggressive, and they would become the third largest commercial lender in the United States of America. Why? Why did they feel this need? They were doing fine. It was a strong bank. It was a well-run bank. In order to accomplish this they used some very innovative practices. They said that, from here on in, as you cited earlier, loan decisions will be made at the lower level and we will insulate ourselves from that. Then they were aggressive in seeking funds, actually hot money, a lot of money. 278 You wonder why. What is the motivation? What is it? I shouldn't say a disease, but it seems to be an addiction of some in the banking industry to get bigger and bigger. So I ask you again, how long does it usually take a large bank, one of the money center banks, to correct the problems cited by your examiners in the Continental situation? What is the normal period of time? Mr. CONOVER. Mr. Chairman, I am not sure I can give you a precise answer to that. It will depend on the nature of the deficiency, how widespread it was, whether it means changing behavior throughout the bank or simply modifying a practice in a particular department, and so forth. Since the situations are so different, I am not sure that I can tell you t h a t it takes a month or 2 months or whatever. What we generally do, and I intend to do in the future with more vigor, is to identify clearly the specific actions we want banks to take and have a followup mechanism in place to assure t h a t those corrections are being made between examinations. One of the early steps in the followup examination will be to go back and review the banks progress in taking corrective actions. Chairman S T GERMAIN. Mr. Conover, Acting Comptroller Bloom, and we have had a lot of acting Comptrollers, in a 1976 appearance, had this to say and I quote: Now, I would like to turn to the new system which we are developing which we hope will give us an earlier and clearer and more accurate way of singling out banks for special supervision. The new system will be a computerized early warning system called the National Bank Surveillance System, which we call NBSS. NBSS will help in detection of impending problems before they become serious cases. It should, however, substantially aid in the prevention of future bank failures. Now is NBSS still in operation and alive and well at the Comptroller's Office? Mr. CONOVER. Yes; it is. It is alive and well. It has been improved several times, and we have plans for improving it in the future. Chairman S T GERMAIN. Was NBSS utilized in the case of Continental? Mr. CONOVER. The NBSS system is really more appropriate for evaluating the vast number of smaller banks. We have in place a multinational bank division t h a t gets much more complete information on multinational banks, not just information from call reports and examination reports, which are the primary data sources for the NBSS. For the multinational banks, then, we use a separate information system and do separate analysis of those banks directlyThus, the NBSS system is alive and well and being improved. But it really isn't the most appropriate mechanism for tracking a bank like Continental. Chairman S T GERMAIN. Are you saying NBSS does not have the capacity to take the input that you would get from a multinational bank? Mr. CONOVER. I am saying it is designed to take information on 4,700 banks and that we have a much more precise and direct way of getting and manipulating data on the 11 multinational Chairman S T GERMAIN. Are you telling me that the methods you use for the 11 multinationals is superior to NBSS? 279 Mr. CONOVER. Yes, I am, because there is more information that is available for examination and analysis. Chairman S T GERMAIN. Well, in view of that statement, this question arises in my mind, if the system utilized for the multinationals is superior to the NBSS system, what do you feel happened at Continental? It seems as though, as I recall, what was the date of that reassuring statement you gave to the world at large? Was it May? Mr. CONOVER. May 10. Chairman S T GERMAIN. May 10. Now as I recall in that statement, you said that everything was fine at Continental and that no one should be perturbed and people shouldn't remove their funds. So that means as of May 10, 1984, the superiority of the NBSS system utilized for the multinational banks did not indicate any problems at Continental Illinois. Well, t h a t being the case, I have to scratch my head and say how much faith can we put in NBSS and the superior system utilized for the multinationals as an early warning system? Or is it perhaps that when you get to the multinationals that they are so big that there is no way to really and truly and effectively have an early warning system? Mr. CONOVER. N O , I don't think that is the case. Chairman S T GERMAIN. Because, remember at Franklin National the examiners were in Franklin National. They had left one section of the bank; its operations. It was so vast that they were in another section of the bank's operations when all of a sudden the Federal Reserve Board said, hey, come on now. We have pumped enough money into this situation. Let's find a merger partner. Some of the examiners who were working in the bank at that time didn't know how bad Franklin National was. With these large money center banks is it perhaps that there is no way to really know? Mr. CONOVER. No, I don't think that is true. I think we get a sufficient amount of information. The information we get and the analysis we do, don't enable us to reach a conclusion, per se, about the situation in the bank, but they do raise red flags. They help identify areas that ought to be looked at in greater depth. Chairman S T GERMAIN. Where were the red flags on May 10, 1984? Were there no red flags flying? Mr. CONOVER. Let me clarify what I said in the release on May 10, because I think there has been a significant amount of misunderstanding. I did not say t h a t the bank was just fine, thank you. What I did say was that the Comptroller's Office was not aware of any significant changes in the bank's operations that would serve as a basis for the rumors that were being circulated. The release also denied a report that had been carried by a Japanese news service that our office had discussed the bank with or requested aid for Continental from any Japanese bank or securities firm. Obviously, the condition of the bank, as was reported in its financial statements, was well-known to the banking industry and to the public at large. We were not denying that the condition of the bank was poor or shaky. We were simply saying that we knew of no change in its condition, the condition that everybody knew about, 280 t h a t could have served as the basis for those rumors t h a t were flying around all over the place. Chairman S T GERMAIN. Excuse me. Are you telling me t h a t John and J a n e Q depositor, who were constituents of Mr. Annunzio in Illinois—this is the little old man and the little old lady who have worked hard all their lives, and as a result of very penurious living, they happened to have, instead of $100,000, they have $150,000 in Continental Illinois. Now do we expect t h a t these unsophisticated day laborers read the financial reports in such a m a n n e r as to be able to reassure themselves of the fact t h a t Continental did have problems? Because as Comptroller of the Currency, you issued a statement. I know how to make these statements, too. You can make a statement t h a t really is designed to do one thing, but you have got yourself covered so t h a t if the implications t h a t are derived therefrom are what you want them to be, but yet are not accurate, then you can say, well, here is what I said exactly. Mr. Comptroller, as a matter of fact, word went out to the effect t h a t you, the Comptroller, said t h a t there were no big problems t h a t people should be concerned about at Continental. That was the interpretation of your statement. That was on May 10, 1984. Now if you or one of your successors should make that type of statement in the future, how much credence do you think will be given to it? That is my concern in this instance. Again, where were the red flags? Mr. CONOVER. The words in the statement were carefully chosen to have only the meaning t h a t they had. Chairman S T GERMAIN. OK, how about Mr. CONOVER. There was no intent on our part to give any other meaning to any potential reader of t h a t statement as to the condition of Continental Illinois. Chairman S T GERMAIN. Was this before or after, help me out here, the statement by Bill Isaac stating all accounts would be covered? Mr. CONOVER. Oh, this was before. Chairman S T GERMAIN. Before. Mr. CONOVER. That statement was not made until the temporary assistance package had been put together, around May 7. Chairman S T GERMAIN. The purpose of this, then, obviously, was to attempt to stem the outflow of funds, right? Mr. CONOVER. It was to indicate t h a t there were rumors t h a t clearly were bashing Continental and t h a t in our view those rumors were unjustified. We didn't know what the basis of them was. Chairman S T GERMAIN. Excuse me, Mr. Conover. My question is, wasn't it the purpose of this to stem the outflow of funds t h a t were occuring at that time in a very dramatic way? Mr. CONOVER. It was intended to say, again, t h a t we knew of no basis for the rumors so t h a t the run, if you like, t h a t was the result of those rumors, would stop. Chairman S T GERMAIN. YOU were attempting to stop the run on the bank? 281 Mr. CONOVER. We were attempting to provide accurate information to the marketplace so t h a t any run t h a t was based on misinformation would stop. Chairman S T GERMAIN. And you feel t h a t this was accurate information? It is a cute statement. It says there haven't been any significant changes; right, essentially it says this. Mr. CONOVER. That is what it says. Chairman S T GERMAIN. N O significant changes. It doesn't say, however, t h a t there should be some significant changes so t h a t there wouldn't be a reason for a run. Mr. CONOVER. Of course it doesn't say that. That wasn't the situation we were in. Chairman S T GERMAIN. It wasn't? Mr. CONOVER. N O ; the point, Mr. Chairman Chairman S T GERMAIN. Well, if t h a t is the case why did we put new management in? Why did we get rid of Mr. Taylor and all those wonderful things? Mr. CONOVER. The point was t h a t the bank was having funding difficulties as a result of rumors and t h a t we had no knowledge of any reason t h a t those rumors were circulating. Chairman S T GERMAIN. Mr. Conover, I have got Mr. CONOVER. The alternative was not to issue the statement. Chairman S T GERMAIN. That's right. But, remember, the rumors t h a t gave rise to funding difficulties came about as a result of actual factual information t h a t international money managers and domestic money managers were aware of. Is t h a t not the case? Mr. CONOVER. I wouldn't put it t h a t way, sir. I would say t h a t the rumors had the effect they did because the bank was in fact extremely vulnerable to rumors due to its financial condition, due to the known weaknesses in its loan portfolio, and due to its funding strategy. Where the rumors started from and why they started, I don't know to this day. Chairman S T GERMAIN. But the rumors were not inaccurate? Mr. CONOVER. Sure they were. There were rumors t h a t were circulating and had circulated in the previous several days, for example, that the bank was going to declare bankruptcy. That got a little coverage in the press. Anybody who knew anything about how Chairman S T GERMAIN. Why would t h a t type of rumor arise? Mr. CONOVER. Mr. Chairman, I don't know how the rumor arose. Chairman S T GERMAIN. Because some financial analysists in New York a year previously had said they wouldn't even analyze t h a t stock any further and they wouldn't recommend its purchase by anyone. Isn't it things like t h a t t h a t led to this eventually? Mr. CONOVER. Well, we can speculate as to what the cause and source of the rumors were. But I don't know to this day what they were. Chairman S T GERMAIN. DO you to this day feel comfortable with the statement t h a t you issued on May 10, 1984, to the world at large? Mr. CONOVER. I am comfortable t h a t the statement t h a t was issued on May 10, 1984 was accurate based on the information t h a t I knew at that particular time. 282 Chairman S T GERMAIN. And you are comfortable with the fact t h a t it didn't accurately document the situation—accurate and as you agree, meaning carefully worded? You are comfortable with the fact t h a t it could not have misled people? Mr. CONOVER. It certainly was not intended to mislead anybody. Chairman S T GERMAIN. Whether it was intended Mr. CONOVER. Whether it did or not, I obviously couldn't control. As I said at the outset when we touched on this subject, I think t h a t t h a t particular statement has been widely misinterpreted. Chairman S T GERMAIN. Well, Mr. Conover, you have got to be very cautious when you are in a position of the Comptroller of the Currency or chairman of the Banking Committee. Mr. CONOVER. I am Chairman S T GERMAIN. YOU have got to be very careful about what you say. Mr. CONOVER. I am well aware of that. Chairman S T GERMAIN. Because people will try to inter pet anything. They try to interpret me even when I don't speak. Mr. CONOVER. The fact t h a t it was rumored t h a t our office was actively engaged in meetings and discussions with Japanese banks or securities firms to try to arrange a sale of Continental was one of the things t h a t caused me to decide t h a t it was appropriate at t h a t time to make an exception to a longstanding policy of not making statements about individual banks and t h a t we ought to put t h a t issue to rest then and there. Mr. A N N U N Z I O . Will the chairman yield? Chairman S T GERMAIN. Sure, Mr. Annunzio. Mr. ANNUNZIO. Mr. Conover, when we are talking about rumors, isn't it true t h a t there were rumors in the Chicago paper about the First National Bank of Chicago having an interest in taking over the Continental Bank? There were rumors of an Arab group. There were rumors of a Japanese group. There were rumors of Citicorp. There were all kinds of rumors. Every day there was a rumor of a new group t h a t was ready to take over Continental, because Continental was ready to close its doors. Mr. CONOVER. Yes, t h a t is true. Mr. ANNUNZIO. I feel, personally, t h a t what really destroyed confidence in Continental were these rumors. And no one knows where they really got started. Chairman S T GERMAIN. Incidentally, Mr. Conover, the rumors of the possible purchase or merger of Continental with all these institutions was not all—these were not all t h a t inaccurate because we know of the fact, don't we, t h a t three major banks went in and spent substantial amounts of time, effort, and manhours analyzing Continental to determine whether or not they indeed did wish to make a merger offer. Mr. CONOVER. Oh, yes, we do. That was after the temporary assistance package was announced. Chairman S T GERMAIN. Yes. Let's look at a letter dated May 17 from the Comptroller to Mr. Isaac: This is to inform you of developing circumstances which may soon threaten the solvency of Continental Illinois National Bank and Trust Co. of Chicago, Charter 283 No. 13539. As of March 31, 1984, the bank had assets of approximately $40 billion and deposits of $28 billion. The bank is with the exception of directors' qualifying shares, wholly owned by Continental Illinois Corp. There are over 21,000 shareholders of Continental Illinois Corp. None own over 5 percent of the common stock of the corporation. Both the bank and Continental Illinois Corp. own a significant number of subsidiaries. On March 14, 1983, the bank entered into a formal agreement with the Office. This is 14 months prior to the May 10 statement. The bank entered into a normal agreement with the office. That means the Comptroller's Office. However, the bank's condition has continued to deteriorate. An examination as of J a n u a r y 31, 1984, revealed that nonperforming assets had reached approximately $2,300,000,000. Although, the bank's capital structure appears sufficient to absorb the probable losses in its portfolio, rumors and speculation regarding the bank's condition have received prominent coverage in the news media. As a result, the bank has experienced increasing problems in meeting its short term 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. That was the day before your letter. That was typed in, I guess, so you could fill in the blanks. If the bank's ability to obtain funding continues to deteriorate, the bank may become unable to meet its obligations as they become due. Now t h a t is 7 days after your May 10 statement. And it appears to me t h a t this letter probably was written a few days before May 17, because there were blanks left for the May 16 insertion of the borrowings from the Fed. So you are telling us that in 7 days the condition changed that dramatically? Mr. CONOVER. First of all, the letter was written on May 17. And the fact t h a t there were blanks left in it was simply so that those numbers could be filled in as soon as we had them accurately. That letter was a standard kind of letter in which we request the FDIC to consider providing assistance under 13(c) of the Federal Deposit Insurance Act. That type of letter is written a number of times a year when a bank is in jeopardy and the FDIC awaits official notification from the primary supervisor Chairman S T GERMAIN. Mr. Conover, I am sure you don't write this type of letter several times a year. Maybe this form, but not this type of letter. I think the magnitude of this one is not a common occurrence, is it? Mr. CONOVER. Of course not, because this is the biggest Chairman S T GERMAIN. This is the biggest biggy ever. Mr. CONOVER. Absolutely. Chairman S T GERMAIN. Right. So Mr. WYLIE. Will the chairman yield? Chairman S T GERMAIN. Sure. Mr. WYLIE. Isn't it part of your role to try to maintain some confidence in the banking system and to try to maintain confidence in Continental Illinois, in this case? And wasn't t h a t the case on May 10, 1984? You were trying at that particular time to make something out of this to try to see that the Continental Illinois was to continue as an ongoing financial institution. Wasn't it your role to be optimistic rather than to view it with alarm, which would have only made matters worse? 284 Mr. CONOVER. Well, it certainly is our responsibility to try to maintain the health of the system and of individual banks within it. Because we felt that the bank was being battered unfairly due to the rumors t h a t were circulating, we issued the statement t h a t we did. Now, between May 10 and May 17 a lot of things happened. The bank continued to have serious funding difficulties- A temporary funding arrangement put together with a number of banks to the tune of $4.5 billion began to unravel by May 15. That led to discussions between myself and Chairman Volcker and Chairman Isaac and a number of banks in New York, which ultimately resulted in the temporary assistance package. The statement issued on May 10 did little, as it turned out, to calm the marketplace. The bank continued to have funding difficulties. The so-called safety net t h a t had been put together over t h a t weekend, I don't recall what day of the week the 17th was, began to fall apart, or there was good evidence t h a t it had fallen apart by Monday noon. So we were dealing with a very rapidly changing situation. This letter was written as one of the things that had to be done in order to put the temporary assistance package into place. Chairman S T GERMAIN. Mr. Conover, do you at this point feel t h a t this press release was wholly consistent with the unpublished information t h a t your office had concerning the condition of Continental Illinois? Mr. CONOVER. Yes; I do. Chairman S T GERMAIN. All right. Now, I agree with Chalmers t h a t you do have a duty to try to maintain confidence in the system, as well as in individual institutions. And it is for t h a t reason t h a t I am concerned about this particular statement, its timing, the fact that 7 days later a letter that is—it is not a usual letter. It is an unusual letter because it served to trigger one of the biggest bailouts—the first nationalization in many, many years of a bank in the United States of America. My concern is that in the future, when the Comptroller, as I stated earlier, either yourself or one of your successors, attempts to make this type of statement, the marketplace, and this is very important as you are dealing in big numbers, is going to say: Aha, is this another carefully worded pronouncement that can give no more credence to than we should have given to that one of May 10, 1984 with respect to Continental Illinois? Is it a repeat? That is my concern. Mr. CONOVER. I share your concern about any decision to make a similar statement in the future and how the marketplace might react to t h a t statement. I just want to make it absolutely clear t h a t in issuing the statement we did, we acted with the full knowledge of the facts t h a t were available to us at the time. And there was never any intent to mislead anybody as to the condition of Continental Illinois. [Under unanimous consent the press release dated May 10, 1984, and the letter to FDIC Chairman Isaac dated May 17, 1984 from Comptroller Conover referred to by Chairman St Germain are placed in the record at this point:] 285 Comptroller of the Currency Administrator of National Banks Washington, D.C. 20219 ^r immediate Release Dt May 10, 1984 ae Statement on Continental Illinois A number of recent rumors concerning Continental Illinois National Bank and Trust Company have caused some concern in the financial 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 the basis for these rumors. Contrary to a report carried on a Japanese news wire service, the Comptroller of the Currency has not discussed Continental with or requested aid for Continental from any Japanese bank, any other bank, or any securities firm. Continental Illinois Corporation, the parent of the bank, is the eighth largest bank holding company in the U.S. As of tdarch 31, its assets totaled $41.4 billion. Total equity for the corporation exceeded $1.8 billion, and its reserves for possible loan losses totaled more than $400 million, or 1.32 percent of total credits. Total primary capital was $2.2 billion. Continental's equity-to-asset ratio was 4.41 percent, and its ratio of primary capital to total assets had increased to 5.84 percent. These ratios compare favorably to those of other major multinational banks. # *# * 39-133 0--84 19 286 o Comptroller o1 ttw Currency Administrator of National Banks Washington. DC. 20219 May 17, 1984 The Honorable William M. Isaac Chairman of the Board Federal Deposit Insurance Corporation 550 17th Street, N.W. Washington, D.C. 20429 Dear Mr. Isaac: This is to inform you of developing circumstances which may soon threaten the solvency of Continental Illinois National Bank and Trust Company of Chicago, Charter No. 13639. As of March 31, 1984, the bank had assets of approximately $ 40,000,000,000 and deposits of $28,000,000,000. The bank is, with the exception of directors' qualifying shares, wholly owned by Continental Illinois Corporation. There are over 21,000 shareholders of Continental Illinois Corporation. None own over 5% of the common stock of the corporation. Both the bank and Continental Illinois Corporation own a significant number of subsidiaries. On March 14, 1983, the bank entered into a formal agreement with the Office. 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 the probable losses in its portfolio, rumors and speculation regarding the bank's condition have received prominent coverage in the news media. As a result, the bank has experienced increasing problems in meeting its short term 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. Further administrative action by this Office will not alleviate the bank's immediate funding problems. Therefore, the Office suggests that the Corporation consider providing appropriate assistance to the bank under Section 13(c) of the Federal Deposit Insurance Act. Among many possibilities under the Act, this assistance may be in the form of a purchase by the Corporation of a demand subordinated note which would be treated as an increase in the bank's capital account. Such a note could be retired on the demand of the FDIC. To this end, this Office has issued, a letter to the bank granting approval of any decrease in capital which would result from such a demand by the Corporation. As always, we will respond to any informational requests or provide assistance as you deem necessary. Should that be the case, please feel free to contact National Bank Examiner James w. McPherson or National Bank Examiner Bobbie Jean Brookins in our Multinational Banking Department at (202) 447-1522. Sincerely, C. T. Conover Comptroller of the Currency 287 Chairman ST GERMAIN. Mr. Annunzio. Mr. ANNUNZIO. Thank you, Mr. Chairman. Mr. Chairman, I would like to ask unanimous consent t h a t I been given an additional 5 minutes for a total of 10. I want to be fair to the other members. Please keep the time for me. Mr. Conover, there has been much criticism leveled at the regulatory agencies for saving Continental. Will you please tell me and this committee what would have happened if Continental was not saved? I am interested in the 12,000 jobs t h a t would have been lost and the 66 banks t h a t have deposits, t h a t have more t h a n 100 percent of their equity capital on deposit in Continental. What would have happened to those banks, and what would have happened to all those employees, and to the banking communities in the Midwest where these 66 banks are located? Mr. CONOVER. Sixty-six banks, as you know, had deposits in Continental in amounts in excess of the total net worth of the bank. Another 113 banks had deposits in Continental amounting to between 50 and 100 percent of their net worth. If Continental had failed and had been treated as a payoff, certainly those 66 banks would have failed and probably a goodly number of the other 113 would have failed, if not immediately thereafter, then certainly within some period of time afterward. So let us say that we could easily have seen another hundred bank failures. Mr. VENTO. Will the gentleman yield to me to that? I have just a short question, an informational question. Mr. ANNUNZIO. I yield to Mr. Vento briefly because I still want to get my answer on these people losing their jobs. Mr. VENTO. Yes, OK. I just would like to know for the record, Mr. Conover, how many foreign banks were involved and what percentage of the assets were affected by the actions taken in terms of the agreement? That is a question I asked yesterday and your examiners couldn't answer it. So I want to again state it for the record. I thank the gentleman for yielding. Mr. CONOVER. The 66 and the 113 t h a t were cited are domestic banks. I do not have available right here the number of foreign banks t h a t might have been impacted, but I will be happy Mr. VENTO. And the deposits. Mr. CONOVER. I would be happy to provide that information for the record. Returning to Mr. Annunzio's question, it happens that of those 66 banks, 54 were in Illinois, and 70 of the 113 were in Illinois. The impact would have been much greater t h a n simply t h a t of an additional number of bank failures. There could also have been a significant number of corporate bankruptcies t h a t would have resulted as depositors were unable to get their cash and given receivership certificates in their place. It is difficult to buy not only groceries but industrial equipment as well, with receivership certificates. We debated at some length how to handle the Continental situation—whether it ought to be done on an open bank or a closed bank basis, what the consequences of a payoff might be, and so forth. Participating in those debates were the directors of the FDIC, the Chairman of the Federal Reserve Board, and the Secre 288 tary of the Treasury. In our collective judgment, had Continental failed and been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international, financial crisis the dimensions of which were difficult to imagine. None of us wanted to find out. Mr. A N N U N Z I O . Mr. Conover, what you are telling the committee is that without action, there would have been sweeping repercussions in the entire economy of the country and in the banking system of this country. Is there any way t h a t you can tell this committee how much money would have been lost by closing these 179 banks. How much money would have been lost to the corporations in this country, to the individuals in this country, to the individual job holders I described yesterday? I am not interested in upper echelon bankers. I am talking about the cashiers, janitors, clerks, and the lower echelon people in all of these institutions throughout Illinois. Are there any figures available as to what has been lost? What I am trying to point out is t h a t the biggest factor in every one of the bailouts of various companies by this committee, as far as I was concerned, was saving jobs of people and keeping them working in private industry, off of the unemployment compensation roles where it would be like a double taxation. And this could have happened in this case. Now if it is possible, I would like you to supply some kind of a dollar figure. But before I end my question, I want to say that, fortunately, this committee has a 100-percent track record in every one of the bailouts, including the two bailouts for New York City. All loans have been paid back, and the Government actually made money, Mr. Barnard, just like we did on our George Washington commemorative coin where we made millions of dollars on t h a t particular silver coin. And for the first time it was designated, in a bill, t h a t the profit be used to repay the national debt. So what I would like to know from you is, what is your feeling about—we will call it a bailout. We will call it whatever you want to call it. But in the end, what is the dollar amount that would have been lost? Do you feel t h a t we are in the ballpark? J u s t like the Cubs ball team, you know, on its way to winning a pennant, are we in the ballpark to really pull this off with Continental and keep it going on a sound basis in the city of Chicago? Mr. CONOVER. Let me try to provide some perspective in response to your question. In the case of the 66 banks t h a t I referred to t h a t had more than 100 percent of their equity deposited in Continental, their total assets were approximately $4.8 billion. In the case of the 113 banks t h a t had between 50 and 100 percent of their eqi ity on deposit in Continental, their total assets were $12.3 billion, t don't know what portion of the $12.3 billion to count, nor do I have a way of assessing the impact of lost jobs in those institutions or in businesses t h a t were customers of those institutions. But I think it is safe to say t h a t we are clearly dealing in this case with a multibillion-dollar situation in which many people, many businesses, and many financial institutions could have well have been h u r t to a significant degree. Now let's look at the condition of Continental today. Assuming t h a t shareholders approve the deal on September 26, it will be an 289 institution under a new management team with a substantially improved asset portfolio, with a sound balance sheet in terms of the proportion of capital to assets, and with the continued support of the FDIC and Federal Reserve System. Another way of describing all t h a t is to say it is probably the safest bank in the world to deal with today. The regulators, working together, put this package together over a period of several months. I think t h a t the American public, the banking community, and the international financial community ought to take some solace from the fact t h a t the U.S. Government has stood behind its banking system, t h a t the regulators have worked together effectively to accomplish this goal. The package is not without some weaknesses, however, and we can discuss those later, if you like. But I think the important thing is that the overall goal of maintaining the financial stability of the Nation's banking system has been achieved. Mr. ANNUNZIO. I have tried to get a loss figure. And I realize how difficult t h a t is. But would you estimate t h a t the Government placed about $16 billion in Continental? Mr. CONOVER. I heard the chairman refer to t h a t number yesterday, and I am not quite sure where he got it. I understand the $4.5 billion in loans t h a t are being purchased by the FDIC. Chairman S T GERMAIN. The discount window. Mr. CONOVER. Discounted loans. Chairman S T GERMAIN. Discount window. The Fed. Mr. CONOVER. OK, the billion dollars of capital infusion and the x billion—what number do you want to use for the discount window? Chairman S T GERMAIN. Well, it varies constantly. It was up to $7.5 billion Mr. A N N U N Z I O . Say they used $10 billion. Ten and $4.5 billion is $14.5 billion. Mr. CONOVER. I get up to about $12.5 billion in t h a t case. Chairman S T GERMAIN. HOW about the other banks t h a t have put funds in? Mr. CONOVER. The other banks have provided an additional $5.5 billion. Chairman S T GERMAIN. Doesn't t h a t come to $17 billion? Mr. CONOVER. All right. That comes to $17 billion. Chairman S T GERMAIN. I add pretty good, Mr. Conover. Mr. CONOVER. YOU did just fine. Chairman S T GERMAIN. I add pretty good. If the fellows at Continental, before we put in this good managing team added as well, it would be great. Mr. A N N U N Z I O . The chairman is absolutely right. We will say $17 billion. Now, my question to you, Mr. Conover, is what would the total loss have been to all these institutions, jobs, welfare, unemployment compensation, the American people if we hadn't put this $17 billion in? Mr. CONOVER. I don't know how to come up with t h a t number. But let me go back to the $17 billion because the presumption is t h a t the $17 billion has been spent and is gone, and I don't believe t h a t is the case. The FDIC will work out the $4.5 billion loan portfolio. That is not 100 percent loss; they would not tell you t h a t it is. 290 The $7 billion loan at the discount window is secured by quality assets t h a t the Federal Reserve Bank of Chicago has on assignment there. The $5.5 billion t h a t has been provided by the other banks as an overnight funding facility is, in the first place, not free. The banks are earning a market rate of return on those funds and have every intention of being repaid. Of course, this is all going to take some time. Continental has got to get back on its feet. It needs to start reporting profits on a quarter-to-quarter basis. Mr. ANNUNZIO. We have to find some way to end rumors which destroy confidence. Mr. CONOVER. I agree with that. Mr. ANNUNZIO. Confidence is the one thing t h a t the people have always had in the banking system of this country. What makes banks institutions that are respected by people, is the amount of confidence t h a t they have. We cannot destroy confidence in the banking system. What the regulators tried to do is save t h a t confidence. My time is almost up. Mr. BARNARD. Will the gentleman yield? Chairman ST GERMAIN. Mr. Barnard. Mr. ANNUNZIO. Yes. Chairman S T GERMAIN. Mr. Annunzio, we are going to give you another opportunity. Your time is up now. Mr. ANNUNZIO. I just have one more question. That is all. You have already made the statement that Continental, in your opinion, at this time, is a sound institution. And that in your judgment, Continental will survive. Mr. CONOVER. Yes, I did. Mr. A N N U N Z I O . All right. Chairman S T GERMAIN. Mr. Conover, t h a t was a delightful exchange. But did you ever stop to estimate how much grief and how many lost jobs occurred when W.C. Grant went down the tube? How many banks were affected? How many developers and shopping centers went into dire difficulty and how many actually failed? How about WPPSS? How many senior citizens who put their life's savings into WPPSS have been destroyed? How about Baldwin-United? We could have gone in and saved all those people. And Penn Square. How many people ended up with no money and, therefore, couldn't buy the groceries, like you said in your answer? What we have to look at in this instance is, and certainly it is laudable t h a t you can save these banks from failing, t h a t these banks have more t h a n a $100,000, far in excess of t h a t obviously, and large portions of their assets were in Continental Illinois. These were Illinois banks you told us. Quite a few of them. Sure, t h a t is unfortunate. But you have to question the judgment of those bankers, as well. Maybe they should have known a little more or paid a little more attention to their deposits and investments. But the big question is, what do we do with the next big bank that ends up in this situation? Do we have to come in and do the same thing all over again? 291 How do we say no in the future? That is what we have to address. I don't have any time right now, but I couldn't let t h a t go. I ask unanimous consent, incidentally, t h a t at the end of my first round of questioning where I was citing the press release and letter to Mr. Isaac from Mr. Conover t h a t these be placed in the record at t h a t point. Without objection, so ordered. [The press release and letter referred to may be found on pages 285, 286.] Chairman S T GERMAIN. Mr. Wylie. Mr. WYLIE. Thank you, Mr. Chairman. I was beginning to think it was my turn. There are a couple of points t h a t I want to clear up. The chairman made much of the letter of May 10, 1984 and some of the rumors t h a t surrounded that. I think the point to be made there is t h a t you were still trying to work something out between May 10 and May 17. Things happened very quickly and very rapidly there. Is t h a t a fair statement? Mr. CONOVER. Yes, it is. During t h a t time period we were monitoring Continental's funding situation not just on a daily basis, but literally on an hourly basis, and tracking its funding from the Far East through Europe, as well as domestically. The conditions t h a t the bank was facing in funding itself were changing rapidly. So while the time between May 10 and May 17 may seem short in terms of 7 days, t h a t was an eternity in terms of what was happening to the funding position of the bank. Mr. WYLIE. Exactly right. Then when you weren't able to work something out within the existing frame work, you came up with the package which you say now you have reason to be optimistic about again, t h a t Continental Illinois will indeed be an ongoing institution. And you have expanded on t h a t sufficiently. The impression has been left, it seems to me, t h a t somebody came up with a $17 billion gift to Continental Illinois. I want t h a t to be cleared up. In the first place, a part of t h a t comes out of FDIC, which is insurance money, not taxpayer money. Another part comes out of the discount window which has to be repaid. The other part of it comes from other banks. But the point there is, and you make in your statement, t h a t although Continental was weakened by asset deteriorations, its losses never exceeded capital and thus it never reached book insolvency. Rather, its near collapse was triggered by funding problems. Would you like to expand on that? Mr. CONOVER. That is correct. At the time t h a t the final package was put together, Continental's losses had still not wiped out its capital. We were confident of t h a t because the 1984 examination was done jointly by the Comptroller's Office, the FDIC, and the Fed. We reached a uniform agreement as to the classification of the loan portfolio, including the losses t h a t were to be charged. Even after those losses were taken, I believe the bank published some pro forma statements as to what its balance sheet would look like after the deals were consummated, and there was at least $600 292 million of shareholders' equity remaining in the bank. So the bank never reached book insolvency. Mr. WYLIE. It was never insolvent, so this $17 billion is, in effect—is this the proper word—it was collateralized. Mr. CONOVER. The $17 billion is not an appropriate measure of the cost of this transaction. It would be nice if we could know the costs instantaneously, but we can't. We won't know them until the loans purchased by the FDIC are worked out and we are able to see what kind of proceeds they yield. As I said, the $5.5 billion to the banks will be paid back with interest. I think t h a t the Fed's loan will also be paid back with interest. The FDIC could very well break even and could even make a profit on this deal. Mr. WYLIE. Perhaps a more important issue which the chairman touched on, Mr. Conover, and there has been much debate surrounding Continental and the fact t h a t there was a serious policy question which had to be resolved, simply stated, does a dual system exist—and this may be difficult for you to answer—but does a dual system exist for deciding if banks are allowed to fail, or are given a chance to survive? The Federal regulatory agencies that have come to the assistance of a $45 billion Continental Bank, one of the largest money center banks in the world in its heyday, while smaller community banks, as has been pointed out, in the Midwest have been allowed to fail. Have the agencies been able to promulgate a dual policy and do we now have a policy where banks or savings and loan associations above $5 billion, $10 billion, or $25 billion simply are not allowed to fail or cannot be allowed to fail no matter for what reason? I think this policy question has implications for all depositors and for the insurance agencies and for the monetary and financial stability and for consideration of the Financial Institutions Subcommittee. Mr. CONOVER. I would agree with you, Mr. Wylie, that t h a t is an important question. And let me say at the outset t h a t I think it is essential t h a t we have a policy and practices in place to handle large bank failures and small bank failures in a consistent way. Now, let me talk about what was done at Continental versus how small banks have been handled. In the Continental case, although, as was just pointed out, the bank never became technically insolvent, it was treated as if it had failed. Management has been removed. Shareholders face a major, if not total, loss, just as they would if the bank had been declared insolvent. And managers and directors face potential liability because I am sure the FDIC intends to pursue action against them. Chairman S T GERMAIN. Excuse me. You say the shareholders face a total loss if this bailout plan succeeds? Mr. CONOVER. The shareholders' interest has immediately been diluted by 80 percent. They face the risk of losing the remaining 20 percent. Chairman S T GERMAIN. HOW would t h a t happen? Mr. CONOVER. It would happen if the FDIC's losses in the liquidation of the $4.5 billion portfolio t h a t they purchased exceed the remaining shareholders' equity in the bank. 293 The shareholders are totally at risk in this case, just as they would be if the bank's doors had been closed and it had been technically declared insolvent. Mr. WYLIE. But on the other hand, they have a chance of coming out of it. Mr. CONOVER. They have a chance, t h a t is true. When the FDIC infused the $2 billion of subordinated capital notes as part of the temporary package on May 17, t h a t immediately created a condition. That condition was t h a t any action other t h a n a payoff would be $2 billion cheaper to the FDIC than a payoff. We discussed whether to leave t h a t condition for people to try to analyze and interpret or whether the FDIC ought to make an explicit statement saying what the effect of t h a t capital infusion was. In order to avoid confusion, the FDIC elected to make an explicit statement, that the bank would be handled in a way t h a t all depositors and creditors would be made whole in the final long-term solution. That statement has been widely misunderstood and misinterpreted to mean t h a t the FDIC extended, perhaps illegally, deposit insurance to amounts above $100,000. That was not the case. Chairman S T GERMAIN. Because the bank was not closed. Mr. CONOVER. That is correct. Chairman S T GERMAIN. But had the bank closed, then you would have had a difficult situation. You would have to look into the legality of living up to the Bill Isaacs' commitment. Mr. WYLIE. Right. Mr. CONOVER. Had the bank closed, the FDIC would have taken the action which was the least costly to it. By virtue of putting in $2 billion into the bank, t h a t meant t h a t doing a payoff had a $2 billion disadvantage compared to alternative actions. Now, let's contrast t h a t situation with what has happened in small banks. I think we are up to 57 bank failures this year. That means that since J a n u a r y 1982, we have had 147 bank failures— approximately 1 percent of the total number of banks in this country. The vast majority of those—well in excess of 80 percent of the 147—have been handled through purchase and assumption transactions. In those transactions, the bank is sold to another bank and usually opens its doors on the following morning. And the effect is that all depositors and creditors remain whole. So Continental's depositors and creditors were treated in a way t h a t was certainly consistent with the way 80 percent of the small banks t h a t have failed during t h a t time period were treated. Now, if we look at the remaining 20 percent t h a t were treated differently, they fall into three categories. The first category would be those in which there was some massive fraud or contingent liability in existence such that the FDIC felt that it could not put the risk on the insurance fund, and so a payoff was arranged. A second category would be where an attempt was made to arrange a merger with another bank, which usually involves having people submit bids, and no bids were forthcoming. Again in t h a t case, a payout was arranged. The third category would be eight banks where in 1984 the FDIC experimented with something known as a modified payout. In 294 those cases when the bank failed, rather than providing the uninsured depositors with receivership certificates for the total amount in excess of $100,000, a payout was made based on an estimate of what Chairman ST GERMAIN. YOU may proceed. Mr. CONOVER. In the modified payout case, a partial payment was made to uninsured depositors based on an estimate made by the FDIC of what they would be able to garner through liquidation of the bank's loan portfolio. There were eight of those, which were done as an experiment. In some of them, a complete payout was probably more appropriate. The FDIC is writing up the results of t h a t experiment, but I have not yet seen the final report. The bottom line on all this, however, is that those who say t h a t large banks, specifically Continental, have been treated significantly differently from the way small banks have been handled, at least during the period from 1982 to the present, are incorrect. Basically, the treatment of large banks has been consistent with the way small banks have been treated. Mr. WYLIE. My time has expired, and I think that has been very elucidative and information we can use. One-hundred-fifty-seven banks have failed. Now t h a t doesn't mean that any depositors have lost money, and most of those institutions have been folded into some other institution. How many new banks have been chartered by the OCC in t h a t time period? Mr. CONOVER. I don't have t h a t number at hand, Mr. Wylie, but there were a good number of them. I am sure there were enough t h a t the total number of banks has not declined. Mr. WYLIE. That is the point. Can you provide t h a t for the record? Mr. CONOVER. I certainly will provide t h a t for the record. [In response to the request of Congressman Wylie, the following information was submitted for the record by Mr. Conover and may be found on page 366.] Chairman ST GERMAIN. Mr. Hubbard. Mr. HUBBARD. Thank you, Mr. Chairman. Thank you, Mr. Conover, for being with us today. I listened to your comments in response to what Mr. Wylie asked. There were 54 small banks across the United States forced to close thus far this year. There were 48 small banks closed last year. The theory I am told for closing small banks is that it is cheaper to liquidate the bank, sell its assets and pay off the depositors. J u s t 1 minute ago I heard you say t h a t you didn't treat Continental any differently than you do these small banks t h a t were forced to close. Forgive me, but I didn't catch your thinking on that. How is the continuation of Continental Illinois National Bank justifiable to a Member of Congress from a State like Kentucky where we have had several bank closings and where we have seen several of our banks collapse because of the Butcher empire in Tennessee? A lot of people in my State were put out of work too. Of course, I don't represent Chicago, but I represent Mayfield, KY, where jobs are just as important to us as they are in Chicago. Mr. CONOVER. I understand, Mr. Hubbard, but I am afraid I have to take exception to your initial statement, which was, I think, t h a t 295 when a small bank fails, the preferred or cheaper way is to pay off the insured deposits, liquidate the bank, and provide the depositors having in excess of $100,000 with receivership certificates so they, in effect, see what they get over time. In my exchange with Mr. Wylie, I think I pointed out t h a t well over 80 percent of the small bank failures in the last three years have not been handled that way at all. In fact, the vast majority of failed banks have been merged with another bank, or, where State laws don't permit that, they have been sold to a bank newly chartered to take over the failed bank. In the vast majority of cases, this happens on a Friday night or over the weekend, and they open for business Monday morning under a different name. I can't assure you, however, t h a t t h a t has happened in every case in your State over the last 30 or so months. Mr. HUBBARD. What about the other 20 percent? Could you tell us what is happening there? Mr. CONOVER. Yes; I said t h a t the other 20 percent fell into three categories. The first category would be those situations in which there was significant fraud or contingent liability t h a t the FDIC insurance fund would have to face such t h a t in the FDIC's judgment, it was cheaper to do a payoff of insured Chairman S T GERMAIN. By that, you mean they shut the bank down, people lost their jobs and couldn't buy their groceries in many instances; right? Mr. CONOVER. That is correct. Chairman S T GERMAIN. Sure. Let's put it in factual language, rather t h a n the Mr. CONOVER. That is Chairman S T GERMAIN. Those people took a hit. Mr. CONOVER. They did. That is absolutely right. Chairman S T GERMAIN. TO say to those people t h a t took the hit, Well, too bad for you, buster. And your bank wasn't big enough, you see. You weren't a Continental Illinois. That is what Mr. Hubbard is concerned about. Mr. CONOVER. I understand that, but t h a t isn't the reason, in the case I am citing, t h a t those banks would have been paid off by the FDIC. They would have been paid off because there was significant fraud or other contingent liability such t h a t it was cheaper for the FDIC to pay off insured depositors in order to comply with their statutory mandate. Mr. HUBBARD. Up to $100,000. Mr. CONOVER. They have to meet a cost test in dealing with failed banks. One of the costs they take into account is the potential claims against the insurance fund. Mr. HUBBARD. What were the results of the cost tests regarding Continental Bank? Mr. CONOVER. It was very clear t h a t the way to deal with Continental was not to do a payoff of insured depositors. Chairman S T GERMAIN. If the gentleman would yield, when was the cost test performed on Continental, and when can we have the results of t h a t test? Mr. CONOVER. I believe cost analyses of the various alternatives were carried out between the time the interim assistance package 296 was put together and the final one was enacted—between May and July of this year. Chairman S T GERMAIN. Our staffs have not been able to get any copies of these cost tests. Do you mean you ran the models on various alternatives that you have described to us, in very much detail just now? Mr. CONOVER. They were evaluated. Chairman S T GERMAIN. They were evaluated the same way as you evaluate those little banks. Mr. CONOVER. Exactly. Chairman S T GERMAIN. Determining what the cost would be— why is it we haven't been able to get copies of those evaluations? Mr. CONOVER. I don't know, Mr. Chairman. You will have to ask Mr. Isaac about that. Chairman S T GERMAIN. My staff tells me that no one has been able to locate them. Did you see them? Mr. CONOVER. Yes, I did. Chairman S T GERMAIN. YOU saw the actual computer runs? [Witness nods yes.] Gentlemen, maybe you could find out for us where they are, because no one has been able to locate them. Mr. CONOVER. A S I said, they are not in our files, they are in the files Chairman S T GERMAIN. But they do exist? Mr. CONOVER. There are cost analyses Chairman S T GERMAIN. Of the same type you have described just now for the smaller banks? Mr. CONOVER. Of the same type. Chairman S T GERMAIN. And scope? Mr. CONOVER. But recognizing t h a t in the case of Continental, the long-term solution that was put into effect hadn't been tried before. Chairman S T GERMAIN. I want to know how much a payoff would have cost. Therefore, if they exist, perhaps you could help us to find them. Mr. CONOVER. I believe they do exist, and I believe I recall seeing Chairman S T GERMAIN. And you saw them. So, then, we can continue to pursue those. I t h a n k the gentleman for yielding. Mr. HUBBARD. Reclaiming my time, Mr. Conover, what would have been the liquidation value of Continental Bank approximately? Mr. CONOVER. I am not sure precisely what you mean by the term. Mr. HUBBARD. Could the depositors be paid off on liquidation? Mr. CONOVER. There were roughly $3 billion of insured deposits in the bank. That means that there were roughly $37 billion of uninsured deposits in the bank. That leads rather quickly to the conclusion that you couldn't pay off the bank. You could pay off the $3 billion. Then you would be in the position of liquidating $37 billion worth of assets. And, as I indicated earlier, that would have had a tremendous effect on a large number of other banks and borrowers and on the national financial system, if not the world's. Nobody wanted to find out what the full effect was. 297 Chairman S T GERMAIN. DO you, when you are closing a small bank, take a look into the effect it would have on other banks and borrowers, and all the borrowers? That happens in every bank, doesn't it? Mr. CONOVER. Yes. Mr. HUBBARD. Mr. Conover, let me say there is that feeling in rural America that these small banks that have been closed, 48 last year, 54 thus far this year, are indeed treated differently than the FDIC and OCC treated Continental Illinois National Bank because it was so big and because in Chicago, and an important State, this particular year, et cetera. But in rural America, we are also confused as to how the OCC and FDIC could not find earlier than we did the gross problems involved with the Butcher banks, the United America Bank of Knoxville and all those banks under it. That, of course, is in east Tennessee, and I represent the western part of Kentucky, the most western area, but its ripples definitely affected several banks and depositors in my area. Just these few questions, and I will conclude. On page 9 of your statement, Mr. Conover, you describe the difficulties Continental had in its oil and gas portfolio 2 years ago. Can you say to what extent the problems with these oil and gas loans were attributable to the fact that Continental was extending loans or participating in loans for which the collateral was oil rigs, undeveloped property, lease line arrangements or other nontraditional, to say the least, types of collateral? Mr. CONOVER. Yes, we have that information. I do not have it here, but we would be happy to provide it. [In response to the request of Congressman Hubbard, the following information was submitted for the record by Mr. Conover and may be found on page 366.] Mr. CONOVER. There is a chart on page 40 of the appendix that indicates the composition of Continental's losses from J u n e 1982 through J u n e 1984. Some two-thirds of the losses charged to the bank were the result of oil and gas loans. Approximately 41 percent was attributable to Penn Square loans, and 26 percent was attributable to other oil and gas loans. As I say, we have the breakdown by category of oil loan if that is of interest to you, and we would be happy to provide it. Mr. HUBBARD. On page 21 of the appendix, you also point out Continental began to lend to small independent drillers and refiners more aggressively in the late 1970's. This, of course, was a factor in Continental's problems. With respect to these new forms of collateral and lending to smaller companies, to what extent was OCC aware of these trends? Mr. CONOVER. We were aware that Continental had focused on energy lending. The bank had developed a reputation as an energy lender from the early 1950's and had had many years of profitable results from its energy lending. In 1979, 1980, and 1981, however, two things happened. Their lending standards changed. And the internal controls that might have been effective in enabling them to make loans under new lending standards were either not developed or were developed and subsequently ignored by Continental management. 298 Mr. HUBBARD. Did OCC issue any warnings about these trends, given the concentration of oil and gas in Continental's portfolio? Mr. CONOVER. Your question deals with two factors, I think: concentrations and internal controls. Let me deal with concentrations first. It is our responsibility to identify and point out concentrations to the bank. We criticize them if we think there is a problem in the way they are dealing with the loans they are making and if their policies and practices need strengthening. We have to be careful in the concentration area, however, because some concentrations are inevitable. For example, in some parts of the country, you almost can't avoid having a concentration in agricultural loans, auto-industry-related loans or forest product loans. We don't want to be in the business of allocating credit. If we do choose to criticize a concentration, we ask management and the board to reconfirm their policy or change it. If they decide to change it, we ask them to develop a strategy and a timetable for reducing their concentration. Given the emphasis on energy self-sufficiency and the like at the time, and Continental's expertise and good track record in the energy industry, we did not criticize them for their concentration in oil and gas lending. In retrospect, I think t h a t we should have criticized them, at least for their Penn Square exposure and for aggressively making oil and gas loans without adequate controls. Did I answer your question? Mr. HUBBARD. Right. You did. Let me please ask you this. Was Continental solvent? Mr. CONOVER. It was and is. Mr. HUBBARD. Does t h a t mean it has Mr. CONOVER. That depends. Mr. HUBBARD. Why does it depend? a positive liquidation value? Can't you give me a yes or no on t h a t simple question? Does t h a t mean Continental has a positive liquidation value? Mr. CONOVER. It depends on the time over which the liquidation would take place. Just as with any corporation, if you liquidate it on a fire sale basis, you may not have a positive liquidation value. If you liquidate it carefully and prudently over time, getting the best price for your assets, you may very well have a positive liquidation value. So I am not trying to duck the question. I just think it really can vary. Now Continental had, subsequent to the assistance package but not including the capital t h a t was infused as part of it, a remaining net worth of some $600 million. In that sense, Continental was and is solvent. Mr. HUBBARD. Continental was and is solvent. Assuming it has a positive liquidation value, doesn't that mean that you could have paid off the depositors under those circumstances, assuming it was solvent? Mr. CONOVER. N O , I don't think it does. If you pay off the depositors under those circumstances, one of the things you do immediately is have a big impact on t h a t liquidation value. For example, an awful lot of those borrowers, who may be perfectly good borrowers, may require additional funding in order to complete projects t h a t they have underway. They may be depending on t h a t funding from the bank under a commitment t h a t would not be honored by 299 the FDIC because the FDIC does not make additional loans to customers, and the like. Mr. HUBBARD. Lastly, just let me say t h a t there still is t h a t feeling in rural America t h a t the smaller banks are treated differently than the OCC and FDIC did in regard to Continental Illinois. There were 22 banks closed in Kentucky and Tennessee in 1983 and 1984. Twelve of these banks were closed last year. Ten of these banks have been closed this year. Of course, we realize Chicago is big. I guess it is the same thing t h a t we have when a small corporation in Russellville, KY closes and is forced to close, and they are gone. But the Federal Government also bailed out Chrysler Corp. in big Detroit. Mr. CONOVER. Mr. Hubbard, let me say t h a t I understand the feeling still exists in rural America, as you say it does. And I think we need to work toward some mechanism—I will be the first to admit t h a t I don't have t h a t mechanism in my hip pocket—so t h a t we do treat large banks and small banks in a consistent way t h a t is fair to both of them. The Continental situation and how we dealt with it was obviously influenced by our judgment as to the impact of failure on the Nation's, if not the world's, financial system. Mr. HUBBARD. Forgive me for saying this, but folks in rural America also think the decision was influenced by the 1984 Presidential election. Mr. CONOVER. Sir, I can assure you t h a t the 1984 Presidential election never came up, was never discussed. We didn't take it into account for 1 second. Chairman S T GERMAIN. Mr. Conover, where does Continental Illinois' rank in size among the banks of the United States of America? Is it 11th, 10th, 9th, 8th? Mr. CONOVER. It seems to be moving. Chairman S T GERMAIN. Where was it? Mr. CONOVER. It was eighth, approximately. Chairman S T GERMAIN. Number eight? Mr. CONOVER. Yes. Mr. WYLIE. YOU have 11 multinationals? Mr. CONOVER. Right. Chairman S T GERMAIN. All right. Ever see the fellow who is painting himself into t h a t corner? He doesn't realize there is no door back there. And there is less floor for him to walk over. I got news for you. You are painting yourself in a corner because my question now is: Can you foresee, in view of all the reverberations internationally t h a t you described, had Continental Illinois been allowed to fail, and all those people put out of work and all those corporations out of money and all those other banks t h a t would have failed, in view of that, can you ever foresee one of the 11 multinational money center banks failing? Can we ever afford to let any one of them fail? Mr. CONOVER. The answer to that, Mr. Chairman, is that we have got to find a way to. In order Chairman S T GERMAIN. YOU are not answering. Mr. CONOVER. In order to have a viable system. Chairman S T GERMAIN. Mr. Conover, you said you don't have in your hip pocket the solution for the small banks, and you are never going to have it. 300 The fact of the matter is, as a practical matter, neither you nor your successors are ever going to let a big bank the size of Continental Illinois fail. Mr. CONOVER. Mr. Chairman, it isn't whether the bank fails or not. It is how it is handled subsequent to its failure t h a t matters. And we have to find a way. I admit t h a t we don't have a way right now. And so, since we don't have a way, your premise appears to be correct at the moment. Chairman S T GERMAIN. That is one of the prime reasons for these hearings. We have quite a few, but one of our principal reasons is we have to make a decision. Do we allow, ever, a large bank to fail? Mr. Barnard. Mr. CONOVER. I think it is important that we find a way to do that. Mr. BARNARD. Thank you. Mr. M C K I N N E Y . Would Mr. Barnard yield for a moment so I could follow through on the chairman's statement? Mr. BARNARD. I want to follow through too, if you don't mind. Mr. M C K I N N E Y . With all due respect, I think seriously, we have a new kind of bank. And today there is another type created. We found it in the thrift institutions, and now we have given approval for a $1 billion brokerage deal to Financial Corporation of America. Mr. Chairman, let us not bandy words. We have a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank. Chairman S T GERMAIN. The time of the gentleman has expired. Mr. Barnard. Mr. BARNARD. YOU know, I have six questions. I am sure I am not going to cover all six. But each time I add one to the top. Here is what concerns me, Mr. Chairman. All of a sudden, I am having to do these in inverted order. What happens to t h a t resolution Congress passed in 1982 t h a t says t h a t the full faith and credit of the U.S. Government is behind the insurance fund? Chairman S T GERMAIN. Maybe we ought to repeal it. Mr. BARNARD. Anyway, though, I think in a way t h a t has a relationship as to why the big banks don't fail. How do you respond to that, Mr. Comptroller? Do you all take t h a t resolution into consideration? Mr. CONOVER. N O , not really. Mr. BARNARD. It just didn't make any difference, did it? Mr. CONOVER. N O . Mr. BARNARD. Well, that is good. That solves that one. You know, I want to draw a scenario. Here is a bank t h a t is a good bank, a survivable bank. All of a sudden a rumor begins. It starts to rumbling. This is a big bank. All of a sudden, the international press grabs hold of this. Here is a bank that is subject to bankruptcy. Here is a bank subject to insolvency. Here is a bank t h a t is going to be taken over by a foreign government. And it hits the press. East, west, across the Pacific, into Japan, across to China. Here we go. Aleutian Islands, Alaska, and Australia. But here we go, all across the world, t h a t this bank is failing. What is your remedy? Is there a remedy in law, especially when the information is false? 301 Mr. CONOVER. When the information is false, you get into the dilemma t h a t I found myself in. Mr. BARNARD. But you don't have a remedy in law, do you? Mr. CONOVER. NO, I don't believe we do. Mr. BARNARD. There are some State laws which say that anyone who starts rumors t h a t cause failure of a bank can be prosecuted, isn't that true? Mr. CONOVER. I understand that t h a t is true in several States. It is, as I understand it, not a Federal law. Mr. BARNARD. Isn't it just as serious in this instance? Mr. CONOVER. Absolutely. Mr. BARNARD. A S crying "fire" in a crowded theater? Mr. CONOVER. It is. You may not solve t h a t problem, however, by simply passing a law t h a t says if you yell the equivalent of "fire" in a movie house or a church, t h a t becomes a crime because it is virtually impossible to trace the source of rumors and how they get started, just as it is virtually impossible to find a leak that originate in your agency. Mr. BARNARD. Are you telling us t h a t in this instance, though, there had to be unusual steps taken because of this singular situation with Continental? Mr. CONOVER. Oh, absolutely. Mr. BARNARD. Although Continental had been rumored previously not to have been in the greatest of condition, on the other hand, the rumors you feel like were tantamount to causing a run on the bank? Mr. CONOVER. The condition of Continental was well known. It had not only been reported in the business press but had been reported in the popular press, in newspapers and magazines throughout the country. Mr. BARNARD. YOU know, the thing about it t h a t concerns me, though, as common as this practice could be, do you think we need some Federal laws addressing unfounded rumors? Mr. CONOVER. I think it would be wonderful to have them if they could be crafted so t h a t somehow you were able to track down how the darn thing got started. I guess I would like to have the tool. I am uncertain as to how effective it would be in a lot of cases. Mr. BARNARD. My question number three. One of the things that is hard to understand, and I think this hasn't come up yet, I believe is an unusual treatment of the Continental Bank holding company. You know, I can see for my own benefit that what was done, as far as the bank was concerned, was to save the bank, to save the depositors and look after their interest. Wasn't there some unusual aspect of the refinancing as far as the holding company was concerned? Mr. CONOVER. Yes, there was. As a result of this transaction, there was one undesirable outcome t h a t I will describe. In order to do so, I have to step back and describe the two options that we had available to us. Mr. BARNARD. Mr. Chairman, since this is so important, I don't think this ought to count against my time. Thank you. Mr. LEACH. Mr. Chairman, on behalf of the minority, I think we ought to have a semblance of some order, but I would certainly hope that t h a t order would include full response to the gentleman 39-133 20 0—84 302 from Georgia's question, which is so important, and certainly in relation to any other question any other member has, I am sure more important. Mr. BARNARD. Well, t h a n k you. Thank you, Mr. Chairman, and Mr. Leach. Proceed, Mr. Conover. Chairman S T GERMAIN. Don't press your luck. Mr. CONOVER. We had two options. One option would have been Mr. BARNARD. NOW, my question was, wasn't there some unusual feature of the holding company? Mr. CONOVER. That is correct. I will get to that. It may take me a while, but this is an important Chairman S T GERMAIN. Mr. Conover, if you take too long, you will run out of time. I think you want him Mr. CONOVER. This is important for the committee to follow because it may be t h a t there is some potential legislation t h a t should grow out of this particular situation to correct the problem at hand. We had two options. We could put capital in the form of debt directly into the bank. We couldn't put preferred stock into the bank because there were covenants in the bond indentures of the holding company which said you couldn't do that unless you had the permission of the bondholders. In this case, they were holders of bearer bonds which had been sold in Europe. Since we didn't have a chance of getting the bondholders' approval, the FDIC could not have acquired preferred stock in the bank. Its only alternative was to put debt into the bank. The disadvantage of putting debt into the bank was t h a t we would have ended up with a very strange looking balance sheet. There would have been a little bit of the remaining shareholders' equity and a big pile of debt. We figured t h a t it was not going to help the bank recover as it published its quarterly financial statements to have a balance sheet t h a t didn't look like a bank balance sheet ought to look. So we considered the other option—buying preferred stock in the holding company and having the holding company downstream it into the bank in the form of common stock equity. That satisfied our goal of having a sound looking bank balance sheet when the bank's financial statements were published. It had the undesirable feature of propping up the holding company bondholders and commercial paperholders. We knew t h a t at the time, and there was significant debate back and forth about which was the preferable way to go. The Treasury Department felt, and several memos were written to Mr. Volcker and Mr. Isaac and myself, t h a t the alternative of putting debt into the holding company was the preferable one because you could always say "Oh, look, the Federal Government is standing behind this bank, anyway." I felt and my fellow directors at the FDIC felt and Mr. Volcker felt t h a t the appropriate way to go was the way we went—buying preferred stock in the holding company. Mr. BARNARD. Isn't that a dangerous precedent, though? Mr. CONOVER. It is a dangerous precedent. It is bad public policy as far as t h a t particular item goes. It can be corrected in one of two 303 ways. Since we knew there was a way to correct it, we thought we ought to do what was right for Continental, then discuss the problem and identify the ways to correct it and see if we could get some corrective action taken. There are two ways to correct it. One is that you can simply prohibit those kinds of covenants in bond indentures of holding company Mr. BARNARD. Why would a bank want to issue bearer bonds? Mr. CONOVER. The holding company issued the bearer bonds. Mr. BARNARD. Why would the holding company want to issue bearer bonds? Does it need money t h a t bad? Mr. CONOVER. I don't know. That was a technique they used in Mr. BARNARD. IS t h a t a common practice with bank holding companies? Mr. CONOVER. I am not sure how common a practice it is. The second way t h a t you could deal with t h a t problem is simply to grant the FDIC the authority to purchase preferred stock, or common stock for t h a t matter, in a bank when certain emergency conditions exist. In other words, the FDIC would be able to do t h a t without getting a vote of either the bondholders or stockholders because of the emergency situation and because it was essential to save the banking institution. The language t h a t would be required to enact t h a t into law can be put on one side of one piece of paper. It is a minor change in the Federal Deposit Insurance Act. That is something t h a t you may as a committee want to consider discussing thoroughly. Chairman S T GERMAIN. Excuse me. Hopefully, we won't have to because we won't have another Continental Illinois. Then why should we need this? Mr. CONOVER. That is true, Mr. Chairman, but I think you also want to make sure t h a t you have a regulatory system that is armed with appropriate arrows and quivers to deal with any circumstance that might arise. Mr. BARNARD. Mr. Conover, in your first classification of banks, which have not been supported and which have been permitted to fail, you mentioned fraud and similar Mr. CONOVER. Ones t h a t have significant amounts of contingent liability that might fall to the fund. Mr. BARNARD. Does Penn Square fall into t h a t category? Mr. CONOVER. It certainly does. The primary reason Penn Square was treated as a payoff was t h a t there were massive contingent claims well in excess of $l-$2 billion. Of course, because they were contingent, no one knew what the total downside risk might have been. Mr. BARNARD. Mr. Comptroller, what has been done to correct the problems of communications t h a t developed between the divisional supervisors of the Comptroller's Office in regard to Penn Square and Continental? Mr. CONOVER. Mr. Barnard, we were criticized, as you know, 2 years ago for a weakness in communications between our Dallas office and the examiners who were dealing with Continental. We achnowledged the weaknesses in the system at the time and took corrective action as follows. First, we made changes in the call 304 report. As of J u n e 1983, the call report contains a figure for participations sold, a clear flag we can look at to see if there are banks t h a t have a significant amount of participations sold. Second, reorganizing our field offices into six districts enabled us to more conveniently get the deputy comptrollers who run those six districts together. They meet monthly and discuss managerial and administrative problems, as well as problems of a supervisory nature involving individual banks where a problem in one bank might spill over and become a problem at another bank. Third, we have issued specific written procedures in 1983 and 1984 to examiners, as well as to banks, on how to deal with these kinds of problems. Finally, we have included these kinds of instructions in a training course we give our examiners on how to deal with problem banks. So, as I said, t h a t was a weakness we were criticized for 2 years ago. We recognized it, and it has been fixed. Mr. BARNARD. What about brokered funds? Do these call reports also identify the amount of brokered funds that banks are negotiating? Mr. CONOVER. At the moment, the call reports provide information as to certificates of deposit of over $100,000, but they are not broken out by source. That is an improvement that would be helpful to us in monitoring banks which suddenly start taking on Mr. BARNARD. YOU do support further disclosure of brokered funds by financial institutions? Mr. CONOVER. In a big way. Yes, I do. Mr. BARNARD. I am interested in knowing what part is played by the individual audits of banks, the outside directors' audits? I mean, why weren't some of these difficulties with Continental alerted through the internal audit? And did you get to see a copy of the internal audit? I mean of the audit? Mr. CONOVER. Of the external audit? Mr. BARNARD. Mr. CONOVER. Yes. We normally get to look at both internal and external audit information. As to why the external auditors didn't uncover something that would have been helpful in the Continental case, or in any other case for that matter, I am not sure. I think there is a Mr. BARNARD. YOU know, we found some continuity in t h a t problem. We found the problem in Penn Square. We found the problem in the United American, where they were certified as a good, sound institution. Two weeks later they were closed. You know, this disturbs me. Is there a point in time when we need to impose liability on these certified public accountants for t r u t h in auditing? Mr. CONOVER. Well, I think there is a liability that gets imposed upon them in the form of suits that are filed against them in exactly those kinds of cases. I am sure t h a t the firms you have alluded to in both the Penn Square and the Butcher cases are involved right now in litigation that could be quite costly to them. Mr. BARNARD. What about in the Continental situation? Mr. CONOVER. I think that remains to be seen. Mr. BARNARD. DO you think there is a possibility? Mr. CONOVER. I don't really know. I think, if anything, the FDIC may 305 Mr. BARNARD. There have to be actual losses and Mr. CONOVER. The FDIC may pursue a claim. I am not sure. Chairman S T GERMAIN. Excuse me. Maybe they ought to at least file suit now in the event that the nationalization bailout doesn't work. Then there will be a loss to the FDIC, and we don't want the statute of limitations to run. Mr. CONOVER. Usually, as you know, Mr. Chairman, the FDIC sues everybody in sight. Chairman S T GERMAIN. All right. Mr. BARNARD. Mr. Chairman, I appreciate the time. Chairman S T GERMAIN. NOW, the moment we have all been waiting for. Mr. Leach. Mr. LEACH. The minority does appreciate the chance to participate at the hearings, Mr. Chairman. So I t h a n k you. I would like, just for a moment, to begin at the beginning and plough over some of the ground that has been covered before. As I listened to your very careful testimony, Mr. Conover, I am struck by the justification, which I think is plenty for the Continental bailout. But the question still remains whether there is any justice in it. Can you, as Comptroller of the Currency, tell us explicitly whether in your view the big, as well as the small, have the right to fail, whether there are absolute guarantees t h a t exist today for big banks that don't apply to small? And don't you see some irony in the notion that, if a big bank gets into trouble and oversteps itself, punishment will be in the form of Federal aid to compete against rivals as a quasi-nationalized entity? Mr. CONOVER. I am not sure what the question is, Mr. Leach. Mr. LEACH. Can you tell Mr. CONOVER. IS there equity today between small and large banks? Mr. LEACH. Yes. Mr. CONOVER. I have said I think there ought to be, which, I think, implies t h a t there probably isn't at present. Mr. LEACH. Second, are you implying a large bank does not have the right to fail? That the repercussions are too great? Mr. CONOVER. Well, I would say t h a t Continental did fail in several major respects. Remember, when a bank fails, the shareholders get wiped out. That applies to Continental. Management Mr. LEACH. Not as yet. Mr. CONOVER. Not as yet. Mr. LEACH. There has been an 80 percent dilusion of stock, but that was already reflected in the market. If this bank survives, there is some prospect t h a t the stockholders will Mr. CONOVER. There is some chance. Mr. LEACH. I understand your reluctance to answer specifically. But let me go on then a little bit more. As you know, this Congress and this committee had major jurisdiction over a lot of this, funded legislation to bailout Lockheed, Chrysler, New York City. These acts were very controversial, but they were debated. They received the support of Congress. They received the signature of the President of the United States. 306 Do you see any irony or unseemliness in the fact t h a t the only approval required for the regulator's approach is a formal vote of the shareholders of the bank to be saved rather than from the taxpayers and their representatives in Congress who may have to foot the bill. Mr. CONOVER. I certainly see it as ironic that the shareholders, acting last, seem to have the final word in effect on whether the deal as proposed goes through. What I thought you were going to get at was the fact t h a t in the Lockheed, the New York City, and the Chrysler cases, those things were debated before the Congress and signed by the President. In this particular case, as the chairman has pointed out, this was done, in effect, without such a process; the regulators got together and did it. Do I see anything inappropriate about that? Frankly, I don't. But what I am relying on is the fact that Congress established a mechanism to deal with exactly these kinds of problems. There was no mechanism established in law with a long-time organization in place to deal with a Lockheed, a Chyrsler, a New York City, et cetera. The FDIC and the Fed did, in this case, what Congress set them up to do. Now if you want to, I suppose we could have a debate on t h a t and rethink what the role of FDIC and the Fed and the Comptroller's Office ought to be. Mr. LEACH. Let me approach it in a different way. I think you have a valid point. What we are dealing with is valid legislation on the books granting the regulators wide discretion in how they deal with book failures. Here, then, the question is whether Congress should continue to grant the regulators such broad powers and should pass sense of the Congress resolutions stating that full faith and credit of the U.S. Government rests behind the deposit insurance fund. And so one of the interesting questions is to ask, why the problem in the first place. Second, what to do about this or similar problems in the future? Let me in terms of confidence in Congress go back to why the problem. And then talk a little bit about the future. In terms of why the problem, it appears we had a bank t h a t enjoyed rather rapid growth. It was defined as a "go-go" bank. The regulators weren't the only ones fooled. Duns Review mentioned it as one of the five best managed companies in America. So it isn't just that the regulators alone were out of step. Perhaps the press had as poor judgment as a Federal bureaucrat. But it should be stressed t h a t Continental didn't operate just as any other bank. As this committee looked at Penn Square, we found it was unusual in t h a t it operated as a merchant bank rather than commercial bank and it didn't have particular adequate safeguards. With regard to Continental, it appears what we have is a merchant bank's bank. Also, without adequate safeguards. And yet, despite the unusualness of both of these banks, but I don't want to put Continental quite in the same category as Penn Square, the examiners gave an "A OK" approval to the adequacy of the capital ratios. And I just think it isn't good enough for you to imply in your statement today t h a t you didn't foresee, as many 307 in the economy didn't foresee, a downturn in oil prices. Regulators clearly missed the mark. If Continental had had the same capital ratios as the superintendent of Iowa Banking requires for Iowa banks, that is, about 9 percent, and if the bank had been forced to writeoff loans as rigorously as the superintendent of Iowa banks requires of Iowa banks, this problem would not have existed. That is why we are where we are today. The way you solve the solvency problem is with more capital and this committee certainly feels very strongly t h a t the private sector solution is better than the public and t h a t is t h a t the regulators simply demand that banks have a stronger capital base. Mr. CONOVER. I couldn't agree more. I am sincere in that. We have been working to increase capital levels in the multinational banks for some time. And, as you know, we are about to take the next step in t h a t regard. Mr. LEACH. Let me stress under your leadership that has been happening and this committee and the Congress is observing that. And I would only add as a footnote t h a t the strongest and the most secure way you add to capital is the old fashioned way. That is selling equity. One of the odd ironies in the capital base calculation is t h a t items t h a t are debt reserve are allowed to be called capital. This raises some doubts in the views of some t h a t have looked carefully at the issue. I would certainly stress to you t h a t what is happening at this time under your leadership is to be appreciated. I would also stress that as we look back over the last decade, it appears that the Comptroller's Office, to some degree, has been caught with its pants down. It isn't a wild, new phenomenon t h a t was not observed 7, 8 years ago, whether it be in Congress or by a number of observers of the banking system, t h a t problems were bound to arise when you had 25 percent real growth in Eurocurrency markets and large banks growing at a faster rate than their capital base. So what you are doing now is catching up with what I think was a little bit of looseness in past years, t h a t 1975 to 1982 period, in particular. So what you are doing now is correct. But let's not assume t h a t regulators have anything but a little bit of blot on their record. Let me just come back to the issue which I think is the most important one for this committee, and t h a t is where we go from here. From several of your statements, but more importantly, from a number of comments t h a t have been made privately, as well as publicly, it appears t h a t one of the reasons t h a t is really at the forefront for moving in on Continental the way you did is concern about this international issue of what do we do if one of our banks fails and a lot of international banks lost a lot of money? Do we have a real confidence crisis in international banking, per se? Here I would only suggest that there is more than one way to skin a cat. That is, a 100-percent security for 100 percent of depositors makes sense only if there is no clearly understood alternative in advance t h a t is well worked out internationally. In t h a t regard, it strikes me that if there is a little bit of a failure in the regulators approach up to this point in time, it has been 308 t h a t there has been no clear standard or alternatives, and no preparation in the sense of a warning to international depositors as well as domestic that in essence, management of funds involves risks. When you take risk, you may lose something. That is why it strikes me t h a t the regulators might well want to consider the notion that, in the event of a large bank insolvency or failure, perhaps the role of the FDIC should be to step in and guarantee a percentage or pro rata portion immediately of deposits t h a t are uninsured. And, for example, if you take the Continental issue, you have argued to this committee—and I am not, frankly, totally persuaded t h a t basically at all times you had a solvent institution. If it were terribly solvent, one presumes the marketplace would have vindicated it and another bank or private investors would have come in and taken it over. So at least the marketplace disagrees with that assessment. In any regard, most who have looked at the bank think it might have been insolvent at the most up to about $5 billion. Five out of forty would imply that the most t h a t would have been lost would have been 15 cents on the dollar for the uninsured depositors. Therefore, if the regulators had in place a mechanism t h a t everyone knew and understood in advance t h a t there would be a payout, and let's say it is 80 cents on the dollar for uninsured deposits, you would have a system by which there would be risk management of funds in which risks would be taken and in which the FDIC would not be on the line which the taxpayer also would not be on the line. And I think t h a t type of approach ought to seriously be considered by the regulators. And let me just ask, are there other alternatives that are being considered? Or is a 100-percent payout the only thing t h a t you are considering at this time? Mr. CONOVER. I agree with you if we can design such a system and put it in place so that everybody knows in advance. I am not sure exactly how you do that, but you say starting J a n u a r y 1, 1986, we are putting you all on notice that it is going to be like this from now on. Of course, nobody will believe you until the first one is really done that way. You have touched on the fact that the deposit insurance system needs to be reevaluated and perhaps revamped. We think so, too. The approach that we tried as an experiment in 1984—the so-called modified payout system—was an attempt to provide some market discipline on the part of large depositors by letting them know in advance t h a t they were going to be subject to some loss in the event t h a t a bank failed. There has been a lot of hue and cry about that particular practice. And, as I say, I haven't seen the final report on the evaluation of it. But it was an attempt to try something different, to see if we couldn't get large depositors to pay more attention to where they were putting their funds and thereby provide leverage on the management of those institutions to keep their house in order and run their affairs in a prudent way. I think t h a t is still a fundamentally sound principle. Whether the modified payout practice is the one t h a t ends up being adopted, 309 I am not prepared to say. But we need something like that, and we need to implement it carefully over time, in a way t h a t does not provide a tremendous shock to the system and does not have people screaming, "Gee, we didn't know." Mr. LEACH. I appreciate t h a t and I couldn't agree more fully with what you have just said. Let me conclude, Mr. Chairman, with the observation we all know t h a t there is some concern in the financial community t h a t gets quickly reflected in this committee between divergences between small banks and big banks and their guarantees. But I would like to move away from t h a t and stress two things. One, t h a t there are implications for how the money supply is managed if one doesn't have a given kind of prudence in the banking system. But, second, in a way, more importantly, there are implications for where there is economic growth in the economy, nationally and worldwide. Let me just give a contrast. I have a hometown called Davenport t h a t has a marvelously safe, dominant bank. It makes few loans, has an exceedingly high capital ratio. But, in a way, the bank has operated for less growth and more security, and the community itself has somewhat suffered in comparison with a larger community t h a t has a less safe bank and more growth in the banking system. And as we look at where the growth in banking is, it is not too foolish to suggest that, if you allow bank growth abroad, you, in effect, allowing foreign governments to grow at a pace faster—foreign economy at a pace faster t h a n the domestic and t h a t the real issue is not so much the big bank/small bank contrast in terms of who gets the earnings, but who gets concerned. And in t h a t service area, all of us have a great deal of concern. That is why I think it is so important t h a t regulation be evened out, not so much for small banks to compete in an earning sense with large banks, but for small communities to compete and receive funds in comparison with the larger communities, or in the case of the last several decades, with other countries who are being better served by the American banking system t h a n the hinterland parts of this country, all as a function of regulation. In other words, t h a t you, sir, as Comptroller of the Currency, have governed the largest amount of foreign aid ever given by this country, including the Marshall plan, including the sum total of AID, as a function of regulation. That may be good, or it may be bad. But I think we have to understand t h a t what regulation is all about is where money flows. And if you regulate in one direction, it flows one way. If you regulate in another, it flows another. And t h a t is the primary reason I think this committee ought to be very concerned about evenness and fairness in the actions and rules and regulations t h a t you as Comptroller of the Currency put forth. Mr. CONOVER. I agree with you, Mr. Leach. I think you may have just given a very strong argument for interstate banking. Many of those 310 Mr. LEACH. The argument I have given is for fairness in regulation. Mr. CONOVER. I would agree with that, but I think fairness in regulation also means having the freedom to operate in domestic geographic markets. Many of our banks which are being criticized for having gone overseas and made loans overseas did so because they didn't find domestic outlets and domestic opportunities. Chairman S T GERMAIN. And they didn't do so because the interest rates were so much higher, and the potential profits so much larger. Mr. CONOVER. I am sure t h a t had something to do with it, but t h a t changes over time, too, as you know. Chairman S T GERMAIN. Incidentally, how many oil and gas wells are there in Chicago, IL? Mr. CONOVER. None that I know of. Chairman S T GERMAIN. YOU know, earlier you said in answer to one of the questions that it was inevitable that banks go into certain areas of lending, like forestry, agriculture, automobiles, steel, and so forth. That is why I wondered, how inevitable was it for Continental Illinois to go into lending on oil wells and gas fields. I think they did t h a t by choice because they were looking for a high return. My next question is going to be to you, for the record, I would like to know, what amount of the loan portfolio was lent within the city limits of the city of Chicago, IL, by Continental Illinois Bank? Mr. CONOVER. I think we can provide you with that. Chairman S T GERMAIN. YOU can provide t h a t for us? Mr. CONOVER. Yes. Chairman S T GERMAIN. I think some of my colleagues, one in particular might be interested in that. He and I, I bet, would enjoy that. It goes beyond the trivial pursuit question. Mr. CONOVER. Yes, I understand. I think you will find t h a t it will be a relatively small percentage. [In response to the request of Chairman St Germain, the following information was submitted for the record by Mr. Conover and may be found on page 367.] Chairman S T GERMAIN. Mr. Vento. Mr. VENTO. Thank you, Mr. Chairman. Mr. Conover, maybe now you understand why I would like t h a t information on foreign investment in the bank and loans t h a t we are talking about in terms of this particular problem. I followed with interest some of your responses. I can't really let the problem pass in terms of suggesting you treated both the small and large institutions similarly in terms of the past 2 years. The fact is that this bank has been nationalized, with 80 percent of the stock in the holding company and the downstream method t h a t you commented about. The question is whether you took 80 percent of the small banks. Instead you provided for merger, that was a market type of transaction, other than whatever the value was to expand t h a t bank into t h a t marketplace. Is t h a t accurate? Mr. CONOVER. Yes, t h a t is accurate. In this particular case, we 311 Mr. VENTO. Where is the market test in this? Mr. CONOVER. The only market test in this is that we tried very hard for a private sector solution before we ended up Mr. VENTO. I mean the point is this is far and away different. I understand that, but this is far and away different to any type of comparable treatment to what was divied out to the others when there were mergers. Whether or not there should have been mergers is a different question. This is far different treatment. There is no market test in this particular example, is that accurate? Mr. CONOVER. Well, I agree with that in that, as I said, we looked for a private sector solution and didn't find one. Mr. VENTO. HOW long will it be before the nationalization of this bank is concluded? How many years into the future are we going to have this 80 percent stock in this bank? Mr. CONOVER. It is hard to say. Here is what I think has to happen. First of all, obviously, the stockholders need to approve the deal. Then the bank has to get back on its feet in a way that will attract the marketplace back to it. It has to start reporting quarter to quarter profits. It ought to be positioned to do that because we positioned it t h a t way. Then it is a question of how many quarters of profitable operations have to pass until it makes sense Mr. VENTO. What is the order of payout t h a t will occur? I assume you or someone else will be doing the voting in the national government from the regulatory standpoint; is that accurate? You will be voting that 80 percent stock in the holding company? What would happen first? Will the discount window be paid off first? How will this work? Will the FDIC get their billion dollars back first? What is the order of managing this particular matter? Mr. CONOVER. The order is that the shorter term debt will get paid first, debt to the Fed and the banks, because that is debt. And the FDIC has a preferred stock investment in the holding company. Now as the bank gets healthy, and let's say it reports x quarters of good earnings and it pays back the Fed borrowings and the bank borrowings, there comes a time when it is appropriate for the FDIC to make the bank private again. It has several options in doing that. No. 1, it could sell what is then a healthy institution to another domestic or foreign bank. No. 2, if it seemed like it would get a better price, it could hold a public offering. It would have an underwriting and sell the shares to the public, thereby returning the bank to total widespread private ownership. The intent is to return the bank to private ownership as soon as possible. Mr. VENTO. Can you give us any type of timeframe at all, Mr. Conover? Mr. CONOVER. I think you are going to get different judgments on this. You ought to ask Bill Isaac for his and Paul Volcker for his. As far as I am concerned, I think we are looking at a couple of years of reported profits before it would make any sense to Mr. VENTO. What is the position of the bearer bonds you talked about in the bank t h a t are held by a multiplicity of individuals? What would have been the loss if the bank, if you had permitted the bank to fail? 312 Mr. CONOVER. The bearer banks were in the holding company. And if the bank had failed, chances are the holding compay would have become bankrupt. The assets and liabilities of the holding company were a close, but not an identical, match. Mr. VENTO. HOW much? Mr. CONOVER. I said a close, but not an identical, match, so t h a t there probably would have been some loss to those bearer bond holders. Mr. VENTO. I was trying to get an amount. Mr. CONOVER. I don't have it. Mr. VENTO. YOU have no idea how much we are protecting in t h a t instance. One of the nagging problems this obviously is the supervisory role t h a t you played. I am sure it is troublesome to you and to your predecessor with regards to Continental Illinois. After all, it involved a supervisory agreement. It involved management. In a sense, I suppose one might say t h a t really you had your shot in terms of trying to correct this bank, but for some reason t h a t didn't happen. I would like to try and establish some of the problems t h a t existed, Mr. Conover. As you know, the national bank examination reports are transmitted to the bank board of directors with a cover letter from the Deputy Comptroller for Multinational Banks which sets forth these matters upon which the board is expected to act. It is our understanding the board is supposed to review the transmittal letter and the examination report and reply in a timely fashion. Mr. Chairman, I have a series of those letters t h a t will be presented to the members t h a t are still with us. I would like them to be made a part of the record. They result from materials starting in 1979, I think, going all the way through 1982. Chairman S T GERMAIN. The gentleman asks unanimous consent. Is there objection? The Chair hears none. [The material submitted for the record by Congressman Vento follows:] 313 PERTAINING TO OCC EXAMINATION COMMENCED: May 21, 1979 CLOSED: August 3, 1979 Washington, DC, October 25. 1979. BOARD OF DIRECTORS, Continental Illinois National Bank and Trust Company of Chicago, Chicago, IL. LADY AND GENTLEMEN: This letter is supplemental to, and part of, the enclosed combined specialized report of examination. The examination, performed by National Bank Examiner Allan J. McCarte, was concluded on August 3, 1979. The purpose of this letter is to highlight matters in the examination report which deserve the attention of the Board of Directors. Since it is part of the report of examination, its content is to be treated with the same degree of confidentiality. The report is divided into five sections: Commercial, International, Trust, Electronic Data Processing, and Consumer Affairs. Each director is requested to review this report with particular emphasis on the examiner's Letter to the Board of Directors and letters to management accompanying individual sections. Viewed in the aggregate, the examination results reflect favorably on management, however, we direct your attention to the certain areas warranting attention. Classified assets remain high equaling 30% of gross capital funds. This figure does not include [words deleted] and related lines which were classified as Uniform National Credits subsequent to the close of the examination. While the decrease in assets classified as doubtful and loss is favorable and encouraging, intensified efforts on the less severe classifications are important in view of current economic uncertainty. 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 which were internally rated "B", and which have traditionally been regarded as sound from a review evaluation standpoint, are criticized in the report of 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. Another area of concern is the credit card program. The mass mailing of credit cards produced significant growth in outstandings, but also resulted in a number of problems. A breakdown in controls at the inception of the program was a contributing factor in the S10MM in charge-offs recorded in the first four months of this year. While management expects a substantial moderation of these losses through the remainder of the year, careful monitoring of the program will be required. 314 The growth in earnings has been achieved by virtue of increasing loan and asset volume leverage. The interest margin has remained relatively level since 1977. The ratio of 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. The bank has developed a well-managed program for funding purposes. Liquidity world-wide is satisfactory. Vulnerability to a high level of purchased rate sensitive funds is regarded as a part of the bank's funding environment. There were a number of violations of law and regulation cited in the report of examination. Violations of the consumer laws has resulted in uncertainty regarding overcharges to some of your customers. Violations outlined require remedial attention. Several parcels of other real estate owned are cited in the report which are carried in excess of the appraised value. In accordance with Interpretive ruling 7.3025(e), carrying values which exceed appraised values must be charged-off. For the purpose of monitoring compliance with laws and regulations, please provide a response outlining action taken or contemplated to correct violations. In addition, please indicate the dates on which entries are processed for the amounts classified as loss in the report of examination, and respond to Other Matters Requiring Attention in the Trust section of the report of examination. All correspondence should be addressed to Comptroller of the Currency, Administrator of National Banks, Attention: Billy C. Wood, Deputy Comptroller for Multinational Banking, Washington, D.C. 20219, with a copy to Rufus O. Burns, Jr., Regional Administrator of National Banks, Sears Tower, Suite 5750, 233 South Wacker Drive, Chicago, Illinois 60606. Sincerely, BILLY C. WOOD, Deputy Comptroller for Multinational Banking. Enclosure. CONTINENTAL BANK, Chicago, IL, June 13, 1980. Mr. BILLY C. WOOD, Deputy Comptroller for Multinational Banking, Office of the Comptroller of the Currency, Washington, DC DEAR MR. WOOD: AS requested, we are writing in response to the last Combined Report of Examination reflecting work done by your staff at our Bank. As agreed in advance with you, we are responding to the comments referenced in your transmittal letter which accompanied the Report. It was noted that classified assets "remain high equaling 80% of gross national funds." Recognition was also given to decreases in the more severe classification categories, but current economic uncertainties were also noted. We are heartened by the substantive reduction in the ratio of classified assets to capital that has occurred since the high point of 1977 las reported in the examination of that year), and with the noted shift into the less severe catego- 315 ries, but we are by no means satisfied with the ratio level as reported in the current examination. Further, we share your concerns about the effects of a probable recession. Please be assured of management's continual and close attention to this matter. Comment was made about the credit review system with respect to both the identification of, and the rating of, loans. In addressing the first comment, concerning unrated credits, we have implemented a control feature which includes a periodic reporting mechanism to monitor unrated credits. We feel the mechanism is working well. The second comment, concerning the rating of loans is more difficult to address because of the subjective nature of the evaluation and rating process. A review of the specific loans in which there was material evaluative difference disclosed an appreciable incidence of timing difference. That is, there had occurred a change in the borrower's fortunes of a material nature between the time the credit had last been rated internally and the time the examiners rated it; for those cases, our credit review team would agree that the examiners' rating constituted a more adequate evaluation with the benefit of the information obtained subsequent to the internal rating date. There were, however, several instances in which the rating differences appear to stem from judgmental positions. We must confess that, in retrospect, we were somewhat surprised that such instances of judgmental differences have not been noted in the past. Given the necessarily subjective element in a credit rating process, occasional differences of opinion would perhaps not be unusual. We would anticipate, however, that such instances would involve rather narrow judgmental differences and would in all cases call for re-review by the internal rating staff. Your letter commented on the level of charge-offs in the Credit Card program and acknowledged managment's expectation of a moderation in the loss factor. We are pleased to report the loss levels have moved approximately as we anticipated. Mention also was made of a decrease in the ratio of equity capital to total assets since 1976, and the observation was made that if the rate of growth continues to outpace internal capital formation, external sources should be identified to support asset leverage. We consider the issue of capital adequacy and the leveraging levels to be matters of paramount importance and they remain under constant review and analysis. Be assured we continue to seek opportunities to take advantage of favorable market situations. We are pleased to advise you that all amounts classified as "loss" or which were directed to be charged off were charged off shortly after receipt of the Combined Reports of Examination. Thus, all charge-offs were reflected in our 1979 Financial Statements. The Trust Section of the Report contained a comment on the "Other Matters Requiring Attention" page concerning the manner in which the Trust Department fulfills the obligation to audit or review individual Trust accounts. The thrust of the comment concerned a discrepancy between the written policies and procedures of the Trust Department, and the policies and procedures of the Auditing Division. We are pleased to advise you that the written procedures in the Trust Department have been brought up to date and now agree with the written procedures of the Auditing Division. 316 A number of instances of non-compliance with regulations were noted in the Consumer Section of the Report. We are pleased to report that corrective action has been taken for each instance of noted non-compliance. Also, the examination noted three violations of the Municipal Securities Rule Making Board rules; we are pleased to report that all have been corrected. To return to the area of consumer protection, we have completed a review of our consumer protection law compliance mechanism, and we are revising our internal structure and methodology better to assure an acceptable level of compliance in the future. We would like to take this opportunity to offer some observations on the new Combined Examination concept which, on the whole, we consider beneficial and which we encourage you further to follow and develop. We do feel unused lines of credit should be excluded from reports of classified credits and from country outstandings. As you know, our feelings is that, as a practical matter, banks will take appropriate action when either an individual credit or a country deteriorates in credit quality, and unused lines (which we differentiate from unused legally binding commitments) should not be included in evaluative totals. While the absolute dollar diference caused by this definitional difference is not great with respect to our Bank, we made the suggestion, both as a matter of principal and of practicality. Finally, the Trust Section of the Report contains a full reproduction of the annotated list of pending litigation facing our Trust Department. The criteria used to develop this list was, by decision of the examiners involved, different than the criteria used to request similar litigation reports for the Bank as a whole. We suggest that, first, the criteria for Trust be the same as for the rest of the Bank, and second, that the entire list of Trust litigation not be reprinted in the Report. Our concern here revolves around the continuing erosion we observe in the confidentiality of Examination. If you have any questions, please do not hestitate to call. Sincerely, DONALD C. MILLER. COMPTROLLER OF THE CURRENCY, ADMINISTRATOR OF NATIONAL BANKS, Washington, DC, June 20, 1980. Mr. DONALD C. MILLER, Vice Chairman Continental Illinois National Bank and Trust Company of Chicago, Chicago, IL, Dear Mr. Miller: Thank you for your letter responding to the combined Report of Examination of May 21, 1979. We have noted those areas in which corrective action has been initiated or effected and took note of your concerns. With regared to your response to the comment on the credit review system, we acknowledge that the process of evaluating credit quality contains a fair measure of subjective analysis. However, one of your comments cause us particular concern. You state: "A review of the specific loans in which there was a material evaluative difference disclosed an appreciable incidence of timing difference. That is, there had occurred a change in the borrower's 317 fortunes of a material nature between the time the credit had been last rated internally and the time the examiners rated it; for those cased, our credit review team would agree that the examiners' ratings constituted a more adequate evaluation with the benefits of the information obtained subsequent to the internal rating date." We feel that this situation reflects a need to focus on the timeliness of your problem loan identification system. It is important to identify potential deterioration at the earliest possible time in order to respond appropriately. The full impact of the current recession is unknown at this time, however, we do know that detection of financial deterioration of borrowers generally lags behind economic indicators. Based on this knowledge, an increase in loan problems can be expected in the months ahead. Generally, the credit officer is the first to become aware of changes in a company's financial condition. In order to improve the timeliness of the credit rating system, the credit officers coilld serve as the vanguard of an early warning system to alert management and the Loan Rating Committee of impending problems. A copy of your letter has been forwarded to the examiner-incharge of the 1980 examination. Your comments will be given full consideration during the examination. Sincerely, BILLY C. WOOD, Deputy Comptroller for Multinational 39-133 0—84 21 Banking. 318 PERTAINING TO OCC EXAMINATION COMMENCED: JUNE 23, 1980 CLOSED: OCTOBER 30, 1980 Washington, DC January 13, 1981. BOARD OF DIRECTORS, Continential Illinois National Bank and Trust Company of Chicago, Chicago, IL. • MEMBERS OF THE BOARD: Enclosed with this letter is the combined report of examination which was completed on October 30, • 1980 by Senior National Bank Examiner Allan J. Mc Carte. The purpose of this letter is to highlight matters discussed in the report which deserve your attention. Since it is part of the report of examination, this letter is to be treated with the same degree of confidentiality. The report is comprised of four sections: Commercial, which also includes comments on International Operations; Trust; Data Processing; and Consumer Affairs. Each director is requested to review this report with particular emphasis on the examiners • Letter to the Board of Directors and letters to management accompanying individual sections. The results of the examination indicate that, overall, the institution is sound and well managed. Although no major problems were disclosed, there is concern over asset quality and the several violations of regulation in the trust area. Earnings have reached new* highs, primarily on increases in assets; such growth has also resulted in increased leverage. The level of criticized assets remains high at 82% gross capital funds. Although the preponderance of such assets do not carry a high loss potential with actual classifications declining since the previous examination, there are, nevertheless, continuing significant losses from the consumer portfolio, especially credit cards. It is recognized that reduction of criticized totals may be difficult given the current environment. In this context, appropriate consideration should be given to the comments concerning the internal credit review program which appear in the examiner's "Letter to the Board." 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 Office. While neither the present level of capital nor the current capital planning efforts 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. Earnings, the primary source of the institution's capital, continue to reach new highs. However, the increases have emanated primarily from higher levels of earning assets. On a quarterly basis for 1980, earnings have fluctuated significantly. The unprecedented movements in interest rates were a major factor in those results. Such volatility also underscores the importance of quality in earn 319 ings and the need to continue considering alternative sources of capital. For the first time, all three of the primary segments of trust activities were examined: domestic, stock transfer and international. The results indicate there is a need to enhance the audit process and improve certain operational controls in several areas both domestically and overseas. There were several violations of regulation dealing with administration of fidiciary powers, funds awaiting investment and records accessibility. In Consumer Affairs, several violations of the regulations were disclosed. Progress achieved to date in improving the compliance performance should be continued. The bank's community reinvestment program is conducted satisfactorily with no noncompliance situations disclosed. The Data Processing function was found to be managed satisfactorily. Threats posed by a major disaster involving data processing activity are recognized by management and while steps have been taken to minimize the risks, it is an area deserving continued awareness. Several violations of law or regulation other than those mentioned before are noted in the commercial and consumer affairs areas. All such citings require remedial action. For the purpose of monitoring compliance with laws and regulations, please provide a response outlining action taken or contemplated to correct violations. Also, please furnish responses to comments in the examiner's Letter to the Board of Directors and Matters of Major Importance Requiring Attention in the Trust section. All correspondence should be addressed to Billy G Wood, Deputy Comptroller for Multinational Banking, Comptroller of the Currency, Washington, D.C. 20219, with a copy to Rufus O. Burns, Jr., Regional Administrator of National Banks, Sears Tower, Suite 5750, 233 South Wacker Drive, Chicago, Illinois 60606. Sincerely, BILLY C. WOOD, Enclosure. Deputy Comptroller for Multinational Banking. CONTINENTAL ILLINOIS NATIONAL BANK AND TRUST COMPANY OF CHICAGO, July 9, 1981. Mr. BILLY C. WOOD, Deputy Comptroller for Multinational Banking, Office of the Comptroller of the Currency, Washington. DC DEAR MR. WOOD: We are writing in response to Combined Reports of Examination tas of June 30, 1980) sent to us by your office. Our response includes, but does not repeat in detail, the discussion you had with our Directors' Audit Committee and with our Corporate Office, and it includes the results of the meeting in your offices between Messrs. Bottum, Hlavka, Miller, Johnson, and you. As is customary, we are touching upon the the comments referenced in your letter of transmittal. The Reports noted that criticized assets totaled 82% of gross capital funds, and the percentage was referenced with a comment about concern over asset quality. The level of criticized assets has 320 been declining for five years in terms of absolute dollars, in terms of relationship to gross capital, and in terms of severity of classification. We hope to see the trend continue as it is our goal to have the lowest possible level of criticized assets consonant with a balanced portfolio that provides an adequate return while providing our customary level of service to an expanding market share. Comment was made that we have experienced ". . . continuing significant losses from the consumer portfolio, especially credit cards." The consumer banking credit losses in 1980 totalled $27.6 million vs. $30.2 million in 1979, and the 1980 experience indicated a quarter-to-quarter declining trend over the year. We anticipated an increase in losses at the time we embarked on a program of national expansion. Frankly, what we did not anticipate was the effect of the economic turn-down and the sharp rise in bankruptcies because of the new Federal law. Overlayed on those market factors were some unexpected developments such as problems in our collection unit and problems with changes in technology. The combined result has been a loss factor greater than we anticipated. We think we have overcome the internal factors, especially by restaffing our collection unit in suburban locations, a move which is showing very positive results. The level of losses and delinquencies are coming down slowly, but they are still well in excess of the levels we desire. This will continue to be a priority effort in the Personal Banking department. The Examiners' comments regarding our internal credit review and rating system indicated it is functioning very well and appears to be cost effective. The comment was, 'V. . raised because the existing procedure followed by the Rating Committee does not include any on-site or interim independent review." This comment contains two points. The first refers to our program of having documentation sent to Chicago from branch and subsidiary units, with all credit rating work being done there. Because of our genesis as a unit bank, the natural evolution of the loan evaluation process was a highly centralized effort. To date it has been successful and cost effective, and we do not see any particular stresses or inadequacies resulting from it. We do recognize, though, that as our business becomes more complex and we continue to expand with other offices, the time may well come when it will be more appropriate to shift to some form of on-site reviews. To that end we have been exploring the methodologies and examining the specific mechanisms by which this can be done in a cost effective way. We contemplate an experimental field review run some time in the next six to twelve months. The second point in the Examiner's suggestion, that of interim review, relates to the practice of preparing a quarterly Watch List report in which the individual lending officers submit information on all deteriorating credits they are handling. In almost all cases the individual lending officer is the first one to spot potential problems, or a deteriorating situation, and we concur in recognizing the importance of inducing the individual lending officers to report deteriorating situations as soon as possible so that appropriate steps can be taken, but we feel the best way to elecit appropriate behavior is through the commercial banking line organizations as opposed to the credit rating staff function. We will continue to stress this with our lending officers. 321 Your letter of transmittal comments that capital adequacy for banks in general is a matter of growing concern to the Office of the Comptroller. It was noted that our current level of capital is ". . . considered adequate," but that the asset structure has been growing more rapidly than the capital base, and that for the past two years capital generation has occurred through retained earnings. You call on management to continue seeking alternative sources to bring the capital and asset growth rates into balance. We have been to external markets, notably debt markets, a number of times in the past ten years, and we will have no hesitancy in going again. Unfortunately, market conditions have ranged from bad to disastrous, and we prefer not to go until conditions are favorable. The Combined Reports of Examination cite three violations of law and regulation in the commercial section and several in the consumer section. Needless to say, any such violations at Continental Bank are inadvertant. We are pleased to report that all citations have been corrected. The corrective action relating to the consumer affairs findings were as outlined in the Report itself. The actions taken with respect to the findings in the commercial section were appropriate to the nature of the items (Board resolution, property appraisal, etc.) The Turst Examination portion of the Reports contains several comments and recommendations which we accept, and concerning which corrective action has been taken. There are, however, several comments with which we must respectfully disagree. A number of alleged violations of Regulation subsidiaries; legal counsel advises us that Regulation Nine does not apply to the trust activities of these foreign subsidiaries. The possibility exists, of course, that new trust business in those subsidiaries may well bring Regulation Nine into force at some future time, and—even currently—Nine is one of several possible standards for use as a managerial tool; accordingly, we are making a study of these subsidiaries' trust activities using Regulation Nine as one of the evaluative yardsticks. In the domestic trust Report a request was made that income cash be reinvested for the time period between receipt and periodic distribution to income beneficiaries. After careful study by management, we conclude such reinvestment at bank discretion is inappropriate under Illinois law. A request was made for the internal auditors to increase the number of so-called "administrative audits" performed and to review our Law Department's work safeguarding against conflict of interest and self-dealing in the Trust Department. Both of these citations and requests were made because of lack of conformity with the "guidelines" contained in the Examiners Handbook. As we have discussed with you at length, both in our offices and in yours, we feel we have been undertaking actions in appropriate places in our organization that more than adequately meet the underlying needs that are the basis of the "guidelines" themselves. As we agreed, the 1981 examination effort will, we hope, demonstrate this to our mutual satisfaction. 322 If you have any questions, or if we may be of further assistance, please let us know. Sincerely, DONALD C. MILLER, Vice Chairman. COMPTROLLER OF THE CURRENCY, ADMINISTRATOR OF NATIONAL BANKS, Washington, DC July 22. 1981. Memorandum to Thomas M. Fitzgerald, Director, Multinational Examinations. From: Bruce Ellard, National Bank Examiner. Subject: Continental Illinois—Report response. The recently received response to the June 30, 1980 examination does not address all matters highlighted either in the transmittal letter or in McCarte's Letter to the Board. In several cases, the responses are simply a statement of disagreement; no comments are given in particular instances although no critical issues were left unaddressed. The letter appears to have been put together hastily—bank personnel apparently were embarrassed when it was realized a response had not been prepared. Also, the letter does not follow directly either one of our pieces. While the letter is not fully responsive, any follow-up would be better handled through the current examination. McCarte has a copy of the letter and has been monitoring concerns from the previous examination. Our lingering questions, generally, can thus be easily answered through McCarte. Major outstanding items continue in the Trust area: (1) applicability of Regulation 9 to overseas subsidiaries of the holding company or bank, (2) investment of income cash and (3) administrative audits. Number 1 has been referred to Doyle for clarification; number 2 represents a point of contention between this Office and several banks—a call for legal briefs seems to be the next step; and number 3 awaits, at the least, bank submissions to the Trust examiner which the bank hopes will fulfill our requirements in a less onerous fashion. 323 PERTAINING TO OCC EXAMINATION COMMENCED: JUNE 1, 1981 CLOSED: AUGUST 21, 1981 Washington, DC October 19, 1981. BOARD OF DIRECTORS, Continental Illinois National Bank and Trust Company of Chicago, 231 South LaSalle Street, Chicago, IL^OMS*DEAR BOARD MEMBERS: Enclosed with this letter is the combined report of examination completed August 21, 1981 by Senior National Bank Examiner Allan J. McCarte. The results of the examination show the institution has sound management and good earnings. There are, however, areas of concern including the high level of classified assets. The primary focus 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 (GCF) and criticized assets to 99% of GCF from 61% and 82% respectively the previous examination. A significant increase was shown in the level of doubtful assets which more than doubled. The sharp increase is primarily attributable to one large credit which was entering bankruptcy at the time of the examination. Management reports that, since that time, collateral documentation has improved and the balance reduced significantly. While Continental's historical loan loss experience is among the best of the multinational banks, the current level of classified assets is quite high. Continued close monitoring will be required to reduce classified to a more satisfactory level. The system for internally identifying problem credits works reasonably well; however, a number of credits are criticized/classified in the report which do not appear on the bank's "Watch Loan Report." While neither the number nor dollar amount of those loans is currently a cause for concern, we feel the system could be strengthened by performing random supplemental reviews in addition to the scheduled reviews as they are now performed. The examiner indicates that the Rating Committee is considering initiating on-site loan reviews. As part of those reviews, it is suggested that a random sampling of loans, not appearing on the " Watch List," be tested for credit quality. In the installment lending area, no formal charge-off policy has been formulated. Such a policy should be developed and implemented in the context of the policy of this Office as stated in Banking Circular 140. 324 Earnings continue at record levels on an absolute basis. Also, the quality of those earnings appears to be good. 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. The examination of the Data Processing function disclosed no significant problems. The area has sound controls and is well managed. Management is encouraged to continue, without delay, the development of measures to be taken in the event of major disruption or disaster with respect to data processing capability. The Trust Department is operating under sound fiduciary principals. While the level of administrative audits is acceptable, given the present scope of those audits, management is encouraged to increase the number of those audits. The institution conducts a satisfactory program with respect to Consumer Affairs and Community Reinvestment. There were no noncompliance situations cited. Please outline the remedial steps taken with respect to the violations of law cited in the report of examination and furnish the date requested charge-offs were effected. A copy of a formal installment loan charge-off policy should be provided when adopted. Also, provide responses to comments in the examiner's Letter to the Board of Directors, Matters of Major Importance Requiring Attention in the Trust Section, and Conclusions in the Data Processing Section. Responsses should be directed to Billy C. Wood, Deputy Comptroller for Multinational Banking, Comptroller of the Currency, Washington, D.C. 20219 with a copy to Rufus Burns, Regional Administrator of National Banks, Suite 5750, Sears Tower, 233 South Wacker Drive, Chicago, Illinois 60606. As this letter is part of the report of examination, it should be treated with the same degree of confidentiality. Sincerely, BILLY C. WOOD, Deputy Comptroller for Multinational Banking. Enclosure. CONTINENTAL BANK, Chicago, ILf February 19, 1982. Mr. BILLY C. WOOD, Deputy Comptroller for Multinational Banks, Office of the Comptroller of the Currency, Washington, DC. DEAR MR. WOOD: AS requested, we are writing in response to the last Combined Report of examination reflecting work done by your staff at our Bank. As directed in your transmittal letter which accompanied the report, we are responding to the comments you have referenced. It was noted that "this examination showed the level of classified assets increasing from 61% of gross capital funds to 67%" and "the level of total criticized to 99% of gross capital funds." We are concerned with monitoring the level of classified loans in the portfolio, and keeping them to a minimum without establishing overly re- 325 strictive credit policies. We do not feel there is a problem of loan portfolio quality, either in absolute terms or in terms of trend when one considers the current state of economic environment. Indeed, given the prolonged period of record high interest rates and the state of the economy, it is surprising that more difficulties have not surfaced. You may be assured that mangement will provide close, continued attention to this matter. Comments regarding the loan review system were generally very positive in nature: however, three suggestions for improvement were offered. In addressing the first comment, regarding credits not rated on schedule, this matter has been receiving attention and we expect to see imporvement. We have emphasized to lending personnel the need to address and resolve in an expedient manner loans not rated on schedule. Furthermore, consideration is being given to the need to review certain types of credits as frequently as they have been in the past, thereby allowing the staff more time to review other credits that will benefit from increased coverage. The second suggestion concerned the strengthening of reports to the Board by including, "A total stratification of the remaining assets by quality rating." We feel this comment is due in large part to the fact that our internal loan rating categories do not coincide with categories used by your examiners. The quarterly reports currently received by the Board track quite closely the more severe rating categories and the movements "in" and "out" of those categories. The cost/benefit to modify our operating systems to compile the information necessary to aggregate loans by ratings and to track rating histories is unclear to us. The final suggestion deals with your examiners feeling that a form of independent review by Loan Administration, such as on-site reviews of loans made from nonChicago offices, could be instituted to insure the accuracy and timeliness of information presented to them. As you will remember, all loans over $500,000 have always been reviewed by the staff here in Chicago. The Loan Administration Division performed its first experimental on-site review at the Continental Bank International Miami Branch Office in October, 1981. Additional exercises are being scheduled, and an on-site review is currently underway in Taiwan. Your examiners comments regarding installment lending indicated that "A formal realistic charge-off policy should be developed." This comment stems from a sector of the examination in which we did not communicate with your examiners as effectively as we should have. The Bank does, in fact, have a written policy governing the charge-off of installment loans. This policy is under revision, and the lending area is following an approximation of the anticipated revised policy; however, some of the credits cited by the examiners should have been charged-off sooner. This matter will be put in order in the near future. Comments regarding capital adequacy identified the need to "Bring capital growth in line with asset growth." Management recognizes the need to keep the Bank's leverage position within reasonable constraints. A great deal of time has been spent on this issue in the past, and it is an implicit part of our strategic planning. This issue will continue to receive priority attention in the years ahead. 326 The cited violation of the U.S. code involving unsecured credits to affiliates and violations of the Municipal Securities Regulatory Board rules were noted. Management has taken appropriate steps to ensure that these violations do not reoccur. We are pleased to advise that all credits classified as "Loss" in the Report of Examination were charged off during the examination or in the third or fourth quarters. Thus, all charge-offs are reflected in our 1981 financial statements. The Trust section of the report contained two comments requiring response. The first comment indicates that the Trust Department should be temporarily investing income cash generated in trusts, whether or not the governing instrument authorizes it to do so. Management continues to feel that under Illinois law, a fiduciary has no authority to invest income cash. This position has been supported by legal opinions from our own Legal Department and the Corporate Fiduciaries Association of Illinois. In the final point, your examiners have again recommended that the Audit Division should monitor the outside interests of Trust Department officers and managers. We continue to feel that the annual survey and monitoring of all officers' and managers' outside business interests performed by the Law Department adequately addresses this issue. It makes more sense for attorneys, rather than accounting graduates, to review questions concerning conflict of interests. If you have any questions, please do not hesitate to call. Sincerely, DONALD C. MILLER. Copy to Mr. Rufus O. Burns, Jr., Regional Administrator of National Banks, Sears Tower, Suite 5750, 233 South Wacker Drive, Chicago, Illinois 60606. 327 Mr. VENTO. I am sure you are aware of the concerns we have here. We are especially concerned about the lack of a timely response, it seems to me, with regards to receiving the letter and the response from the board. Continental Illinois Bank took 8 months to reply to a Deputy Comptroller Billy Woods' letter in 1979 transmittal letter, 7 months to reply to his 1980 letter and 5 months to respond to a letter in 1981. Are these time periods comparable to length of time other large multinational banks take? I state this in the context of your pointing out how important 6 days were in terms of your impression of what was going on. Mr. CONOVER. I understand. Those were rather longer response times than we would normally expect from other multinational banks. Let me make a couple of points about something you said earlier. The banks are required to read not only the letter of transmittal but the examination report, period, all of it. In addition, with the multinational banks, we meet with the board of directors, or its auditing and examining committee, and present the results of the examination. At least since I have been here, this is usually done with a slide presentation given by the examiner in charge, who conducted the examination. We spend several hours with them, discussing points in the examination, corrective actions that need to be taken, and so forth, so that in many cases the actions that we are proposing they take have been taken long before we get the written response from the board. Mr. VENTO. That is very interesting because in some of these letters—look them over—it seems first of all that some of the transmittal letters at least are very specific, but that the tendency is that many of the key points are either not responded to or are downplayed in terms of their importance. I call to your attention that the first letter there was also from Mr. Wood, October 1979, examination report, put Continental's board of directors on notice regarding significant problems in the bank's system for identifying rating problem loans—I quote. "The importance of reliability of internal loan evaluation procedures, as is an early warning mechanism, to control credit quality in a growth environment cannot be over emphasized." It took Miller of Continental 8 months to reply to that and come up with, in his reply, as I said, it downplayed the significance of Mr. Wood's comments. Mr. Woods' 1981 transmittal letter contained a variety of comments to the board regarding such matters as the 1982 percent ratio of criticized assets to growth capital funds. In fact, the capital had not kept pace with the asset growth. Internal Office of Comptroller of Currency memorandum, July 22, 1981, said regarding Continental's response sent 7 months later; this is what it said: The recently received response, dated June 30, 1980, does not address all the matters highlighted either in the transmittal letter or in Mr. McCarte's letter to the board. The letter appears to have been put together hastily. Bank personnel were apparently embarrassed when it was realized the response had not been prepared. So I think the point is that they are not even responding to some of the concerns or many of the key concerns that are being raised. How would you answer that particular type of criticism, Mr. Conover? 328 Mr. CONOVER. I would agree with you that incomplete responses and responses that downplay something that we think is important for the bank to do certainly call for us to tighten our procedures and approaches to identify clearly what it is we want the bank to do and to follow up to ensure that the bank does it. Mr. VENTO. DO you think you have the leverage to get banks to respond? We have a lot of money center banks in the country. It appears to me you either don't have the will, determination or ability perhaps. And I probably chose the latter. The Government simply is trying to deal with the large institutions, money center banks; simply has been too timid. Even as I look at some of the transmittal letters, they seem to me to say on this hand you have serious problems. On the other hand, they seem to be taking a different attitude. Let me get to a different problem that points up Mr. CONOVER. May I answer your question? Mr. VENTO. Yes. Mr. CONOVER. We have the capability, and we have the will, and we are in the process of doing just that. Mr. VENTO. Well, the thing is you had supervisory agreements t h a t were in place. I want to refer to one other instance. That deals with the ratings of Continental and a dispute that occurs with regard to what they call the CAMEL rating between the FDIC and Office of the Comptroller. I am sure you are familiar with that dispute. It is a CAMEL rating of three or four and, of course, the Office of Comptroller of the Currency is on the liberal side in terms of trying to provide a more generous rating than the FDIC. Here is what your Mr. Martin said with regard to the FDIC. Mr. Martin, of course, who is working for the Office of the Comptroller of the Currency, The FDIC has no appreciation of the understanding of the strength and staying power of large institutions, but rather continues to make assessments based upon unclassified assets as a percentage of capital. It sounds as though you are suggesting that a more generous rating is in line. This is occurring in 1983, Mr. Conover, in light of the whole record that existed. Maybe you ought to explain to the committee what a CAMEL rating is and why Mr. Martin took the position t h a t he took with regards to this issue and what do you mean by strength and staying power of money center large banks—what Mr. Martin meant in that instance. Mr. CONOVER. First of all, there is a uniform CAMEL rating system t h a t is used by all the bank regulatory agencies as a way of describing and classifying individual banks. Ratings are assigned for capital, asset quality, management, earnings, and liquidity. Then a composite rating is developed out of the previous five ratings. We provide all of our examination reports as a routine matter to the FDIC. Included in those examination reports are the CAMEL ratings. Mr. VENTO. Are there frequent differences betwen FDIC and yourself with regards to these issues? Mr. CONOVER. Occasionally that happens, just as you would expect t h a t it would. After all, we are talking about a shorthand method of putting a grade on a bank that was developed as a mech- 329 anism for communicating among bankers. It is not unreasonable to expect t h a t one agency might in certain circumstances come up with a different rating t h a n the other. I can't cite for you how many times t h a t happens in a given year, but it is probably relatively few. Nevertheless, it is not a totally abnormal kind of thing to have happen. In the case of the dispute, if you will, our office in the person of Mr. Martin and the FDIC went back and forth over the CAMEL rating of Continental. At the time, we felt Continental warranted a three rating. The FDIC felt it warranted a four rating. We felt t h a t they were focusing more intently on the asset quality of the bank in assigning t h a t rating. We were focusing more on the definition of the rating, which indicated t h a t in a four-rated bank there was significant probability of failure. So a number of memos were written by the two agencies. The fact t h a t t h a t occurred did not have any impact on the m a n n e r in which we dealt with the bank. Mr. VENTO. Except t h a t Mr. CONOVER. In fact, at the end of the 1982 examination, we downgraded the bank's CAMEL rating to four. I think the difference of opinion on this subject has been overplayed. Mr. VENTO. Mr. Chairman, I ask unanimous consent to have the documents placed in the record. Chairman S T GERMAIN. Without objection. [The following documents in regard to the CAMEL rating of Continental Illinois National Bank were submitted for the record by Congressman Vento:] 330 FEDERAL DEPOSIT INSURANCE CORPORATION^Vaihington. DC. 20429 OFFICE OF DIRECTOR -DIVISION OF BANK SUPERVISION Kav 2 / 1 9 8 3 Mr. H. Joe Selby Senior Deputy Comptroller Office of the Comptroller of the Currency Washington, D.C. 20219 A RECEIVED m s 1?# Dear Mr. Selby: This is in response to former Deputy Comptroller Martin's March 31, 1983 letter relative to conversations with Review Examiner Ralph Hartman and Associate Director Stanley J. Poling, with respect to the Continental Illinois National Bank of Chicago. The primary issues, as I see it, are the composite rating definition and how the FDIC distinguishes the differences between a "3" and "A" rated bank. It is obvious from the rating which we have assigned to the subject institution that we feel "there is an immoderate volume of asset weaknesses or a combination of other conditions that are unsatisfactory — they could reasonably develop into a situation that could impair future viability and a potential for failure is present but is not pronounced." That-is precisely the reason for the rating assigned. We 4o oot feel that the rating assigned is inconsistent with the composite definition contained in the Guidelines and Procedures for the Uniform Evaluation and Rating of Banks (CAMEL). The other issue discussed in Mr. Martin's letter is, and I quote, "the side issue of the problem that could occur if composite ratings by total assets are published by the two agencies." This concern is valid and one vhich we share. However, to allow a fear of public disclosure to mitigate the application of consistent standards would, to a large degree, compromise our efforts to measure the risk to the deposit insurance fund. We are certainly willing to discuss this situation further with you and attempt to reconcile our differences. We^should* Jiowavar^-xacognize.that our agencies will continue to have honest differences of opinion. 331 o EM]©[FM»™ Comptroller of the Currency Administrator of National Banks Washington, DC-20219 T The F i l e s O *** William £ . Kart o,,, SMM.I February 1 8 , 1983 Continental Illinois National Bank In late December I was contacted by Ralph Bartman of the FDIC who stated that they had reviewed the Continental Illinois report and had concluded that it should be accorded a composite rating of 4. Mr. Bartman stated he was contacting me for the purpose of getting my reaction. I asked him on what basis he had reached that conclusion and he stated that he had "looked at the loans and they don't look too good and the classified was high." I asked him if he had recently familiarized himself with the definition of a composite 4 and he stated that he reviews it every day. I asked him if he felt the bank was in danger of failure on the fairly near term and he stated no. I then asked if he had focused on the prospect of failure language that is contained in the definition and he said yes but he was unable to reconcile his two statements. Mr. Bartman at no time mentioned funding as an issue but rather said that asset quality was the basis for his determination. I asked him if he gave any credence at all to the fact that the bank made ^ an extraordinary loan provision of I482MM pre-tax and still resulted in a profit for the year of $81 million and he stated he was unaware of the full year's earnings for the bank but was working with third quarter figures. Be was unimpressed with the fact that the earnings trend had absorbed the massive losses. I stated that before he reached his final determination, I felt that we should make sure he had as complete a picture as possible and perhaps we could sit down and talk about it and he agreed. About two weeks ago, X spoke with Jim Sexton and told him that there seemed to be some disagreement on this and I felt that perhaps the FDIC was limiting its views strictly to total classified rather than looking through to the real threat to solvency that such classified might present. X stated that I would appreciate the opportunity to sit down and discuss it before final determination was made and he agreed. 332 Yesterday Z received a call from Bob Ahrens who stated that Stan Poling had phoned and stated that he was sending over a letter stating their disagreement with the composite 3 and that they were signing a composite 4. This morning I spoke with Stan and related to him that both Ralph and Jim had agreed that we would sit down and discuss the matter and I was a little surprised that they had chosen to go ahead and stick with their 4 rating and merely submit a letter to us. Be stated that he viewed it as a 4. I again asked him about the definition of composite 4 and the bank's prospects of failure. Be also stated he really didn't think the bank would fail but he felt the ingredients in the bank were sufficient to justify the rating and he further stated that he felt that they used a different standard for assigning 4 ratings and since that was their conclusion, he really didn't see any value to discussion. I reminded him that the definition of a composite 4 was subject to interagency agreement but he again stated that they viewed the rating system somewhat differently. Be then suggested that we might discuss it in Tucson next week but clearly that indicates they have no intention of seriously discussing it if he expects it to take place in that remote location without benefit of records. We did tentatively agree that we would get together at a future time to discuss it. I raised this issue by memo for two reasons: First, if the agencies ever report composite rating categories by asset totals there will be a substantial discrepancy which will no doubt be easily traced to Continental. Second, I do find the FDIC's attitude slightly shocking in that they admit that they are applying a different set of standards for assigning such a rating rather than following the definition which was arrived at through interagency agreement. And third, it confirms for me again, that FDIC has no appreciation or understanding of the strength and staying power of large institutions but rather continues to make assessments based upon classified assets as a percentage of capital. I am surprised that they did not follow through with our agreement to discuss the matter and when they did decide discussion was appropriate obviously indicated a cursory meeting at a remote location, I see no need to have a formal meeting later and do not intend to follow up. This morning I was speaking with Jack Ryan on a number of items and told him of the disagreement over the rating and he told me his concern was that if those numbers ever got reported by asset size that Continental would stick out and we would have disclosed the rating for that institution and students of that rating system would certainly perceive the insolvency implications. cc: B. Joe Selby William Robertson Michael Patriarca 333 Mr. VENTO. In other words, you are suggesting—obviously, Office of Comptroller is taking the attitude that the strength and power of that bank is such that they deserve a lower rating simply because they are a large institution. That is what this statement says, of course. It may be taken out of the total letter. The point is that is what it says. Obviously, you are aware of it. And that is the attitude, I guess. Is t h a t right? Mr. CONOVER. The letter says what it says. The judgment made at that particular time was that the bank was more appropriately rated three for the reasons spelled out in Martin's memo. As I say, I think much too much is made of this because it didn't have any impact on the manner in which Continental Illinois was supervised from that point on. Mr. VENTO. Thank you, Mr. Chairman. Chairman S T GERMAIN. Mr. Conover, did you, meaning you and your very excellent personnel, at any point, have reason to suspect that there was insider abuse at Continental? Frankly, I am referring to Mr. Lytle, who as we found out, was the man who was doing the Tennessee Waltz with Bill Patterson. Mr. CONOVER. We certainly didn't suspect that there was any insider abuse on the part of the top management of Continental. As far as Mr. Lytle goes, I am not sure what his current status is. Chairman S T GERMAIN. I am asking Mr. CONOVER. I know he has been dismissed by the bank. Chairman S T GERMAIN. When did you and your office discover that indeed there was some hanky-panky going on? Mr. CONOVER. Probably not until after the Penn Square Bank had failed and the investigation took place as to the manner in which the loans Chairman S T GERMAIN. Remember, we had our hearings at the time and brought out the fact Mr. Lytle Mr. CONOVER. I am aware of that. Chairman S T GERMAIN. Would t h a t be about the correct date? Mr. CONOVER. I would think so. I don't think we suspected or knew t h a t there was any potential insider abuse on Mr. Lytle's part, or anybody else's part in the bank, prior to the Penn Square Bank failure and the subsequent hearings relating to it. Chairman S T GERMAIN. At that point, did you insist that he be removed from office? Mr. CONOVER. We didn't need to. The bank removed him from office. Chairman S T GERMAIN. In a timely fashion? Mr. CONOVER. I believe he was let go in July 1982. Chairman ST GERMAIN. Mr. McKinney? Mr. M C K I N N E Y . Thank you, Mr. Chairman. Mr. Comptroller Chairman S T GERMAIN. Wait a minute, Mr. McKinney, I have to say this. I want you to know that we have been in contact with the FDIC's office. We informed them t h a t the computer runs on what the alternative costs would have been for infusing capital or the bailout, had you allowed Continental to fail. They tell me they are looking for it. That was at a quarter to 1. So I am going to give you every half hour a report on how we are doing with this. Let me ask you this: I will bet you could find it 0—84 39-133 22 334 within your files within a matter of minutes, right, because of the efficiency of your office? Isn't t h a t an important document? Mr. CONOVER. My colleagues are laughing because of the piles of things t h a t are stacked in my office. Chairman S T GERMAIN. But whatever important things are stacked, I promise you can. So, too, in mine, Mr. Conover, but no matter how high they are stacked I can tell you I can find them in a moment's notice. Mr. CONOVER. If you want to look into the evaluation of different potential courses of action vis-a-vis Continental and why the decision was made to go as we did, you would probably want access to those documents. Chairman S T GERMAIN. I think they are rather important documents. I just want you to know they are looking for them. Mr. McKinney? Mr. M C K I N N E Y . Mr. Chairman, if they should be as fast as the Defense Department, you will still be here next Christmas. Mr. Comptroller, I think whatever they want to concentrate on, we have been through all the implications. It is semi-staggering what has happened, and I will stay away from my diatribe on the two types of banks. What I really want to look at are two aspects of the situation. One, why didn't we move faster, and, two, just what can you do? I know on page 19 you say we have asked ourselves whether we should have taken action as early as 1976 to prevent Continental from embarking on a course of rapidly becoming a top lender to corporate America. In my view it would have been inappropriate to have done so. It is not the proper function of regulators to decide what business strategy an individual bank should undertake. A regulator's role is to see t h a t whichever business strategy a bank chooses, it has the mechanisms in place to implement t h a t strategy in a safe and sound manner. Then we move over to pages 25, 26, and 27. On page 27, you list a whole pile of things t h a t could be done and you say there is another means of insuring adequate capital, OCC will be scrutinizing the pay out policies in light of its overall capital structure. We will not hesitate to restrict dividend payments when necessary. There is a great deal of talk about the adequacy of capital, but then I go back to Penn Square. When Penn Square failed I asked the direct question. I asked why, in fact, did Seafirst which no longer exists except as part of Bank of America and Continental draw into Penn Square so heavily when the Chases and Citibanks and the rest were not? I was told by many people including my New York banker cons t i t u e n t s that, Seafirst was a poorly run bank and had to be taken over and, in fact all of this was an aberration with Penn Square. You go back to articles in the newspapers of July and August 1982, "Business Week," 1982, October, "Continental Illinois' Most Embarrassing Year" and so on. What is our problem in not getting t h a t red warning flag up sooner? We certainly knew Penn Square was in trouble a long time before it collapsed. Far more important, when the red flag goes up, what can you really do or what are you able to do? It seems to 335 have you in the same spot as the high sheriff on the highway without the powers of arrest, and t h a t really makes your job somewhat superfluous. Mr. CONOVER. In terms of the red flags, most of Continental's loan purchases from Penn Square took place in late 1981 and early 1982. In fact, they took place between examinations. It happened very quickly. If you recall from the Penn Square discussions, it was at precisely t h a t time t h a t Penn Square went on a lending binge of the first order. They must have sold virtually all of the loans t h a t they produced during t h a t time to Continental. Now, we have done some things since then to improve the red flag system. One of the things we did, as I indicated earlier, was to change the call report so we get some information on participations for review quarterly. Mr. M C K I N N E Y . Let me stop you in the process. We have gone I think, from roughly $300 million invested in Penn Square to over $1 billion, correct? Mr. CONOVER. Yes. Mr. M C K I N N E Y . Over Mr. CONOVER. About how many months? $300 million in April 1981. By the fall of 1981, we are talking about $500 million and by March 1982, $1.1 billion. Mr. M C K I N N E Y . I really want to find out this answer because we are going to have to legislate something in here sooner or later. What blows a whistle? Suddenly you have a storefront bank in a shopping center in Oklahoma t h a t borrows $800 million from a big, supposedly sound fiduciary bank in roughly a very short period of time. Does a whistle blow somewhere in your organization to alert you to this unusual activity? Mr. CONOVER. The whistle blows if you know about it. And we now have the mechanism for knowing about it. Mr. M C K I N N E Y . All right, now you have the mechanism to know. I have a degree in history from Yale which doesn't help me here but the minute I see the participation there I say there is something wrong. If there is something wrong with the energy loans from Continental there has to be something wrong with the energy loans period. So the whistle blows in your office. What do you then do? Mr. CONOVER. YOU have to get into, in this case, Continental Bank and take a very long hard look at the loan portfolio including the loans participated out from Penn Square which you focus on first. And then you ask the obvious question or make the obvious observation, which you just made, t h a t if the oil and gas loans they are getting from Penn Square are bad, the other oil and gas loans are probably bad, too. That turned out to be the case. Mr. M C K I N N E Y . We have done t h a t in a miraculous 30 days investigation. We are quite right. The loans stink. Now what do you do? Mr. CONOVER. At t h a t point, if they are on the books, you have got a problem. One thing you can do is change all the policies and procedures and restrict further purchases and the like. That is no problem. The question is what do you do with the loans t h a t they 336 already bought when their system was either out of control or they were being defrauded. If they were being defrauded Mr. M C K I N N E Y . It is tougher to find. Mr. CONOVER. It is tougher to find, but it may also provide them with some recourse. Once the loans are on the books, you are in a workout situation. Mr. M C K I N N E Y . But you say the loans were on the book. Continental continued on the same—I mean $800 million is an awful lot for, as I say, a shopping center bank which has all of a sudden gone crazy in Oklahoma. Can you issue a cease and desist order on any further energy loans until such time as or something of t h a t sort? Mr. CONOVER. Oh, sure, you can say don't make any more energy loans. But you almost don't have to at t h a t point. I mean, there isn't any point. Mr. M C K I N N E Y . But you see, I don't want to get to t h a t point. That is my big problem. I have a bank in Oklahoma operating out of an old storefront in a shopping center. All of a sudden it expands and I see a supposedly prestigious bank t h a t has increased its loans by $800 million. They shouldn't be able to make t h a t increase of $800 million without a whistle blowing somewhere. They shouldn't have gotten past the Mr. CONOVER. Oh, t h a t is correct. I agree with you on that. The control mechanisms broke down in Continental, and we didn't have a mechanism for discovering participations then. We do now. Mr. M C K I N N E Y . Let me tell you what I think is the crux for this committee. What can you really do in cases like this and how fast are you going to find out about it to be able to do anything in time? You know, we all know and we don't talk about it much. We have this wonderfully cozy system. We have the internal auditor, whom we find out is next to worthless at Continental followed by the external auditor, who in the case of Continental got paid $3V2 million for writing his report with the internal auditor. Then we have the internal auditor who also is being investigated, who checks whether or not the bank is in debt and what is the collateral positions, which most people ignore and big borrowers can phone in. You say we may have been carried away by the fantastic growth and success in the seventies of Continental Illinois. We may have been carried away by its management mystique. But is it possible for a mere human being working for a division of the Federal Government to come in at t h a t salary level? Could he walk into Walter Wriston and stop Mr. Wriston lending to Brazil? I doubt it. Mr. CONOVER. YOU are raising another question—whether examiners in general and the Comptroller's Office in particular have the chutzpah, if you like, to walk into top management and say, "Stop, or we are going to take some action against you." There is no doubt in my mind that the examiners in the Comptroller's Office—and I have been involved in meetings with them in an awful lot of banks in the last couple of years—have the guts to say directly to the top management of any bank you want to name that they have got a problem in a particular area. "It is wrong." "It has got to be fixed, et cetera." They grow up on that. 337 Mr. M C K I N N E Y . What if management says buzz off, which is what they did at Penn Square? Mr. CONOVER. It depends on how management says buzz off. If management says buzz off where they are literally trying to defraud you by pretending they are doing something t h a t they are not doing, t h a t makes it very difficult to uncover the wrongdoing. On the other hand, if you have a management t h a t says go away, I don't agree with you, we have ample power, and we use that power to get them to do what we want them to do. Mr. M C K I N N E Y . YOU see, I see Mr. CONOVER. YOU needn't be concerned about that. Mr. M C K I N N E Y . I am not firing at you. Mr. CONOVER. I understand. Mr. M C K I N N E Y . It seems the Comptroller of the Currency at the present time has two big problems. First, the speed alarm on his speedometer isn't working to tell him he is about to get arrested for going too fast and No. 2, he is like the sheriff with a gun without any bullets or car without any tires because essentially your people were in Continental Illinois every 90 days and missed this one. Continental Illinois management knew they were making some rotten loans. Sometimes I feel the quality of management, the three-piece suit and Chicago Club and marble overcomes the fact that it is still a pretty rotten institution. And I don't know what you need, so this kind of thing doesn't happen again because, you see, I have a different theory t h a n a lot of people. I listened to Mr. Rohatyn and a few others in New York and read what they said in the New York Times. They said, "Well, this isn't the taxpayers' money." Sorry. It is the taxpayers' money. Every single American taxpayer who has a depository account with an FDIC or FSLIC insured institution is paying higher bank charges because those banks and institutions are paying higher insurance premiums. So we are dealing with the taxpayers' money in every sense of the word. It is just a different form of taxation. It is called an insurance premium rather than a tax. You say in your testimony that there is a low margin of error allowable in the financial world. Mr. CONOVER. Yes. Mr. M C K I N N E Y . What do you need from the Congress of the United States, No. 1, to give you a system t h a t works better; and, No. 2, what do you need from the Congress of the United States so that you can do something instantaneously? The saddest picture has got to be the 1V2 years of wobbling around in Oklahoma before the crash hit. Everybody isn't saying it is a rotten bank. It is a classified bank. The loans are still no good. And it is still bouncing around on a day-to-day basis. Recently one of my banking friends said, "Well, Stewart, you are proposing we nationalize a bank." I said, "No, we already have nationalized a bank, so t h a t is no longer an issue." Mr. CONOVER. I think the machine on which the red flag goes up is fixed. The mechanism is in place so that we can get information on significant changes in bank activity, in their balance sheets, et cetera, t h a t will raise questions t h a t require followup. 338 Now, I have to put one caution on that. That—going back to the question of fraud again, somebody who willfully wants to get his bank in trouble. The fact of the matter is t h a t if you owned a bank today, you could go home to Connecticut and fail t h a t bank before anyone would know, if you really wanted to. Mr. M C K I N N E Y . In a heartbeat. Mr. CONOVER. You really could. And the problem there is t h a t any regulatory system t h a t would keep you from doing t h a t would be an incredible system. I don't think you or I want t h a t kind of system. Mr. M C K I N N E Y . I agree. Mr. CONOVER. SO I would say, first of all, that we have the tools to get the information that we need. Do we need any new enforcement powers or tools of t h a t nature? I honestly don't think so. I will engage in all kinds of conversations with you to get different points of view on the subject, but we have cease and desist powers, civil money penalty powers, authority to remove officers. Somebody asked me the other day if we shouldn't have a system where we don't have to wait until the bank fails or almost fails to take some action, where we could go in much, much earlier. That sounds good except when you start defining what t h a t trigger point would be. You could say t h a t when you get to 3 percent capital, the regulators can go in and seize the bank. We are seizing private property if we do that. When classified loans get to a particular level do you then, through some emergency power granted to the regulators, automatically let us go in and do something we couldn't otherwise do? Those are possibilities. But they would have to be thought through very carefully. Mr. M C K I N N E Y . Thank you. My time has run out and I am sure we will be having many discussions over the ensuing months. Chairman S T GERMAIN. History at Yale University. We are impressed. Mr. M C K I N N E Y . I might add that the Comptroller and was 2 years behind me. Chairman S T GERMAIN. YOU know, Mr. Comptroller, and believe me, I am going back to many Comptrollers. You are not the first one to sit in this particularly comfortable chair that you are ensconced in at the moment, and the thing that bothers me is t h a t each and every time we go through hearings like this we are told, "Well, we now have it in hand. It won't happen in the future. We will be able to detect this ahead of time in the future. The early warning system, the NBSS, it is really going to function." Now let me ask you this, Mr. Conover. We now know we have got to watch out for the energy-related loans. But one of the new fields I have been reading about is genetic engineering. You have heard about that. All right. Now suppose you find an institution t h a t suddenly decides to go into genetic engineering and they go belly-up, too. Are we going to be told, "Well, we really didn't have enough information on genetic engineering or whether or not there was concentration on genetic engineering loans." What assurance do we have t h a t 6 months, a year or, 2 years from now you or your sue 339 cessor won't be here telling me, "Well, we have got it in hand this time. It won't happen again." Mr. CONOVER. First of all Chairman S T GERMAIN. That is a sincere question. Mr. CONOVER. I understand it is. First of all, there are no absolute, 100 percent guarantees so I can't promise you t h a t t h a t could never happen. Taking the example you cite, however, let me tell you about the mechanism we have put in place to try to deal with that problem. When we reorganized our field structure and our Washington office structure, we did two things. We created an industry review program in the Washington office which looks at particular industries where banks may have some significant concentration, traces through the potential problems t h a t might develop in those industries, and translates them into the potential impact on the banking system. We have done a lot of studies, for example, as to the impact on the banking system if oil were to fall to $25 a barrel or $20 a barrel. At the same time, we have established in our district offices an important position responsible for more local industry analysis. For example, the industry analyst in a particular office might take a look at the local real estate market, assessing whether the area is being overbuilt and whether banks have a number of commitments outstanding to fund buildings t h a t either may never get built or, if they get built, are going to end up sitting vacant and be a terrible drain on their owners for some time. The mechanisms are in place. The challenge to us is to be sure we use them well. And we have a commitment to doing so. Chairman S T GERMAIN. Thank you. Mr. Schumer, the word t h a t was used, I didn't want him to repeat it then because I wanted to use it now. Now we have our chutzpah kid. Mr. CONOVER. Did I mispronounce the word, Mr. Schumer? I apologize. Mr. SCHUMER. I am sure Mr. McKinney didn't learn this in his history courses at Yale, but the word is chutzpah. Mr. CONOVER. I stand corrected. Mr. SCHUMER. It will serve you well in the future to learn the correct pronunciation. Anyway, I have a group of questions. The first question I have relates to something Mr. McCarte told us about yesterday. It seems to us he was the auditor of Continental in 1979, 1980, and 1981. Then in 1982 he was no longer auditor. He was left the job kind of suddenly because he acquired a new position, working for the Continental Illinois Bank. I imagine he got a nice increase in salary. I didn't want to put him through questions like this. He had had a tough day. But I imagine he got a nice increase in salary, et cetera. Don't you think t h a t it is a bad policy to allow auditors of a bank to then immediately thereafter go and work for the bank? Doesn't it tend to create conflicts of interest? Mr. CONOVER. The alternative would be to restrict people's postGovernment employment opportunities and to tell bank examiners that they can't go to work for a bank. Mr. SCHUMER. Plus the bank that they have examined within the last 3 years. 340 Mr. CONOVER. I don't think that that is a problem. We have specific procedures for dealing with cases like that. When Mr. McCarte was approached by the bank, and, incidentally, the bank asked his supervisor first if they could approach him, he made t h a t approach known immediately to his supervisor and informed his supervisor t h a t he would pursue those conversations. We have looked very carefully at the practice to see if there were any improprieties, et cetera and our conclusion is that it ought to be written up as a model for how Government employees are to deal with those kinds of situations. I don't think there ought to be restrictions on post-Government service employment by bank examiners. I can tell you t h a t is where we have lost most of our bank examiners. Banks hire them. Now, I don't know the exact breakdown. Mr. SCHUMER. You are helping me make my point, but I am not objecting to banks hiring. What I am saying is t h a t to go immediately of from auditing a bank, to working for that bank, wouldn't it put strains on Mr. McCarte? What about the next guy who comes in and audits Continental or the people with him? They ought to be asking themselves at least subliminally, "where are my job opportunities if I am not going any further in the Comptroller's Office? I can go right to this bank." Yesterday, we talked about the difficulty for an examiner to go to a board of directors or go to his superiors and say, this bank is in trouble. I can understand that and sympathize with that. It seems to me, however, t h a t this puts an undue strain on the examiner. Take your own job, for example, you can't go work for a bank for 2 years after you leave this job, am I correct in that? Mr. CONOVER. That happens to be true, not by virtue of being Comptroller, but by virtue of being a Director of the FDIC. Mr. SCHUMER. In other words, it seems to me t h a t you should consider the problem because, given all the difficulties t h a t we have, it just creates an appearance of impropriety. There may be none in reality, but more importantly t h a n that, when you are dealing in such a subjective area as bank examination—and it is a subjective area in terms of the the judgments t h a t people have to draw from the specifics they find—that it just makes no sense to allow somebody who has examined a bank 3 years in a row to then go immediately and work for t h a t same bank. I don't think t h a t this should just apply to bank examiners. I think it should be a rule t h a t applies to public service commissioners. They should not be allowed to go to work for the utility immediately thereafter. I think we do have such a rule, in New York State, for the Public Service Commissioners. It is something that I think is wrong, but I guess you don't agree with me on that, Mr. CONOVER. I understand your point and the sensitivity of it. I think it might cause us a lot more problems than it would provide benefits. If the banking industry is one of the places t h a t people go when they leave the Comptroller's Office, and that is particularly true in certain parts of the country where there are a lot of unit banks, I think it would significantly limit our ability to attract and hold people if t h a t restriction were put in place. There are two sides to the coin. 341 Mr. Mr. SCHUMER. CONOVER. Mr. SCHUMER. I understand that. That is all. OK The second question. I asked this yesterday and was kind of perplexed t h a t I couldn't get much of an answer, and it is a general question and your testimony doesn't quite answer it, but it touches on it. What went wrong? What went wrong in the Comptroller's Office t h a t allowed Continental to go under 2 years after you knew there was a problem? Mr. CONOVER. In order to answer t h a t question, I have to give a quick overview of what went wrong with Continental per se. Mr. SCHUMER. That I am pretty much aware of, and I think the committee is. Mr. CONOVER. If you combine the bank's strategy and either the lack of controls or lack of commitment to those controls, and add to that the two recessions, the energy focus and the energy downturn, and the funding situation of the bank, t h a t is how the bank got into the position t h a t it did. As to our office's handling of the situation, I think there are several instances in my prepared testimony where I said that, with the benefit of hindsight, we could have been more forceful in dealing with the internal control system. Mr. SCHUMER. That is after 1982 or before? Mr. CONOVER. Before 1982. I think t h a t is where you break it: up to 1982—Penn Square—and then subsequent to 1982. I think the seeds were very well planted prior to 1982. I think they go all the way back to 1976. Mr. SCHUMER. Mr. McCarte, who did the examination in 1979, 1980, and 1981, seemed to have no idea t h a t anything was wrong with the internal control system. Mr. CONOVER. I think he indicated t h a t there were weaknesses in the internal control systems in specific areas and then made an overall judgment, which I think one tends to do, to try to put the whole thing in perspective and say net you are probably OK, although you need to make corrections in these five areas. Now, I indicated Mr. SCHUMER. He didn't say you are probably OK. He gave it a much cleaner bill of health t h a n that as I remember his language. Mr. CONOVER. Nevertheless, he made a statement which was intended to put his specific criticisms in perspective. I have already indicated t h a t I thought the judgments t h a t were made about the bank and its control system in those years were swayed by the performance of the bank and the responsiveness t h a t management had displayed in dealing with criticisms we had made in the past. Mr. SCHUMER. I take real dispute not with what happened before 1982, but what happened—in terms of what the Comptroller's Office did—between 1982 and 1984. You say in your statement that you are persuaded t h a t since mid-1982 there was nothing more that we could have done to speed Continental's recovery, and thereby increase market confidence. You admit t h a t it was the lack of market confidence that finally caused Continental to fall in 1984? Mr. CONOVER. Yes. 342 Mr. SCHUMER. You are saying then t h a t there was nothing the Comptroller could have done to help bolster t h a t confidence, is t h a t correct? Mr. CONOVER. I think it is. Mr. SCHUMER. Then let me ask a couple of questions. Don't you think that changing management, not just the Penn Square people, but management at the top, would have helped restore confidence, and don't you think the Comptroller's Office was much too timid? I know t h a t the president of Continental was known as a very nice man and all of that. I don't think t h a t enters into it, at least objectively, but I talked to some experts in the field and they say t h a t the Comptroller's Office was terribly remiss, once the 1982 damage was done, in not replacing top level management because, first of all, even though, as you testified they had done a good job of bringing the bank back to health before any management t h a t had no internal control system had to have something severely wrong with it even beyond its Penn Square Loans. That ill existed for an area of lending beyond Penn Square. No. 2, when you replace management, you are telling the world, OK, things are new. We can have new confidence in this bank. Mr. CONOVER. YOU may also be telling them that things are a lot worse t h a n Mr. SCHUMER. They couldn't be worse than they ended up being. Mr. CONOVER. That is certainly true, but you have got to put this in perspective of what was known at the time. You may be telling the marketplace t h a t things are a lot worse than they are. Mr. SCHUMER. I look at Continental's sister big bank, First Chicago, and wonder why you didn't follow t h a t pattern. There were all sorts of rumors earlier t h a t First Chicago was in trouble. I don't know the details, and I don't know what the Comptroller's role was either, but I do know t h a t when the president of that bank was replaced, it seemed t h a t the markets gained a great deal of confidence in First Chicago. Is there an analogy there? Mr. CONOVER. There may be, but in this particular case I think you have to go back and consider what was known at that particular time. I think what we had was a management which had been responsive to criticisms in the past, had gotten the bank out of the 1975-76 problems with the REIT's, had recognized the problems of 1982, and had put in place a mechanism using outside directors, lawyers, and accountants to figure out what had happened and what they ought to do about it. Why did the thing break down? There was evidence that management was committed to doing something about it, and I realize t h a t two different minds can have a different view. Mr. SCHUMER. It just seems to me if the bank didn't fail or come as close to failing as it did, let's not get into semantics at the moment, but it seems to me that if there were 2 years between the time you knew there were real problems and the time the crisis of confidence wave undid everything that there might have been more things that your office could have done. We have had our dispute on that. You can answer t h a t and this question. 343 In effect, what you have said is, there was no reason to suspect anything was wrong with Continental before 1982, and nothing could have been done about it after 1982. You have made a very persuasive argument t h a t your whole operation of bank examination is useless. Mr. CONOVER. No; I don't think so. I think you are overstating the case rather dramatically. Mr. SCHUMER. That is because I think you did when you said those two things. Mr. CONOVER. Well, all right. I have outlined in the testimony what our role is as bank supervisor. I have also indicated precisely what the causes of this particular situation were, noted t h a t there were some weaknesses in the way we handled it, and identified the improvements that we have made in our process for the future. Now, I don't think you can take the particular case at hand and extend it logically to a conclusion t h a t you ought not to have a Comptroller's Office or a bank regulatory function, or whatever because it can't get the job done. I think t h a t before even entertaining such a judgment you have to consider the condition of the rest of the banking system and the timely corrective actions t h a t have been taken by the regulators vis-a-vis any number of other problem banks t h a t have restored them to health. Mr. SCHUMER. Can you give me an example? Mr. CONOVER. I will not give you an example. Mr. SCHUMER. That is the problem. Mr. CONOVER. Let me finish what I was going to say. I will not give you an example of a specific bank because I don't want to name a bank t h a t is open today, and by definition we are talking about a bank t h a t is open today. I will, however, provide you with the following information. As of 1980, when Penn Square became a 3-rated bank originally, there were some 250 banks t h a t were also rated 3 at that particular time. We have gone through and traced exactly what has happened to those banks since then, and I will provide this to you in writing. Now, recognize t h a t you could do this for banks t h a t were rated 3 or 4, or whatever, at any point in time. The data for t h a t particular group of banks indicates that some 65 percent of them have been returned to health and are now rated 1 or 2. Another very large number of them remain rated 3 today but have not deteriorated from t h a t status. A much smaller percentage have declined to 4 or 5 or have failed. Mr. SCHUMER. HOW many have been money center banks or extremely large banks? You never let us see the details so we are sort of groping in the dark here too, but it is my hunch t h a t you do a much better job in examining little banks than big banks. I mean, the people here yesterday didn't even know what was going on in the oil and gas division of midcontinental division of Continental Illinois until it was in their words "too late." How many were large banks? How many of those banks were in the top 50 banks of this country? Mr. CONOVER. I don't know off the top of my head. Mr. SCHUMER. Could you get me that? Mr. CONOVER. I will. Mr. SCHUMER. Was it more t h a n one? 344 Mr. CONOVER. As I said, I don't know. I will provide you with t h a t information. Mr. SCHUMER. My guess is it wasn't very many. My time has expired. Chairman S T GERMAIN. Mr. Conover, we have been in touch through staff with the FDIC and I will ask Mr. Dugger on our staff to tell you what we determined. Mr. DUGGER. Basically, Mr. Northup and Mr. U n t h a n k do not have a clear idea of what you mentioned, the exact analysis you talked about. Chairman S T GERMAIN. YOU asked for what? Mr. DUGGER. I asked them pursuant to the chairman's request, t h a t a copy of the analysis Chairman S T GERMAIN. What type of analysis? Be specific. Mr. DUGGER. A payoff analysis or liquidation value analysis, a purchase and assumption analysis, comparable to what is done with banks in terms of analyzing whether they should be liquidated, assisted, or merged. Chairman S T GERMAIN. And the answer was? Mr. DUGGER. The answer is t h a t while they have looked and looked, they don't have any specific formal analysis of that sort. Chairman S T GERMAIN. And then they asked Mr. Isaac. Mr. DUGGER. Mr. Northup asked Mr. Isaac. Mr. Isaac said he was not aware of one. I am reporting what Mr. Northup said. Chairman S T GERMAIN. What type of analysis did you see, Mr. Conover? Mr. CONOVER. Well, there were analyses t h a t were performed as Chairman S T GERMAIN. SO you can be more specific with the FDIC. Mr. CONOVER. I don't think we are going to reach a conclusion on t h a t while we are sitting here today. Chairman S T GERMAIN. I don't want to wait too much longer. We have been trying for 3 or 4 weeks now to get this. Mr. CONOVER. I understand. Chairman S T GERMAIN. And I am looking to you to help me. Mr. CONOVER. I think what we are talking about are analyses of the impact on the insurance fund of alternative ways of handling Continental in terms of a payoff, in terms of a merger with other banks, and in terms of the final solution t h a t was put in place. Chairman S T GERMAIN. All right. Mr. CONOVER. That information exists. Chairman S T GERMAIN. OK, because you saw those analyses. Mr. CONOVER. It may not be on the same form t h a t is normally used when the FDIC calculates the cost of doing a purchase and assumption. Chairman S T GERMAIN. For a smaller bank, because this is a great big institution? Mr. CONOVER. That is correct. Chairman S T GERMAIN. SO it would seem to me it would be easier to find. Mr. CONOVER. But the substance of t h a t information is available. 345 Chairman S T GERMAIN. The substance. I hope you are not saying t h a t the analysis couldn't be made because there isn't substantive information available to make the analysis. I am hoping t h a t the analysis was made. Mr. CONOVER. No; I am not saying that. I am saying the information is available. I am saying don't be surprised if it isn't on the same form t h a t is normally used when an evaluation of a bank is being made. Chairman S T GERMAIN. NOW I will ask Mr. Dugger to go back and maybe we will have Mr. Northup here with Mr. Isaac so he can talk to the Comptroller before he leaves. Mr. Patman. Mr. PATMAN. Thank you, Mr. Chairman. Mr. Conover, is it correct to say t h a t the decisions made on what the Government would and would not do with respect to Continental Illinois and its holding company, those decisions were made by yourself, Mr. Volcker, Mr. Regan, and Mr. Isaac? Mr. CONOVER. Yes; t h a t is correct. Mr. PATMAN. Did you have any communication with the White House or Executive Office building during this time that you were working on this issue? Mr. CONOVER. N O ; we did Mr. PATMAN. YOU didn't not. have any idea about the White House position on this? Mr. CONOVER. N O ; we didn't. Mr. PATMAN. None of you did to your knowledge? Mr. CONOVER. That is correct. Mr. PATMAN. Each one of you is a White House appointee? Mr. CONOVER. That is correct. Mr. PATMAN. YOU didn't check to make sure you were doing what the White House wanted you to do in this? Mr. CONOVER. That is correct. We were operating under statutory authority contained in the various acts that grant the FDIC and the Fed powers in such situations, and there wasn't any particular reason to contact the White House since we knew t h a t the right way to handle it was in a way t h a t was totally devoid of any political input. Mr. PATMAN. I don't know that you can say it is totally devoid of any political input. You are all political appointees, but let me ask you was there any dispute among you about what should be done? Mr. CONOVER. Was there any dispute among us? There were conversations throughout the process as to what the right way to go was. Mr. PATMAN. And there were differences of opinion? Mr. CONOVER. And there were differences of opinion throughout, just as you would expect there to be. Mr. PATMAN. Who came up with this solution? Chairman S T GERMAIN. Mr. Patman, why don't you ask if it was an opinion whether or not they should bail it out or let it fail? Mr. PATMAN. That is what I would like to get to. Who came up with the final decision t h a t was adopted for the final proposal? Mr. CONOVER. Well, the FDIC Mr. PATMAN. Did you do it or did the FDIC? 346 Mr. CONOVER. The FDIC played the lead role in negotiating with the banks and structuring the deal. Mr. PATMAN. Did any of the four of you suggest t h a t the bank should be allowed to fail? Mr. CONOVER. We talked at some length as to whether the bank should be closed or not. Mr. PATMAN. Did one or two of you or three of you perhaps advocate t h a t the bank be closed? Mr. CONOVER. NO; I don't think so. Mr. PATMAN. Did any of you ask and strongly recommend t h a t the bank be closed? Mr. CONOVER. We laid out and discussed the pros and cons of doing it open versus doing it closed. There were differences of opinion as to the importance of various pros and cons. When all was said and done, there was a unanimous conclusion t h a t the bank ought to be handled through an open bank transaction, as it was, in fact, handled. Chairman S T GERMAIN. Bill, ask about Secretary Regan. What was his opinion? Mr. PATMAN. Did not Secretary Regan put out a statement at one time casting strong doubt as to the legal basis for any takeover of the bank, or what you did? Mr. CONOVER. Secretary Regan's statements focused not on whether the bank ought to be provided with assistance in an open bank fashion, but on whether the FDIC ought to buy preferred stock in the holding company or debt of the bank, a highly technical aspect of the deal t h a t we had discussed at some length earlier. Mr. PATMAN. Were you prevented from extending a loan to the holding company? Why buy prefered stock where you have a place in line behind the bondholders? Mr. CONOVER. That was precisely the technical issue t h a t was brought up. Mr. PATMAN. In other words, they could not issue preferred stock because of some agreement with the bondholders, and furthermore, they could not issue additional bonds, is t h a t what you are saying? Mr. CONOVER. They could not issue preferred stock in the bank, where it would have been preferable for the FDIC. Mr. PATMAN. Right, but did you take preferred stock in the holding company or the bank? Mr. CONOVER. We took preferred stock in the holding company, with the negative result t h a t it provided a direct propping up of holding company bondholders and commercial paper holders. Mr. PATMAN. Could you not have taken a position as a bondholder to the holding company? Mr. CONOVER. NO; t h a t wouldn't have worked because we wanted to gain 80 percent control of the shares in the overall corporation. Mr. PATMAN. But you have the power to take complete control over the bank; do you not? Mr. CONOVER. In what sense? By closing the bank, sure. Mr. PATMAN. DO you not also have the power to remove the officers and substitute others of your choice? Mr. CONOVER. Yes. Mr. PATMAN. IS that not taking over the bank? 347 Mr. CONOVER. Well, t h a t was done as part of the agreement with the FDIC. Mr. PATMAN. IS your power limited to simply closing the bank? Is that what you want us to think? Were you limited in the powers? Mr. CONOVER. I am not sure whether you are focusing on what the Comptroller's Office powers are or whether you are talking about the structure of the deal. Mr. PATMAN. All of the powers really, but first of all, the Comptroller's Office doesn't have sufficient powers in your judgment. Mr. CONOVER. I didn't say that. Mr. PATMAN. With respect to the holding company. Mr. CONOVER. The Comptroller's Office doesn't have any power with respect to the holding company. Mr. PATMAN. Then the only powers you have in this four-part agreement came from the Federal Reserve, is t h a t true? Mr. CONOVER. The deal was struck between the Federal Deposit Insurance Corporation and the bank. Mr. PATMAN. Does the FDIC have any powers over the holding company? Mr. CONOVER. They have the power under the Federal Deposit Insurance Act to provide aid to the holding company if it is pursuant to the rescue of an insured bank. Mr. PATMAN. But would you not say then t h a t your agency, the FDIC and the Treasury Department have no powers with respect to holding companies as far as compelling the performance of certain things you would like to see performed by the holding company? Mr. CONOVER. That is correct. Mr. PATMAN. Only with the Fed do you get any power in this case? Mr. CONOVER. The FDIC had powers vis-a-vis the holding company in this particular transaction, as I have just indicated. The Fed, of course, has authority over the holding company as its primary Federal regulator. Mr. PATMAN. DO they have as many powers as you do over the bank, over the holding company? Mr. CONOVER. DO they have as many powers over the holding company? Mr. PATMAN. DO they have fairly complete powers? Mr. CONOVER. As I understand it, they do. Mr. PATMAN. With the holding company. Chairman S T GERMAIN. Bill, would you yield for a second? Mr. PATMAN. Yes, sir. Chairman S T GERMAIN. I think I would trend along with you. Mr. CONOVER. Please. Chairman S T GERMAIN. The FDIC now many shares of stock? Mr. CONOVER. Oh, I don't remember the amounts to 80 percent. Chairman S T GERMAIN. That is what I stock. Mr. CONOVER. Yes. like to pursue the same owns, or will own, how number of shares, but it mean, 80 percent of the 348 Chairman S T GERMAIN. Therefore, they appoint a new board of directors. Mr. CONOVER. Well, not precisely. The bank will elect the board of directors. Chairman S T GERMAIN. Who elects the board of directors? The shareholders? Mr. CONOVER. The shareholders. Chairman S T GERMAIN. And who owns 80 percent of the shares? The FDIC? Mr. CONOVER. The FDIC does. Chairman S T GERMAIN. SO who is going to elect the board of directors? Mr. CONOVER. I am not sure how the FDIC exercises its voting rights. Chairman S T GERMAIN. And if Ogden and Swaringen don't perform well, the FDIC, I hope will remove them and replace them? Mr. CONOVER. That is correct. Chairman S T GERMAIN. Because of the moneys involved? Mr. CONOVER. That is correct. Chairman S T GERMAIN. IS t h a t what you are looking for? Mr. CONOVER. That is correct, but not because of the moneys involved—because they were not doing the job in turning the bank around t h a t they ought to be doing. Chairman S T GERMAIN. The fact of the matter is, because 80 percent of the shares have been purchased by the FDIC, all of the billions of dollars going in there are from the FDIC. Mr. CONOVER. That is correct. Chairman S T GERMAIN. SO they better watch over it. If the bank starts going to energy loans again, the FDIC will say stop; won't they? Mr. CONOVER. The FDIC has said t h a t it will exercise its rights as a shareholder, that it will try not to interfere in the day-to-day management of the bank. Chairman S T GERMAIN. But the shareholders control the board of directors. Mr. CONOVER. That is right. Chairman S T GERMAIN. The board of directors have a fiduciary responsibility? Mr. CONOVER. That is correct. Chairman S T GERMAIN. Therefore, they run the bank? Mr. CONOVER. That is true. Chairman S T GERMAIN. SO the FDIC, the Federal Government is running t h a t bank. Amen. Mr. Patman. Mr. PATMAN. The preferred stock, does it have any voting powers? Mr. CONOVER. I don't remember. Mr. PATMAN. Just confirm t h a t it does not. It does not, right? All of these money center banks, whether they are called Chase Manhattan, Citicorp, or what have you, are holding companies, are they not? Mr. CONOVER. They all have holding companies, yes, sir. Mr. PATMAN. And they are parts of holding companies? Mr. CONOVER. Banks are parts of holding companies, yes. 349 Mr. PATMAN. The only way that you can really effectively control one of these bailouts, if you want to call it that, and I doubt that you do, would be to have some access to control over the holding company or regulatory authority over it, is that not true? Mr. CONOVER. I am not sure what you are getting at. We were dealing with the bank and not with the holding company. The fact t h a t the holding company owned the bank wasn't a problem except to the degree that there were some restrictive covenants in the indentures on some of the holding company bonds. We knew that was a problem, and, as I have indicated earlier, we know how to correct it so t h a t it won't be a problem in the future. Mr. PATMAN. The assets of the holding company are not subject to the debts of the bank, is that true? Mr. CONOVER. The assets of the holding company? That is correct. Mr. BARNARD. Mr. Patman, would you yield? Mr. PATMAN. Yes, sir. Mr. BARNARD. This is not the first time that the FDIC has taken stock in a bank, is it? Mr. CONOVER. N O , it is not. Mr. BARNARD. In other words, there is a precedent for this type of settlement as far as a bank is concerned as opposed to a holding company. Mr. CONOVER. I believe that is correct. I think it has been done two, possibly three times. One was in the case of the First National Bank of Midland, TX and one in the case of a New York savings bank. Mr. BARNARD. In the Pennsylvania bank though they took warrants, I believe. Mr. CONOVER. That is correct. Mr. BARNARD. And they still own those warrants. Mr. CONOVER. They own a portion of the original warrants that they took, yes. Mr. PATMAN. A S a part of this bailout procedure, do you enter into a contract with the holding company whereby the holding company permits you to enter into the management of the holding company or influence decisions by the holding company on its management? Or did you simply buy preferred stock? Mr. CONOVER. YOU don't enter into a contract with the holding company whereby you influence the management decisions of the holding company. But, as the chairman has pointed out, the FDIC has the authority to eliminate the top management of the holding company any time it wants to, and it happens to have the signed resignations of each member of the board of directors, which can be executed at any time. Mr. PATMAN. Let me ask you—we know that the depositors of over $100,000 were protected under the arrangement that was made. How about the bondholders and the short-term paperholders; were they protected also, in both the holding company and the bank? Mr. CONOVER. All the creditors of the bank were protected. The bondholders and the other creditors of the holding company ended up being protected by virtue of the way the transaction was struc23 39-133 0—84 350 tured, and that is the one thing we have all agreed is an undesirable outcome and ought to be corrected so it can't happen again. Mr. PATMAN. And if there is a loss taken by the Federal Government because it is up to $3 billion, because of this potential of credit of $15 billion or so, will some of those bondholders be able to come out whole and not suffer a penalty, conceivably? Mr. CONOVER. That is possible in the holding company Mr. PATMAN. IS it possible t h a t the taxpayers take the hit and not any bondholder? Mr. CONOVER. That the taxpayers take the hit? I am not sure. Chairman S T GERMAIN. Could we ask it another way. If, God forbid, the FDIC's plan that has been agreed to by the Comptroller and the Fed were to fail, and despite all efforts Continental still failed, then there would be a loss to the FDIC, and then a potential loss to the taxpayers, but the bondholders of the holding company would be protected? In other words, they would not lose anything. Isn't t h a t the problem with this? They get preferred treatment? Mr. CONOVER. They get preferred treatment, but if the bank were to fail thereby wiping out the investment of the holding company in the bank, chances are t h a t the holding company would have to declare bankruptcy anyway. At t h a t point, whether the bondholders got out scot free would depend on the value of the other assets in the holding company. Chairman S T GERMAIN. But you did tell us earlier this morning—it has been a delightful sojourn here—that even if you hadn't nationalized Continental Illinois National Bank, t h a t the bondholders were in good shape anyway, so t h a t we didn't do them t h a t much of a favor. I am at a loss to understand this now. Mr. CONOVER. The distinction is t h a t with the way the transaction was done, the preferred stock is directly junior within the holding company to the bondholders. If we had been able to buy preferred stock in the bank, the holding company by definition would have been strengthened because its primary asset would have been strengthened. So it is a question of whether you have a direct or an indirect benefit to the holding company bondholders. Clearly, in my mind, the indirect benefit was better t h a n the direct benefit from a public policy point of view. Mr. PATMAN. Are you aware that Continental Illinois, the bank, guaranteed the repayment of certain bonds issued by what has been called WPPSS, Washington Mr. CONOVER. NO, I am not aware of that. Mr. PATMAN [continuing]. Power companies? Mr. CONOVER. NO, I am not aware of that. Mr. PATMAN. HOW about asking your staff if they are aware of that? Mr. CONOVER. NO, they are not. Mr. PATMAN. I understand they did, and in large measure Mr. CONOVER. That is probably why you asked the question. Mr. PATMAN [continuing]. Approximately three-eighths of 1 percent of, perhaps, indebtedness. Would you check into that? Mr. CONOVER. Yes, I certainly will. Mr. PATMAN. And report back to us. Are you aware of any other large bank Mr. CONOVER. What was guaranteed? 351 Mr. PATMAN. Guarantee the repayment of certain bond issues by what is commonly called WPPSS. Mr. CONOVER. Yes. Mr. PATMAN. And some of those different subdivisions of WPPSS, whether they be one, two, three, four, five. Mr. CONOVER. Mr. PATMAN. OK. And so you will check on that, and also do you know of other banks t h a t have guaranteed the obligation of municipalities or other bond-issuing agencies, whether they are public or private? Are you concerned about t h a t type of exposure of risk, and do you ask the banks to report such exposures in your periodic reports t h a t you require? Mr. CONOVER. It is a fairly common practice for banks to issue standby letters of credit in certain municipal financing transactions. Those are treated just like any other credit during an examination and are classified as nonperforming or nonaccrual, or whatever the case may be. If you are asking me whether I see that as being a significant problem in bank loan portfolios throughout the country, I don't. Mr. PATMAN. Fine. But you will check into this? Mr. CONOVER. On the WPPSS question, we will look into that and get back to you with an answer. Mr. PATMAN. A S to the nature and extent. Mr. CONOVER. Yes. Mr. PATMAN. Amount Mr. CONOVER. Yes. Mr. PATMAN. Did you and quantity. attempt to get others to make statements favorable to Continental? Mr. CONOVER. N O , I didn't. Mr. PATMAN. YOU didn't ask Paul Volcker to make a statement favorable to the condition of the bank? Mr. CONOVER. I talked with Paul Volcker about whether he would make a statement, and I discussed with him the statement that I made. He indicated t h a t he would not make a statement regarding the condition of the bank. Mr. PATMAN. Was he more doubtful about the bank t h a n you were? Mr. CONOVER. N O . YOU will have to ask him that. I think that Mr. PATMAN. What did he tell you? Mr. CONOVER. He told me t h a t he didn't want to make a statement. Chairman S T GERMAIN. HOW about Bill Isaac; the same thing? Mr. CONOVER. At t h a t time, Bill Isaac was not in an official position to make a statement regarding the bank, so the issue never came up. Chairman S T GERMAIN. Mr. Barnard suggested we rename the bank Continental National National Bank. I am a little intrigued here. You say everybody was on the same wavelength here about what you did? Those aren't the stories t h a t I was getting, and I know they might have been rumors. It seems to me—didn't Secretary Regan, who I think under whom you serve, have a legal opinion prepared as to whether or not 13(c) or 13(c)(1) was applicable? 352 Mr. CONOVER. Yes, he did. Chairman S T GERMAIN. And didn't he have t h a t done because he was upset about what was happening, and he didn't want this course of action to be taken? Mr. CONOVER. He had a legal opinion prepared by the Office of Legal Counsel in the Justice Department. Chairman S T GERMAIN. N O , he had one out of his own office. You see, I have read them all. Mr. CONOVER. He also had one done by his own office. Chairman S T GERMAIN. Yes, sir. Mr. CONOVER. But if you get to the underlying reason for that, it all had to do with the technical structure of the transaction t h a t we have already discussed. Chairman S T GERMAIN. He was concerned about whether or not it could be done at all under 13(c) and 13(c)(1). Mr. CONOVER. But, Mr. Chairman, the underlying reason for the preparation of those opinions was t h a t the Treasury Department did not like the technical structure of the transaction in which preferred stock was going to be taken in the holding company. They were doing everything they could at t h a t particular time to express t h a t point of view as forcefully as they could, to get it structured in a different way. Chairman S T GERMAIN. And Mr. Volcker, as I understand it—I am going to ask him the same; but you were there so I am sure you had discussions. Wasn't Paul Volcker concerned primarily with the holding company aspect and the effect of allowing the bank to fail and therefore the holding company to go bankrupt on all other holding companies around the country? Mr. CONOVER. He was. Chairman S T GERMAIN. Indeed he was. And now Mr. Conover, are you telling me it is ab initio, t h a t Mr. Isaac was all excited and enthused about the course of action t h a t eventually was taken, after having bitten the bullet in Penn Square? Mr. CONOVER. I am sorry, I didn't understand your point. Chairman S T GERMAIN. Bill Isaac, ab initio—that means from the very beginning—was he all excited about taking the course of action that was eventually taken, in view of the fact t h a t he had bitten the bullet hard on Penn Square and delivered a message to this banking world: If you don't manage properly we are going to shut you down, stockholders and others are going to take the losses. Mr. CONOVER. If your question is whether Bill Isaac was in favor of doing a payoff of the bank, certainly not to my recollection. Never in the course of the discussions, t h a t I can recall, did he express an opinion t h a t Chairman S T GERMAIN. Right from the beginning he felt t h a t Continental should be kept open at all costs? Mr. CONOVER. A S I indicated earlier, we evaluated the pros and cons of an open bank versus a closed bank transaction, as anyone would expect us to. Chairman S T GERMAIN. NOW, how did you evaluate that? Mr. CONOVER. By sitting down and literally preparing a list of the advantages and disadvantages of each course of action. Chairman S T GERMAIN. Bill Isaac and who else sat down? 353 Mr. CONOVER. We prepared such a list in our office, and discussed it with people from the FDIC. Chairman S T GERMAIN. But I thought you said you sat down and looked over the alternatives? Mr. CONOVER. Well, if you Chairman S T GERMAIN. Did you sit down with Bill Isaac? Mr. CONOVER. Yes. Chairman S T GERMAIN. And who else? Mr. CONOVER. There were meetings Chairman S T GERMAIN. Excuse me, was Was Paul Volcker there? Paul Volcker there when you had this discussion? Mr. CONOVER. N O , I don't believe he was. Chairman S T GERMAIN. Just you and Bill Mr. CONOVER. N O . S T GERMAIN [continuing]. Mr. CONOVER. N O . Chairman S T GERMAIN. Well, who Chairman As principals? was the other principal involved? Mr. CONOVER. Sprague, as the other FDIC Director. Chairman S T GERMAIN. OK. Mr. CONOVER. And staff from the Comptroller's Office and the FDIC. Chairman S T GERMAIN. DO you know which staff from the FDIC was there? Mr. CONOVER. N O ; I don't. Those meetings tended to take place with a horde of people present. Chairman S T GERMAIN. All right, because I have staff from the FDIC on their way up here right now, so we can find out. Are you now telling me t h a t it wasn't a computer one, it wasn't only the ordinary analyses done for the small banks, but rather just sitting down and writing down on a memo pad what you thought the costs would be? Mr. CONOVER. We are shifting gears now, right? Chairman S T GERMAIN. I don't know who is shifting the gears. You are the one t h a t just told me. Mr. CONOVER. I think you just shifted the gears from a discussion of whether it would be an open bank versus a closed bank transaction. Chairman ST GERMAIN. Correct. Mr. CONOVER. TO what the costs of the various alternative ways of handling the bank might be. Chairman S T GERMAIN. Doesn't t h a t come into the decisionmaking process? Mr. CONOVER. Yes; t h a t is part of it, but there are other considerations besides the pure numbers. Chairman S T GERMAIN. The FDIC Act requires t h a t the least costly method be utilized, does it not? Mr. CONOVER. Yes; it does. Chairman S T GERMAIN. What is the citation here? Section 13(c)(4)(a) says the least costly method should be utilized. Now, how can you know what the least costly method is t h a t is being utilized unless you perform the actual analyses, rather t h a n just sitting down with a memo pad? Mr. CONOVER. I agree with that. 354 Chairman S T GERMAIN. OK. Was t h a t done? Mr. CONOVER. There were cost analyses t h a t were performed, and they were looked at. Chairman S T GERMAIN. Cost analyses were performed by the FDIC? Mr. CONOVER. Yes; by the FDIC. Chairman S T GERMAIN. Because you said you didn't have them in your shop. Mr. CONOVER. That is correct. Chairman S T GERMAIN. Mr. U n t h a n k and Mr. Graham Northup are on their way. Maybe we can tell them what we are looking for and seeking. Mr. PATMAN. Mr. Chairman, may we ask for the record t h a t he present such memorandums as he does have in his possession? Chairman S T GERMAIN. We have those people coming here. Mr. Wortley. Mr. WORTLEY. Thank you, Mr. Chairman. We are coming into the grand finale here, Mr. Conover. I am worn out listening. I would just like to follow up on my line of questioning from yesterday regarding the transmittal of the examination findings. It is my understanding t h a t the national bank examination reports are transmitted to the bank's board of directors with a cover letter from the Deputy Comptroller of Multinational Banking which sets forth those matters upon which the board is expected to act. It is my understanding t h a t the board is supposed to review the transmittal letter and the examination report and reply in a rather timely fashion to the items noted in t h a t letter. Continental Bank took 8 months to reply to Deputy Comptroller Billy Wood's 1979 transmittal letter. It took 7 months to reply to his 1980 letter, and it took 5 months to respond to his 1981 letter. Are these time periods comparable to the length of time t h a t other large multinational banks would take or consume? Mr. CONOVER. N O ; they are not. They are too long. Mr. WORTLEY. Did you do anything to prompt them along? What is the normal period of time a multinational bank would take to respond? Mr. CONOVER. It depends a little bit on the date you begin measuring from. The report is normally submitted to the board, then there is a board meeting held at which representatives from the Comptroller's Office—that includes me—present the examination findings and discuss them with management and the board. It is unlikely t h a t the bank would respond prior to t h a t meeting. If you measure the lapsed time from the date on the letter signed by the Deputy Comptroller for Multinational Banking to the date on the letter in which the bank responded, you get a distorted picture because sometime after the report is given to the board, anywhere from 4 to 6 weeks later, we would have this face-to-face meeting. Mr. WORTLEY. Does the board have two meetings on this letter? In other words, they receive it at one board meeting. They talk about it, and then at a subsequent board meeting a representative of the Comptroller's Office sits down and reviews it with them, and they respond to some of these critical 355 Mr. CONOVER. The report is distributed to them, and they read it. Whether they choose to discuss it among themselves prior to our meeting is up to them. So they may very well end up having a discussion on the subject at the board level on two different occasions. In any event, after they have received it, have read it, and have had a chance to digest it, we have a meeting with them in which usually a slide presentation is given by the examiner in charge. In the most recent case of Continental t h a t would have been Mr. Kovarik. Mr. WORTLEY. This was 7 to 8 months we are talking of? Mr. CONOVER. I understand what you are saying, and I said t h a t that was too long, and I am just indicating t h a t there is Mr. WORTLEY. What is the normal timespan? Mr. CONOVER. A more normal timespan would be about 2 months. Mr. WORTLEY. About 2 months? Mr. CONOVER. Yes. Mr. WORTLEY. Mr. Woods' October 25 examination report transmittal letter puts Continental board of directors on notice regarding significant problems in the bank system of identifying and rating problem loans. I quote him: "The importance of the liability of the internal loan evaluation procedures as an early warning mechanism to control credit quality in a growth environment cannot be overemphasized." It took Mr. Miller of Continental Bank 8 months to reply to that letter, and in his reply he downplayed the significance of Mr. Woods' comments. Mr. Woods' 1981 transmittal letter contained a variety of comments to Continental's board regarding such matters as the 82 percent ratio of criticized assets-to-growth capital funds, and the fact that capital had not kept pace with the asset growth. An internal Comptroller memorandum of July 22, 1981, said regarding Continental's response 7 months later, and I quote: The recently received response to the J u n e 30, 1980, examination does not address all matters highlighted either in the transmittal letter or in Mr. McCarte's letter to the board. The letter appears to have been put together hastily. Bank personnel apparently were embarrassed when it was realized a response had not been prepared. Now, is a 7 months' delay in a cursory written response the normal pattern for money center banks? Mr. CONOVER. N O , it is not the normal pattern. Responses need to be made in a more timely fashion by all money center banks. Certainly the particular case you cite is unacceptable. Mr. WORTLEY. Would it be advisable to give institutions a specific period of time in which to respond, so situations like this do not drag on? Mr. CONOVER. Yes, it would. Yes, it will. Mr. WORTLEY. YOU will, t h a n k you. I think these letters and responses of Continental Bank and the Comptroller's assessment of those responses ought to be made a part of the hearing record, and I would ask unanimous consent that the 1977 and 1982 letters and responses be placed in the record at the proper place. Chairman S T GERMAIN. Along with the others t h a t have already been entered. 356 Mr. WORTLEY. With 1979, 1980, and 1981. Chairman S T GERMAIN. IS there objection? The Chair hears none. It is so ordered. [In response to the request of Congressman Wortley, the transmittal letters pertaining to OCC examinations dated 1977 and 1982 were submitted for the record by Mr. Conover:] 357 PERTAINING TO OCC EXAMINATION COMMENCED: April 25, 1977 CLOSED: March 31, 1977 LETTER TO THE BOARD OF DIRECTORS A general examination of your bank commenced April 25, 1977 using financial information as of March 31, 1977. The examination was conducted in accordance with standard examination procedures of the Office of the Comptroller of the Currency. This report consolidates information from the International Report of Examination, which should also be reviewed and referred to for more detailed information concerning your International activities. The level of criticized assets continues to be of concern, even though a reduction is shown. $1,459 million or 122% of gross capital funds are subject to criticism at this examination compared to $1,546 million or 151% at the Februaary 1976 examination. Meaningful reductions are noted in the level of the most severely classified assets, with the doubtful and loss categories comprising $224 million compared to $391 million at the previous examination. These reductions are a result of an improving economy and the positive steps taken by management to reduce exposures. The majority of your problem assets remain centered in the real estate area where continued emphasis must be placed on seeking final resolution to the numerous workout arrangements already begun. Your management team has taken, an aggressive stance in its attempts to reduce the bank's exposure to loss in this area, and, given the proper environment, should be able to reduce these problem assets to more reasonable proportions. Your recent capital augmentation and continued earnings retention have allowed the equity accounts to increase to a level more in keeping with the growth attained in recent years. The capital plan set forth through 1979 should provide sufficient amounts to sustain your projected growth over the period; however, continued monitoring of the relationship between capital and other balance sheet categories is necessary. The violations of regulations revealed by this examination have been discussed with management and corrective action has been promised in each instance. The examination disclosed on other matters worthy of comment which were not satisfactorily remedied during the examination. The comments and criticisms included in the comment section of this report should receive the attention of the board as considered appropriate in the circumstances. RICHARD M. KOVARIK, Examiner-in-Charge. (By) BILLY C. WOOD, Regional Administrator. 358 PERTAINING TO OCC EXAMINATION COMMENCED: April 30, 1982 CLOSED: November 19, 1982 COMPTROLLER OF THE CURRENCY, ADMINISTRATOR OF NATIONAL BANKS, Washington, DC December 6. 1982. BOARD OF DIRECTORS, Continental Illinois National Bank and Trust Company of Chicago. 221 South LaSalle Street, Chicago, LL MEMBERS OF THE BOARD: The purpose of this letter is to highlight conditions noted in the accompanying combined report of examination completed November 19, 1982, under the supervision of Senior National Bank Examiner Richard M. Kovarik. This letter is considered a part of the examination report and is to be treated with the same degree of confidentiality. Examination results show the condition of the institution to be seriously deteriorated. While the bank enjoyed a large degree of success during the past five years through a policy of aggressive pursuit of dominance in domestic corporate lending, the portfolio generated during that period is failing to weather the test of a severe and prolonged recession. This has produced unsatisfactory performance and a weakened condition which adversely reflects on, and is the responsibility of both management and the board. While we are confident the institution possesses sufficient management expertise to lead the bank through this current period of difficulty, a comprehensive reassessment of corporate objectives, style, and philosophy is required. Management's and the directorates expressed willingness and apparent ability to initiate appropriate corrective measures are viewed favorably. Current problems can be largely attributed to decentralization of authority without adequate policies, procedures and quality control systems, combined with a management direction that encouraged aggressive growth but failed to hold managers accountable. Several large lending relationships raise prudency questions given that one of the most basic fundamentals of banking is the diversification of risk. The magnitude and severity of existing deficiencies do not lend themselves to short-term resolution. And given the current economic outlook, there remains concern that Continental's problems have not yet peaked which creates uncertainty regarding even further impact on the institution. A program of enhanced supervisory oversight is being implemented by the Office of the Comptroller of the Currency. It will address matters detailed by Examiner Kovarik throughout the report of examination. Matters of serious concern include but are not limited to: inordinately high level of classified and criticized assets (172% and 262% of Gross Capital Funds, respectively): unprecedented volume of nonperforming loans (S2 billion at 9/30/82); seriously elevated loan losses: doubtful assets approximating onefourth of primary capital; inadequate loan support systems, including internal credit review; the need for a separate loan workout department; diminished earnings with mediocre prospects for near term recovery; inability to attract market rate funding from cradi- 359 tional sources: liability structure and balance sheet mix; the serious strain placed on capital and the loan loss reserve by deteriorating asset quality; acute need to reassess and revise, as necessary, corporate goals and objectives and internal policies and procedures especially as they apply to lending, internal controls, and certain internal audit procedures; CINB's tarnished reputation in the global marketplace resulting primarily from asset problems and the bank's relationship with the defunct Penn Square Bank, N.A. Violations of law listed in the report of examination should receive immediate attention. Of specific concern are possible violations of 12 U.S.C. 84 (lending limits) and 12 C.F.R. 9.10 (investment of income cash generated by fiduciary relationships). You should be aware that resolution of this latter item could possibly involve disclosure, and/or restitution, to affected beneficiaries. The bank's legal staff has provided responses to the above matters and both are currently under review by this Office. While the overall assessment of the bank's data processing function was favorable, the inadequacy of hardware back-up and contingency planning in key areas was noted. Further, there is a continuing need to clarify corporate policy regarding data file retention. The results of the Consumer Affairs examination indicate a high level of compliance in most operating areas of the bank, including a favorable CRA assessment. However, cited violation of Federal Reserve Regulations B and Z point up a need to further improve the internal compliance system. Please direct your response to matters cited in the examination report to the Comptroller of the Currency, Administrator of National Banks, Attention: Duputy Comptroller for Multinational Banking, Washington, D.C. 20219 with a copy to the Regional Administrator of National Banks, Seventh National Bank Region, Sears Tower, Suite 5750, 233 South Wacker Drive, Chicago, Illinois 60606. Sincerely, WILLIAM E. MARTIN, Deputy Comptroller for Multinational Banking. Enclosures. LETTER TO THE BOARD OF DIRECTORS A consolidated examination commenced May 24. 1982 using financial information as of April 30, 1982. In order to reduce duplication of efforts and to facilitate a more intense review of specific areas, a portion of our work was limited to a review of internal audit reports and work papers. Where significant exceptions were noted in these audits, additional reviews were made to insure that proper corrective actions were being taken. Areas of interest such as Commercial Lending, Funding, Earnings, Capital. Reserve for Possible Loan Losses and International/External Audit received examination in accordance with the General Examination procedures prescribed by the Comptroller of the Currency. The examination reveals the bank to be in serious difficulty. Experiencing an inordinately high level of problem assets and a sig- 360 nificant volume or adverse publicity occasioned by problem loans (more specifically, the relationship with the defunct Penn Square Bank, N.AJ, the bank's image in the financial community has fallen precipitously. Criticized assets have increased substantially to $5.6 billion and now represent 262% of Gross Capital Funds (GCF), compared to 99% ($1.8 billion) at our previous examination. Even absent the significant portion of criticized assets related to participations purchased from Penn Square ($821 million), criticisms still equal 223% of GCF. Either of these levels is much higher than any of your peers, and the highest level ever witnessed by the bank. Even more important is the increased volume of more troublesome assets (Doubtful and Loans) which amount to $778 million, compared to $209 million at April 30, 1981. All losses listed in this report have been charged-off as of September 30, 1982. Those assets classified doubtful ($548 million) carry significant potential for future loss. The Reserve for Possible Loan Losses, considered adequate at September 30, 1982, must continue to receive close scrutiny to insure its continued adequacy. The increased provision taken in the third quarter, together with management's commitment to closely monitor the reserve, should aid in restoring a cushion to absorb unforeseen problems. Beginning with the effects of the failure of the Penn Square Bank in July, significant change in the Corporation's funding profile has taken place. The effects of the bank's relationship with Penn Square on second and third quarter earnings, together with heightened adverse publicity concerning Continental Illinois Corporation, have added to the ongoing change in the funding profile. Because domestic investors are reluctant to purchase long term instruments, the Euro markets are being heavily tapped in order to maintain a relatively stable mix between long and short term funding. At this time, the funding situation has stabilized and, absent any growth (presently undersirable) or further adverse occurrences, the Corporation should continue to be able to fund itself without significant discount window borrowings. A return to more normal earnings, reductions in the level of problem assets, and a more conservative growth objective for the Corporation, will be necessary to regain investor confidence. 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 reflection 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. This occurred primarily in the Oil and Gas Department of the Special Industries Group," which accounted for the majority of total loan growth over the past year and is the major contributor to the increased problem assets" noted at this examination. Certainly, many bank units have operated effectively and have been able to maintain satisfactory asset quality. This is a reflection on the many good managers in place. There are, however, certain bank units 361 (Oil and Gas and Real Estate Services) where this is not the case. The system of "checks and balances" must be predicated on increased levels of responsibility. Since the responsibility was percieved in some cases to rest solely at the orginating unit, the system was compromised. Internal reports reflected growing problems with respect to the Penn Square participations, but these signals were not heeded by management personnel who were responsible for overseeing lending activities. The asset growth was partially the result of a goal to become one of the leading domestic wholesale banks, but was also driven by a need to show higher earnings to the marketplace. Although earnings growth, in dollars, has been impressive, it has mirrored asset growth. Earnings efficiency has remained relatively unchanged over the past five years. Therefore, in order to show better earnings (in dollar terms) more assets had to be generated. Recent asset growth, especially over the past year, was not generated in concert with strategies necessary to insure that the growth was controlled from the standpoint of quality and the organizations ability to handle the increases efficiently. It had become increasingly difficult to maintain asset quality for a combination of reasons. First, the quality of the pool of available assets had decreased due to economic conditions. Secondly, the internal support staffs (operational and lending) were insufficient to properly handle the volume involved. The lack of adequate support has resulted in increased exceptions to proper credit and collateral documentation, most particularly in the Mid-Continent Division of the.Oil and Gas Department, which housed the Penn Square participations. Without complete and proper documentation, quality is difficult to judge, and more importantly nearly impossible to maintain: ' The system of monitoring credit quality also suffered as numerous problem loans were not brought to management's attention. This was witnessed by the increased disparity between both internal ratings and Watch Loan Reported loans, and CCC criticized loans. The need for an improved system to monitor loan quality has been discussed in prior examination reports, and is even more apparent now. Management has now recognized the need for a strong, independent internal review process to augment the officerinitiated Watch Loan Reporting System and serve as the "check" for Senior Management and the Board. As stated previously, the bank's image has suffered greatly. As steps are taken to restore that image, it is essential that a rethinking include reviews of the proper type and mix of assets: funding sources available and/or desirable to compliment the asset portfolio; and adequate capital requirements for the furture. Then, actions must be taken to insure that everyone is working in a way which will achieve the position desired" with the least degree of risk, and efforts can be intensified to strive for regaining the image which is so important to a money center bank. Because much of that image is dependent upon a consistent, quality earnings stream, a major factor in future strategy will have to be restoring . overall asset quality. Leverage ratios compare favorably with your competitors: however, as the problem asset levels far exceed the norm, the capital 362 base is under increased pressure. Presently capital is considered adequate to support operations but is not sufficient to provide for further growth. As noted above, needs and sources of additional capital should be considered in the assessment of the future of the bank. The examination of the Trust, Electronic Data Processing (EDP) and Consumer Compliance areas generally reflect satisfactory conditions. In the Trust area, the major item of contention is the ongoing failure to invest income cash as prescribed by OCC regulations. A formal interpretation of this matter is expected shortly. Progress has been made in upgrading disaster/recovery contingency plans for EDP operations; however, continued emphasis on this endeavor is needed to insure that ail processing areas can deal effectively with disruptions. The Consumer Compliance examination revealed violations of Regulations B and Z of the Federal Reserve Board. Although the violations of Regulation Z did not result in reimbursement being required, the violations of Regulation B do require the bank to notify affected customers. Steps should be taken to prevent the occurrence of consumer violations, as the effect on the bank could be both embarrassing and costly. Other violations of Law, Regulation and Ruling are listed in the Commercial section of the report. Action should be taken to correct these violations, and the Deputy Comptroller for Multinational Banking should be notified when corrections have been affected. A potential violation of the legal lending limit (12 U.S.C. 84) was discovered during the examination. A formal ruling on this matter has been requested. The bank is facing a most challenging period in its history. Management is considered sufficiently talented to deal effectively with the problems at hand. Senior Management and the Board of Directors have reacted appropriately to identify, isolate and deal with the shortcomings of the past. The improvements recommended in this report, and those contained in management's internal review, should aid in returning the bank to a sound condition. RICHARD M. KOVARIK, Senior National Bank Examiner. WILLIAM E. MARTIN, Deputy Comptroller for Multinational Banking. 363 Mr. WORTLEY. I yield back the balance of my time. Chairman ST GERMAIN. The subcommittee will be in recess for 3 minutes. [Recess.] Chairman ST GERMAIN. The subcommittee will come to order. Mr. Conover, as you have heard in our discussion, the FDIC officialdom is going to provide me with an analyses personally. I can then determine whether the requirements of 13(c)(4)(a) were met. Remember, I asked you a question, you said you would submit for the record about how many loans were made by Continental within the city limits of the city of Chicago. Mr. CONOVER. Yes. Chairman ST GERMAIN. YOU said you would be submitting it for the record. That is going to be most interesting to me, because the requirements of 13(c)(4)(a) states, "* * * no assistance shall be provided in accordance with this section/' If the analysis was made, how could anyone say they complied with that first part of 13(c)(4)(a)? Then we go to the next phrase. "Except that such restrictions shall not apply in any case in which the corporation determines that the continued operation of such bank is essential to provide adequate bank services to its community. We did indeed amend that a little bit because of the savings bank situation in New York, stating it would be hard to say that without a particular savings bank—New York City would go down the tube. So we amended it slightly, but still said the community. Since I wrote this, it is my bill, the community I thought about was not—I was thinking about Chicago Bank, Chicago; Woonsocket Bank, Woonsocket, and Providence Bank, Providence. But the community did not extend to the whole Continental United States of America as well as all of its possessions and territories. So that is why I think that that should have been met, that requirement, the analyses should have been done. Mr. Barnard has a question, then I will go to Mr. Leach. Mr. BARNARD. On that particular question, Mr. Chairman, Mr. Conover, what in the Community Reinvestment Act reports identify the loans being made to the local community? Every bank is supposed to file a community Mr. CONOVER. Yes, they would. Mr. BARNARD. Would those reports be available for the file? Mr. CONOVER. Yes, we will answer the question, so that you will know what volume of loans was made within Chicago, assuming the data are available to do so, and I believe they are. Chairman ST GERMAIN. If you would yield, staff informs me that the examination reports state they were in full compliance with the Community Reinvestment Act. However, I guess we don't have the material on which they based that conclusion. So I know, if the gentleman will yield, we are going to want that. Mr. BARNARD. On a separate examination, if I could get the attention of the staff, it seems at the regular examination, or special examination, the Community Reinvestment Act files are examined, and report filed. Am I wrong there, Mr. Comptroller? Mr. CONOVER. NO, that is correct. 364 Mr. BARNARD. That might be helpful in answering the chairman's Chairman S T GERMAIN. In my letter of September 11, you have been most cooperative, really and truly, in assisting us, as has been the FDIC, but in the letter of September 11, I did ask for the provision of a tabulation of the annual rates of asset growth, the ratio of primary capital—or comparable measures in earlier years—to total assets, the ratio of classified assets to gross capital funds,- the ratio of purchased funds to total deposits, the ratio of rate sensitive deposits plus purchased funds to total deposits, the ratio of reserve for possible loan losses to total loans, and the return on average assets, since 1970 for CINB, for its peer money center banks as a group, and for all national banks as a group. I am sure it was an oversight. We would appreciate your supplying t h a t for the record. Mr. CONOVER. If there are any questions that we haven't answered today Chairman S T GERMAIN. That is what we are aware of. [In response to the request of Chairman St Germain, the following information was submitted for the record by Mr. Conover and may be found on page 369.] 365 O Comptroller of the Currency Administrator of National Banks Washington, D.C. 20219 October 5, 198 4 The Honorable Fernand J. St Germain Chairman Committee on Banking, Finance and Urban Affairs U. S. House of Representatives Washington, D. C. 20515 Dear Mr. Chairman: At the September 19, 1984 hearing on Continental Illinois National Bank, I was asked to provide certain information for the record. That information is as follows: Question 1: Tabulation of the time it takes national banks with the lowest ratings (i.e., CAMEL ratings of 3, 4, and 5) to become sound. The following is a tabulation of the average number of months it has taken to rehabilitate and restore to a sound condition those banks that were under special supervisory attention. The data encompass all those banks that were removed from "problem status" for the period covering 12/31/81 through 7/31/84. Total Assets Number of Banks $100MM and under $100MM to $300MM $300MM and over Overall average Question 2: Average Number of Months to Rehabilitate 146 14 7 3D. 3 39.7 57.3 32.2 The extent of Continental I l l i n o i s ' foreign exposure. 3-31-84 12-31-83 Average foreign loans as a % of average total loans ($10,258MM) 34.1% ($10,433MM) 34.7% Average foreign deposits as a % of average total deposits ($15,288MM) 47.9% ($16,378MM) 49.5% Average number of foreign banks with deposits in Continental, May 1984 * 461 39-133 0—84 24 366 Question 3; Dollar loss to individuals, corporations, etc., if Continental Illinois had been paid out. It is not possible to quantify all of the losses that a payout of Continental Illinois would have caused. The most direct and immediate losses would be those incurred by creditors of the bank and the holding company — i.e., the bond holders and uninsured depositors. However, some of these funds would be recovered as the PDIC liquidated the bank. A large number of banks had uninsured deposits at Continental Illinois. Had the bank been paid out, some portion of those funds would have been lost, and some of the small banks with a sizable percentage of their equity capital on deposit would have failed. Other possible losses include the ripple effect of bankruptcies that might have resulted from losses borne by uninsured commercial depositors at Continental and the other failed banks. Finally, the pay-off of Continental Illinois could have sent shock-waves through the international money markets if holders of jumbo CDs decided not to renew their deposits at other U.S. money center banks. Again, no ready estimate of the losses such a reaction might cause can be made, but the danger to the U.S. banking system could have been sizeable. Question 4; The number of national banks chartered since 1982. The number of national banks chartered between January 1, 1982 and June 30, 1984 is 561. Question 5: A breakdown of Continental Illinois' oil and gas portfolio by type and collateral. Type Rigs Undeveloped Leases Refineries Service & Supply Oil & Gas Reserves Integrated Companies Transmission & Miscellaneous ($MM's) 454 90 866 362 3,160 438 549 Collateral secured by rigs secured by leases secured by refineries, receivables, etc. various collateral secured by reserves generally unsecured to the "majors" secured and unsecured 5,919 (Figures are as of year end 1983 and include letters of credit.) 367 Question 6; The amount of the loan portfolio within the city limits of Chicago. ($000's) Consumer loans in Chicago Commercial loans in Chicago Total 136,943 4,916,513 5,053,456 Savings deposits from Chicago 642,079 Checking deposits from Chicago 942,903 Total 1,584,982 (From information obtained during the 1983 Consumer Examination.) Question 7; The amount of the shortfall to corporate bondholders if the holding company had been liquidated. This question is best answered by the Federal Reserve Board since they are most knowledgeable about the assets of the holding company, including its real property assets. Question 8; Of the 61% of banks rated "3" in 1980 that have returned to health since then, the number which were among the top fifty banks. Of the 61% of banks rated "3" in 1980 that have returned to health since then, five were institutions having assets of $1 billion or more. Question 9: Whether Continental Illinois guaranteed WPPSS bonds. Our examiners could find no evidence that Continental Illinois guaranteed, i.e., issued standby letters of credit for, WPPSS bonds. Question 10; The statistical information you requested in your September 11, 1984 letter. See Attachment. Question 11; save a bank. Considerations that enter into making a decision to There are many ways to handle a failing bank. The most common method is through a purchase and assumption by another bank. Second is liquidation, which involves a payout to the insured depositors. 368 Although Continental was not handled using either of these methods, the solution had virtually the same effect on depositors, shareholders, and management as a purchase and assumption. A number of factors were weighed in making the decision regarding Continental Illinois. Each was considered in conjunction with all the others since they are clearly interrelated. These factors included; overall cost to the FDIC, impact on financial markets and on confidence in the U.S. banking system, legal impediments, impact on borrowers who need further funding to continue their business activities and impact on other depository institutions with deposits in the failing institution. Similar considerations would prevail in dealing with the failure or near-failure of any large bank. Question 12; The statistical information requested by Congressman Barnard. See Attachment. Question 13; The date the last Penn Square Bank loan was sold to Continental Illinois. The last Penn Square Bank loan was purchased by Continental Illinois on June 18, 1982. I hope this information is helpful to the Subcommittee. Sincerely, C. T. Conover Comptroller of the Currency 369 ATTACHMENT C O N T I N E N T A L I L L I N O I S N A T I O N A L B A N K Comparative Data* ASSETS ($ BILLIONS) National Peer CINB Group Banks CINB GROWTH RATE Peer Group National Banks 1970 $8.8 $101.7 $371.7 15.8% 8.0% 11.5% 1971 10.0 110.4 418.2 13.6 8.6 12.5 1972 12.3 133.1 489.4 23.0 20.6 17.0 1973 16.4 166.4 569.5 33.3 25.0 16.4 1974 19.1 202.9 629.5 16.5 21.9 10.5 1975 19.8 203.0 653.7 3.7 0.0 3.8 1976 21.4 221.8 704.3 8.1 9.3 7.7 1977 25.0 256.8 796.8 16.8 15.8 13.1 1978 29.9 289.4 892.2 19.6 12.7 12.0 1979 34.3 334.0 996.2 14.7 15.4 11.7 1980 40.3 371.1 1,095.1 17.5 11.1 9.9 1981 45.1 387.2 1,200.9 11.9 4.3 9.7 1982 41.3 415.0 1,297.2 -8.4 7.2 8.0 1983 40.7 417.3 1,392.8 -1.5 0.6 7.4 *The eight wholesale money center banks included in the peer group are Bankers Trust, Chase Manhattan Bank, Citibank, First National Bank of Boston, First National Bank of Chicago, Irving Trust Co., Manufacturers Hanover Trust Go., and Morgan Guaranty Trust Co. 370 C O N T I N E N T A L I L L I N O I S NATIONAL BANK Comparative Data PRIMARY CAPITAL / ASSETS 1/ CINB Peer Groupg/ National Banks J/ CINB National Banks 3/ 1970 7.45% 6.85% 8.80% 21% 12% 1971 6.93 6.65 8.55 22 12 1972 6.75 5.99 8.29 17 11 1973 5.45 5.18 8.49 21 11 1974 5.09 4.81 8.93 65 16 1975 5.22 5.20 8.86 109 18 1976 5.44 5.17 8.80 121 19 1977 5.03 4.82 8.55 86 19 1978 4.67 4.65 8.70 86 19 1979 4.52 4.41 8.92 80 18 1980 4.39 4.38 9.14 61 21 1981 4.52 4.61 9.37 67 26 1982 5.19 4.69 9.70 172 38 1983 5.41 5.19 9.61 219 52 Primary Capital = Equity Capital + Allowance for Possible loan Losses. In 1976 the definition of the allowance for possible loan losses, a component of primary capital, was changed. Data prior to that year may not be comparable with later data. 2/ unweighted average of individual bank ratios. 3/ Unweighted average data from individual bank examinations. 371 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 Comparative Data PURCHASED FUNDS / ASSETS Peer National CINB Group Banks RATE SENSITIVE /' DEPOSITS National Beer CINB Group Banks 1970 N.A. N.A. N.A. 52.5% 44.5% 30.3% 1971 N.A. N.A. N.A. 56.9 47.7 32.6 1972 N.A. N.A. N.A. 60.4 52.1 33.2 1973 N.A. N.A. N.A. 67.1 61.7 35.0 1974 67.4% 61.1% 9.2% 73.0 66.3 36.6 1975 68.1 61.1 8.5 72.1 66.1 36.8 1976 68.8 62.0 9.0 73.0 63.8 36.4 1977 70.1 62.1 9.4 72.5 64.3 36.4 1978 70.7 64.3 11.2 74.0 67.3 38.4 1979 71.9 64.5 11.8 76.1 67.5 43.5 1980 73.4 66.0 12.6 79.1 71.7 48.6 1981 75.0 70.1 14.1 82.5 79.6 52.6 1982 76.2 69.3 14.7 83.2 80.0 52.2 1983 74.6 65.0 14.0 81.1 76.7 46.5 Purchase Funds = Large CDs + Federal Funds and Repurchase Agreements + Foreign Office Deposits + Other Liabilities for Borrowed Money. Rate Sensitive - Total Deposits - Demand Deposits - Savings Deposits. 372 C O N T I N E N T A L I L L I N O I S NATIONAL BANK Comparative Data APLL / TOTAL LOANS National Peer CINB Group Banks RETURN ON AVERAGE ASSETS Peer National CINB Banks Group 1970 2.77% 2.16% 1.58% 1.10% 1.00% 1.18% 1971 2.14 1.89 1.51 0.97 0.93 0.98 1972 1.81 1.73 1.45 0.90 0.87 0.93 1973 1.69 1.42 1.41 0.74 0.88 0.93 1974 1.64 1.26 1.42 0.63 0.60 0.86 1975 1.73 1.32 1.42 0.65 0.55 0.82 1976 1.20 0.85 0.97 0.65 0.52 0.87 1977 1.06 0.79 0.92 0.61 0.47 0.92 1978 0.99 0.84 0.96 0.58 0.53 1.06 1979 0.88 0.88 1.00 0.57 0.56 1.09 1980 0.88 0.87 1.06 0.59 0.58 1.03 1981 0.86 0.92 1.08 0.55 0.60 0.98 1982 1.14 0.94 1.13 0.17 0.60 0.83 1983 1.23 1.02 1.18 0.25 0.59 0.75 APLL - Allowance for Possible Loan Losses. 373 Chairman S T GERMAIN. Mr. Leach. Mr. LEACH. I would just like to probe, if I could, for a minute one further factor I have heard no discussion of today, but there were some hints of in earlier press releases about the issue. That is when you were considering your various options with regard to Continental, did the factor of concentration or antitrust enter into your thinking? That is, was there a desire to save the bank in order to have greater competition in banking within the city of Chicago? Mr. CONOVER. Discussion arose as to whether it would be appropriate for the bank to merge with the First National Bank of Chicago, for example. And in any consideration of t h a t issue, the subject of competition and antitrust would naturally have been raised. But it never became a live issue. Mr. LEACH. It never was a reason for saving Continental in the first place? Mr. CONOVER. N O . It really never was a reason for saving Continental in the first place. Mr. LEACH. In terms of American banking and Chicago banking, is there any reason for the existence of Continental? Mr. CONOVER. In what sense do you mean that? Mr. LEACH. Let's say Continental could be liquidated at no cost to anyone. Is there a loss to society? Mr. CONOVER. If Continental could be liquidated? Maybe that is not the right word, but we will use it anyway for purposes of discussion. If liquidated in a way in which there was no cost to anyone means t h a t all existing customers have a satisfactory alternative way of being served and so forth, then there isn't a reason for Continental. But you can also say there is no reason for any other bank. Mr. LEACH. The point I am making is t h a t sometimes there is an argument on size grounds to save something t h a t is truly important, a national resource. You wouldn't argue t h a t Continental is of t h a t standard? Mr. CONOVER. N O , we never thought Continental was important as a national resource. We were concerned about the impact t h a t a failed Continental would have on the Nation's financial system. But no one ever said there needs to be this thing called Continental Illinois because it is an old, treasured building and has a long history to it and the world would be terrible without it. Mr. LEACH. SO, it wouldn't be analogous, for example, to losing this committee. I mean, if the Banking Committee went out of existence, I mean there would be a great national calamity. But you wouldn't say t h a t would be the case with Continental. No. Mr. Chairman, I yield back the balance of my time. Chairman S T GERMAIN. Mr. P a t m a n for 5 minutes. Mr. PATMAN. Mr. Chairman, I just want to ask Mr. Conover if he would help us in outlining the guidelines, rules or other considerations that show which other banks or holding companies would or likely would receive the same treatment as Continental Illinois and its holding company. Is it size, purely? Mr. CONOVER. The presumption is t h a t we have established a precedent t h a t all banks or bank holding companies of a particular 374 size or particular nature are going to be treated this way in t h e future. I don't buy t h e fundamental premise. This case was handled in the way it was because of the peculiarities of this particular situation. The bank got to where it was because of its peculiarities as a bank, and we have traced through all t h e forces t h a t came together to cause t h e bank to be in t h e nearly failed condition that it was. Mr. PATMAN. What, in other banks, is similar in t h e way of particular peculiarities, perhaps? Or financial institutions. Mr. CONOVER. There are other banks which, in terms of size or type of lending, or number of offices or number of employees, or any number of things, have some similar characteristics to Continental. But Mr. PATMAN. What would impel you as an individual to ask for consideration to be given to other large financial institutions of any kind in America similar to this? Mr. CONOVER. What would impel me? Mr. PATMAN. Yes. What, in your judgment, would w a r r a n t doing the same thing for another institution? Mr. CONOVER. Under the present set of laws and the present deposit insurance scheme, I think if we found a situation similar in characteristics to this one, in which we could find no buyer, and the only alternative was to provide direct Federal assistance through the FDIC and the Fed or pay off the bank and r u n t h e risk of jeopardizing in a very serious way t h e Nation's entire banking and financial system, we might Mr. PATMAN. If any of the banks got themselves in the same predicament as Continental Illinois, you would anticipate we would do the same thing for them, wouldn't you? Mr. CONOVER. I didn't say it precisely t h a t way. Mr. PATMAN. IS there any one of them t h a t you would not do it for? Mr. CONOVER. I certainly wouldn't answer by identifying one. If conditions existed as in this case, since I think this was a good, sensible solution to the problem at hand, it would make sense to deal with it in the same way. Mr. PATMAN. For any of the other large money center banks? Mr. CONOVER. For any whose failure might have the same impact on the Nation's financial system as we thought this one could have. Mr. PATMAN. TO your way of thinking, wouldn't you say t h a t any of the others, upon failing, would have the same impact? Mr. CONOVER. That is probably true. Mr. LEACH. Would the gentleman yield? Mr. PATMAN. What about the next tier down? Chairman S T GERMAIN. Bill, we have "Alive at Five" going. I think you have made your point. Mr. PATMAN. May I ask for the record he submit to the committee the factors that enter into his judgment on cases of this nature? Chairman S T GERMAIN. A S to how far down they go? Mr. PATMAN. That is right, and what guidelines Mr. CONOVER. N O , I can't submit a list of banks. I certainly don't want to do that. Chairman S T GERMAIN. Not t h e banks. Mr. PATMAN. N O . The considerations. 375 Mr. CONOVER. The considerations that went into this deal? Mr. PATMAN. Just give me 25 considerations that should go into any sort of consideration of this type. Or 10, or whatever you think would adequately cover what you think of when you make your dicision. Mr. CONOVER. All right. Mr. PATMAN. Thank you very much. [In response to the request of Congressman Patman, the following information was submitted for the record by Mr. Conover and may be on page 367.] Chairman S T GERMAIN. Mr. Conover, as a matter of fact, the answer to the question, absent anything occurring statutorily or any other way, were there within the next month, 2 months, 6 months or 1 year to occur another situation such as you faced at Continental, you would not have any alternative Mr. CONOVER. YOU would have to deal with it in the same way. Given the current laws Mr. LEACH. May I ask one followup? There is one thing to say, that one might have to save a particular banking operation. But one of the issues this committee has raised and has been raised in other ways by members of the administration is how you handle every part of the package. For example, would you tell the committee that you must protect bondholders of all types, whether they be of the bank or of the Mr. CONOVER. Absolutely not. I mean, I would not do that. That is what Mr. LEACH. SO you might, in reviewing the situation, you might well take a little bit different approach. Mr. CONOVER. Well, if Mr. LEACH. YOU are not saying that you did everything right. Would you want to suggest to the committee maybe if you did it over, you would do it a little differently? Mr. CONOVER. NO; I am not suggesting that, Mr. Leach. I am saying that there were some outcomes of the way we did it that were undesirable. But by virtue of the structure of the beast we were dealing with, they were unavoidable under the circumstances, such as propping up of the bondholders in the holding company. Mr. LEACH. That was unavoidable? Mr. CONOVER. Unavoidable and clearly undesirable as far as I am concerned. Mr. LEACH. Thank you, Mr. Chairman. Chairman S T GERMAIN. Mr. Conover, are you familiar with the Committee on Banking Regulations and Supervisory Practices an international body known as the Cooke Committee? Mr. CONOVER. Yes; I am. Chairman S T GERMAIN. Are you familiar with its functions? Mr. CONOVER. Yes. Chairman S T GERMAIN. Are any American regulators members of that committee? Mr. CONOVER. Yes. Chairman S T GERMAIN. Which are? Mr. CONOVER. The FDIC, the Comptroller's Office, and the Fed. Chairman S T GERMAIN. For how long? Are they recent members? 376 Mr. CONOVER. The FDIC is a recent member. The Comptroller's Office and the Fed go back 6 or 7 years. Chairman S T GERMAIN. With respect to Continental, did you or anyone in your office have any contact with the Cooke committee relative to the Continental situation? Mr. CONOVER. NO; we didn't have any contact with the Cooke committee. Prior to the consummation or announcement of the deal, we advised the Bank of England as to what was about to transpire. And after the fact, we had two representatives go to London and meet with a group of British bankers and people in the London market Chairman S T GERMAIN. Was one Joe Selby? Mr. CONOVER. Yes. Chairman S T GERMAIN. YOU are aware of his statement t h a t the Cooke committee had a better insight into what was happening t h a n we did here in Washington in relation to Continental? Selby was referring to Continental. Do you agree with Mr. Selby's statement? Mr. CONOVER. I wasn't aware of Mr. Selby's statement until you just read it. Chairman S T GERMAIN. IS t h a t Mr. Selby? Mr. CONOVER. Mr. Selby tells me he thinks t h a t is a misquote, t h a t what he did was call Peter Cooke to find out what the reaction of the London marketplace was to the Continental deal. Since Continental had been funding itself in Europe and, more specifically, in the London markets for some time, and since t h a t was where the crisis in confidence occurred, it was of natural interest to us to find out the reaction of t h a t marketplace to the deal after it was announced. So Mr. Selby talked to Peter Cooke and asked him t h a t question. Chairman S T GERMAIN. Maybe Mr. Selby could correct the Fortune magazine article where he contends they misquoted him. I mean Fortune Mr. SELBY. The Fortune article did not say that I talked to the Cooke committee. It said that I talked to Peter Cooke and the Bank of England. Chairman S T GERMAIN. If t h a t be the case, we will correct our record. [The following quotation is taken from the Fortune magazine article referred to:] [From Fortune magazine, Oct. 1, 1984] As concern mounted last spring about Continental Illinois's problems, Joe Selby in Washington was on the telephone to Cooke at the Bank of England to find out what was being said on Threadneedle Street. "They had a better insight into what was happening than we did here in Washington," Selby remarks. At the Federal Deposit Insurance Corporation, Robert Shumway, director of the division of bank supervision, fielded questions from Cooke Committee members in Ottawa, Brussels, and London, cities in which the Chicago bank had offices. The conversations was frank and functional, participants say, and the callers trusted one another with their deepest secrets because they had come to know one another through the Cooke Committee. Once again the U.S. government passed word via the Cooke Committee t h a t it intended to bail out a bank. The result in effect was a nonevent: bankers shook their heads over Continental Illinois, but the international banking system took it pretty much in stride. 377 Chairman S T GERMAIN. On page 7 of your statement, you say, "This is easy, Continental management announced its decision in 1976 to become one of the top three banks lending to corporate America/' For the record, I wish you would tell me what motivates these people to want to be the top 10 or top 5 or top 3? You know, go, go, go. Is there something hyper about these people t h a t they want to be the biggest? I talked to some of the English bankers. The fellow who heads up Barkleys, a big institution, he makes I think maybe $80,000 a year. He is underpaid, like you. The fellow at Continental, he is making a half million. Maybe t h a t is one of the motivations. I believe you have a golden parachute question, Mr. Barnard? Mr. BARNARD. Mr. Comptroller, I wanted to congratulate you and your staff on a very excellent brief on the question of the golden parachute in this particular situation. And I know t h a t the decision not to void this came about because it said that, given the— industrywide practice with respect to such termination agreements, it will be difficult to establish a violation of either paragraph 18 of our interpretive ruling on the subject contained in 12 CFR. It would be interesting to me to know how much you feel would have been excessive in t h a t situation. At the same time, the last and real conclusion, said it is unlikely the Comptroller would be successful in an enforcement action against Continental and/or Anderson, Miller and Perkins given the nature of their contracts. The bank size, financial condition and industry practice—memo to Robert Serino, it might be advisable for the FDIC, considering the leverage it now has over Continental, to suggest t h a t these contracts should be rescinded as they are not in the bank's best interest. Is t h a t your recommendation? Mr. CONOVER. I think we have to break the compensation provided to the individuals into two parts. One is normal retirement; the other is the 2- or 3-year consulting contracts. I have talked both to the subsequent management of the bank and the FDIC, about this subject. I believe the FDIC is at least considering taking, and probably will take, some action regarding those contracts. Mr. BARNARD. In the event these contracts were in the vicinty of, say, $1 or $2 million in separation, what do you think your decision would have been in that instance? Mr. CONOVER. I don't think the decision is really any different whatever the amounts are. I think the important point is t h a t either the bank, itself, or the FDIC is in a better position to do something about this problem than we are. I think they ought to go ahead and do it. Mr. BARNARD. Of course, the safety and soundness of the bank is the main issue of whether or not these parachutes threaten—I think that is one of the criteria. Mr. Comptroller, I don't expect an answer here now. But we need to put this Continental situation in perspective to the total banking system. One of the questions t h a t the committee has asked of you, which I hope t h a t you will reconsider and try to furnish us, is if you can provide us information which would aid this committee in assessing the overall financial strength of the financial institutions over which you have regulatory responsibility. And if you 378 could do that, I think it would help us in evaluating the total financial system, and not just get an impression of what it is, compared to the condition of one's institution. Mr. CONOVER. I think t h a t is appropriate. Mr. BARNARD. In t h a t I would like for you to include the current trends among national banks with regard to the following financial measures: ratio of primary capital to total assets, ratio of classified assets to gross capital funds and ratio of purchased funds to total deposits, and what is the current overall condition of the banking industry which your office is responsible. I will be glad to give you t h a t in writing. Mr. CONOVER. Fine. [In response to the request of Congressman Barnard, the following information was submitted for the record by Mr. Conover:] Chairman S T GERMAIN. The time of the gentleman has expired. Mr. Conover, we want to t h a n k you for a sterling appearance and I will bet while you were at Yale 2 years behind Stu McKinney, you never in your fondest dreams would have thought t h a t you would spend a day with such congenial company as you have here today. Mr. CONOVER. YOU are absolutely right, Mr. Chairman. Chairman S T GERMAIN. We want to t h a n k you for your assistance and cooperation, not only today but in preparing for these hearings, and we hope we can continue to have the same spirit of cooperation. The subcommittee is in recess subject to the call of the Chair. [Whereupon, at 3:10, the subcommittee was recessed subject to the call of the Chair.] [The following additional information: an article entitled "Central Bankers Have a Hot Line, Too" from Fortune magazine of October 1, 1984; an except from the Federal Register regarding the Comptroller of the Currency's proposed rule on "Minimum Capital Ratios; Insurance of Directives"; and the subcommittee's letter of invitation to the witness Comptroller of the Currency the Honorable C. Todd Conover to testify follow:] 379 MONEY & MARKETS CENTRAL BANKERS HAVE A HOT UNE TOO It connects a worldwide old-boy network of banking regulators known as the Cooke Committee. So far, however, this secretive group has been considerably better at crisis management than at crisis prevention. • by Stephen Fay E VERY SO OFTEN Fernand St Germain, the powerful chairman of the House Banking Committee, publicly denounces a mystery-cloaked international body, the Committee on Banking Regulations and Supervisory Practices. Since no snappy acronym can be formed from those initials, almost everyone knows it as the Cooke Committee, after its chairman, Peter Cooke, a Bank of England official. Among the things that arouse St Germain's ire about the Cooke Committee, an arm of the Bank for International Settlements in the prosperous and discreet Swiss city of Basel, is the secrecy with which it operates. "I'm not telling you a goddamn thing about the Cooke Committee," a Washington member of the group barked at a reporter this summer. The mystery surrounding the committee is diminishing somewhat, but Peter Cooke says: "I will defend to the death keeping a very large part of what we discuss secret." His committee is one of the few international organizations that produces no annual report. The document describing the committee's working arrangements and responsibilities, known as the Basel Concordat, was not published until 1981, six years after it took effect. Even more than the Cooke Committee's secrecy, St Germain resents its lack of accountability ;to the U.S. Congress and his House Banking CommitRESEARCH ASSOCIATE Susan Caminiti tee, along with what he regards as its ings of the Banking Committee, failure to do anything constructive Cooke's upper lip unstiffened. "I about the reckless expansion of inter- would not accept that as a statement of national bank lending, especially to what I actually said," he commented Latin American nations that have tartly. Cooke says his committee sent proved reluctant or unable to pay off a paper to commercial banks in March monumental debts. 1982 on managing international lendSt Germain talks about the Cooke ing. Obviously, many banks ignored Committee in terms of an international the sensible advice it contained, such banking conspiracy, a bankers' plot to as the suggestion that small banks takobscure the need for proper regulation ing part in a syndicated overseas loan of international banking. He has held should make their own assessments of congressional hearings on the Cooke risk and not just accept the lead bank's Committee, and at his order the Gen- criteria. eral Accounting Office is even now inCooke is unequivocal: the commitvestigating the group. Last year the tee could do no more. The committee staff of St Germain's House Banking cannot say to banks, "Thou shalt not Committee wanted to haul P e t e r lend to this country or that," he exCooke in to explain himself and his plains, "because that introduces politicommittee—a proposal; that central cal judgment and it sets up all sorts of bankers, proud of their freedom from shocks and tremors. Who am I to say political oversight, found abhorrent whether the. judgment is right or A compromise was arrived at: the wrong politically? Supervisors don't next time he was in Washington, want to get into the business of runCooke would pay a courtesy call on St ning banks for bankers." Germain. The meeting took place in What then is the Cooke Committhe spring of 1983. St Germain de- tee—St Germain's sinister agglomerascribed it: "When Cooke stopped by to tion of faceless bankers or, as Peter chat with us he pointed out that Bank Cooke and his colleagues would have for International Settlements data indi- it, a useful bureaucratic tool? Orgacated in advance the growing debt situ- nized in 1975 by central bankers, ation in developing countries. I asked the Cooke Committee is made up of him what international banking regula- bank regulators and supervisors from tors did to slow the growth rate re- around the world, who use it as a sort vealed by BIS data. Very frankly, he of hot line for reliable information to said [they did] really nothing or very help them deal with banking problems little, except to discuss i t " and troublesome rumors of problems. Reading this in the published hear- "It serves to make the world a little 380 Beyond Peter Cooke, chairman of the Cooke Committee, looms the round tower of the Bank for International Settlements in Basel. PHOTOGRAPHS BY RALPH CRANE OCTOBER 1, 1984 FORTUNE 139 381 MONEY & MARKETS Central bankers relax in Basel on a warm summer Sunday. From left: Gerald Bouey of the Bank of Canada; Erik Hqffmeyerofthe Danish National Bank; Henry Wallich of the U.S. Federal Reserve Board; and Lord Richardson, former Governor of the Bank of England and the man responsible for the founding of the Cooke Committee. 140 smaller," says an American member, H. Joe Seiby, senior deputy comptroller for bank supervision in the Comptroller of the Currency's office. Making the world smaller means, in banking, making it safer. In March 1980, American regulators used the Cooke Committee to spread the confidential word to central banks abroad that the comptroller had determined to save First Pennsylvania Bank of Philadelphia, 'ifter this word was spread, the outflow of foreign funds from the bank diminished, giving the rescuers time to restructure the bank. Similarly, when the U.S. froze Iranian assets during the hostage crisis that same year, the Cooke Committee was able to flash the reassuring message that the U.S. was determined, despite its action, not to disrupt the system of international settlements. As concern mounted last spring about Continental Illinois's problems, Joe Selby in Washington was on the telephone to Cooke at the Bank of England to find out what was being said on Threadneedle Street. "They had a better insight into what was happening than we did here in Washington," Selby remarks. At the Federal Deposit Insurance Corporation, Robert Shumway, director of the division of bank supervision, fielded questions from Cooke Committee members in Ottawa, Brussels, and London, cities in which the Chicago bank had offices. The conversations were frank and FORTUNE OCTOBER 1, 1984 39-133 0—84 25 functional, participants say, and the callers trusted one another with their deepest secrets because they had come to know one another through the Cooke Committee. Once again the U.S. government passed word via the Cooke Committee that it intended to bail out a bank. The result in effect was a nonevent: bankers shook their heads over Continental Illinois, but the international banking system took it pretty much in stride. P ETER COOKE, at least, is not a secret. He is 52 and an associate director of the Bank of England, where he is in charge of banking supervision. He works overlooking the bank's garden court in an office with a fine molded ceiling over the fireplace and landscapes on the walls. His red leather desk is scrupulously tidy. A history major at Oxford, Cooke was hired by the Bank of England some 30 years ago and developed a taste for international economic administration, working first at the BIS and then in Washington at the International Monetary Fund. Eventually, he became a banking supervisor—a specialist occupation, the delicacy of which is illustrated by the legendary bank supervisor's prayer: "Oh Lord, let there be failures, but let them be small ones." Small failures are instructive; large ones are embarrassing. It was a big failure that led to the establishment of the Cooke Committee: the 1974 collapse of the Herstatt Bank, which threatened to spill over not just into the rest of the West German banking system but across national frontiers. That, coupled with frequent disruptions in international markets in the new era of floating exchange rates, led the Governor of the Bank of England, Gordon (now Lord) Richardson, to expound the doctrine that even good supervisory systems in individual countries are not enough to regulate international banking. The first meeting was held in January 1975 with members drawn from the inner circle of BIS members known as the Group of Ten—the U.S., the United Kingdom, France, Germany, Italy, the Netherlands, Belgium, Sweden, Canada, and Japan. Switzerland and Luxembourg were also present, since they are important centers of international banking. The U.S. was represented at that first meeting by the Federal Reserve Board, though the U.S. is not exactly a member of the BIS. It has no voting rights and no members on the board, but when the central bank governors meet in Basel each month to mull over the state of the world's economies, the Federal Reserve Board's representative, Henry Wallich, has his feet under the table. The regulators and supervisors from Washington are accommodated on the Cooke Committee in the same informal way. The Federal Reserve Bank of New York joined shortly after the committee was organized in 1975. The Comptroller of the Currency's office came aboard in 1978, the FDIC in 1984. The U.S. now has more representatives than any other country on a subcommittee of an organization of which it is not a member. In the few months between Richardson's getting the idea and the committee's first meeting, the Franklin National Bank collapsed in New York, emphasizing the need for an international banking intelligence network that might try to spot and correct bad banking behavior. The first task, Cooke recalls, was for the supervisors to get to know one another's systems; the next was to get to know one another. Once they did so, it was clear that the formal meetings were less productive than telephone conversations between supervi- 382 MONEY & MARKETS sors who had already met in Basel. "Banking supervision is often very sensitive, very confidential, often involving secrecy laws. Personal trust is very important in getting the dialogue going," says Cooke. John Heimann was the first Comptroller of the Currency to take part in the Cooke Committee's informal international network. Now deputy chairman in New York of Becker Paribas, an investment banking firm, which is being sold to Merrill Lynch, he remembers: "The meetings were on a totally apolitical basis, and they created an ambiance of trust and understanding so that any one of us could pick up the phone at any time. I might say to a colleague, 'Look, no memos, no attribution, but I'm scared to death of this position. What have you heard?'" " I might say to a colleague, 'Look, no memos, no attribution, but I'm scared to death of this position. What have you heard?'" One of the Cooke Committee's darker secrets was discovered by Richard S. Dale, an English banker who turned academic for a time. Leafing through documents he obtained from the Federal Reserve Board in 1982 under the Freedom of Information Act, Dale found that the committee's members were confused about the division of responsibility in international banking supervision. He unearthed four different analyses of where primary responsibility lay for bank activities outside a bank's own country—an ambiguity that suggested the Cooke Committee was more a network than a safety net. This conclusion was reinforced by the 1982 failure of Milan's Banco Ambrosiano, which had connections with the Vatican bank. Most public speculation about the case concentrated on the bank's president, Roberto Calvi, who was found hanging from Blackfriars Bridge on the River Thames in London. But the Cooke Committee's private damage report revealed that whatever wickedness Calvi might have contrived, bank supervisors had done nothing to prevent default on loans of $400 million by a Luxembourg subsidiary of Banco Ambrosiano. Luxembourg's bank supervisors thought Italy bore responsibility, while the Italians denied accountability. That was embarrassing. What was worse for creditors was that no central bank was willing to act as lender of last resort, and there was no 142 FORTUNE OCTOBER 1, 1984 institution capable of bailing out the bank and protecting victims. (The Vatican eventually did the decent thing, partially satisfying claims from more than 100 banks in July 1984; after all, Calvi was known as God's banker.) Last year the committee's members agreed on a principle called consolidated supervision, which amounts to this: foreign offices of an American bank ought to be supervised by Washington, a British bank's offices by the Bank of England, and so on. Naturally, supervisors keep an eye on foreign banks operating in their territory, reporting any bad news. T HIS PRINCIPLE is expected to bring a change in West German banking laws. West German banks have been able to use Luxembourg as their base for "offshore" business, effectively avoiding supervision of their international activities by regulators at home. The Cooke Committee, says one member, "has pushed the Germans along" toward embracing consolidated supervision by making banks register their offshore offices with West Germany's Federal Banking Supervisory Office. The Cooke Committee also stated that regulators can forbid a foreign bank to open an office in their countries if they are not satisfied with tl.e quality of supervision in the bank's home capital. Britain has already made use of consolidated supervision. South Korean banks reportedly were told that they would not be allowed to operate in London unless Korea's domestic regulators in Seoul pulled up their socks—which presumably happened: the Bank of Seoul & Trust still has an office in London. The concordat fixing supervisory responsibility is "a guideline and an understanding," says Cooke, who is trying to make sure that it is understood in places like Southeast Asia, the Caribbean, and South America. Since Cooke is anxious not to enlarge the committee, the message is preached at conferences for nonmember regulators and supervisors, such as one in Rome in September. New banking centers like Hong Kong and Singapore have been cooperative in following the principle of consolidated supervision, but prob- lems in the Caribbean persist. Frederick Dahl, the Federal Reserve Board's representative on the Cooke Committee, notes: "When one island tightens up, there's always another to go to." If awkward questions are asked about accounts opened by drug traffickers on one island, they can move on to another water-locked haven. But committee members are also concerned about some big recent decisions by U.S. bank regulators. The worries center on an intriguing philosophical principle established in the insurance industry known as moral hazard. This principle states that increasing insurance serves to heighten chances of loss because the players feel they can afford to take imprudent risks. In banking this means that if commercial bankers believe they will eventually be bailed out by the lender of last resort—a central bank or a body like the FDIC—they will be led to behave less prudently. Because of moral hazard, a central banker who privately admits that a bank as large as Continental Illinois cannot be allowed to fail will publicly reject the logical conclusion that the role of the lender of last resort is to dig up cash to prevent all big failures. "Our message is, 'You can't rely on us,' " says one of Europe's senior central bankers. "We have to leave the banks in the optimum degree of doubt about how or when or to what extent we'll bail them out." On the day late in July that the FDIC announced in Washington its plans to become the custodian of Continental Illinois, Joe Selby of the comptroller's office was in London talking to supervisors and regulators from the world over. Having listened to Selby, one member of the Cooke Committee concluded that because Continental Illinois had been bailed out, it does not follow that the next big American bank to be threatened by collapse will be bailed out too. But is that conclusion really true? If one large, troubled financial institution after another wobbles into the emergency room—Financial Corp. of America, owner of the U.S.'s biggest thrift, was the latest—and none is turned away, it will get harder to keep 'em guessing, as the Cooke Committee likes to do. O 383 Federal Register / Vol. 49. No. 172 / Tuesday, September 4, 1984 / Proposed Rules redemption charges which are applicable in accordance with § 1421.733 and $ 1421.753. Except for wheat, barley, sorghum, or rye, commodities which are reconcentrated shall be transported without cost to CCC. CCC shall increase or decrease the loan to the producer by the amount by which the loan value of the commodity stored in the subsequent warehouse is greater than or less than the value of the original warehouse storage loan. The maturity date of the new warehouse storage loan shall be the maturity date applicable to the original warehouse storage loan. 8. In § 1421.19, paragraph (a) is revised to read as follows: §1421.19 Liquidation of farm storage loans. (a) General. In the case of farm storage loans, the producer is required to repay the loan or deliver to CCC a sufficient quantity of the eligible commodity having a price support value equal to or greater than the outstanding balance of the loan. Deliveries may be either of the identical commodity which is subject to the note and security agreement or of other eligible commodities of the same kind. Deliveries shall be made in accordance with written instructions issued by the county ASCS office which shall set forth the time and place of delivery. CCC will not accept delivery of any quantity in excess of the larger o£ (1) 110 percent of the measured or certified quantity, or (2) a sufficient quantity of the commodity having a settlement value equal to 110 percent of the loan value being settled. Settlement of the quantity delivered shall be made as provided in § 1421.22. If the producer fails to deliver to CCC the commodity pledged as price support loan collateral by the date specified by CCC on Form CCC-691, Commodity Delivery Notice, and if the producer subsequently redeems the collateral by repaying the loan before delivery is accomplished, liquidated damages shall be assessed, in addition to any applicable interest due on the loan, on the quantity of the commodity redeemed. Such liquidated damages shall be assessed beginning on the date following the required delivery date and shall continue until the loan is repaid. Liquidated damages shall be computed by multiplying the loan principal on the repaid quantity by SO percent of the rate of interest charged by CCC with respect to delinquent debts on the date the failure to deliver occurred. a In 11421.22, paragraph (a) is revised to read as follows: §1421.22 Settlement (a) General. Settlement with producers for commodities acquired by CCC as a result of loans made or under purchase agreements entered into under this subpart shall be made as provided in this section and in the applicable commodity regulation. The price support rate at which settlement shall be made shall be determined in accordance with the provisions of the applicable commodity regulations. Settlement shall be made on the basis of the grade, quality, and quantity of the commodity delivered by the producer. In the case of farm-stored peanuts and farm-stored tobacco, paragraphs (b), (c), and (e) of this section shall not apply. In the case of farm-stored rice, paragraphs (b) and (c) of this section shall not apply. *, * • * • * 10. A new § 1421.29 is added to read as follows: §1421.29 Paperwork Reduction Act assigned numbers. The Office of Management and Budget has approved the information collection requirements contained in these regulations in accordance with 44 U.S.C. Chapter 35 and OMB Numbers 05600087 and 0560-0040 have been assigned. Signed at Washington, D.C., on August 28. 1984. Everett Rank, Executive Vice President, Commodity Credit Corporation. IF* Doc. M-23317 Filed B-U-M MS am| pa | mfl COOK 3410-QSHI DEPARTMENT OF THE TREASURY ComptroUer of The Currency 12CFRPart3 [Docket No. 84-291 Minimum Capital Ratios; Issuance of Directives AGENCY: Comptroller of the Currency. Treasury. ACTION: Proposed rale. SUMMARY: Section 980 of the International Lending Supervision Act of 1983 (Pub. L. 98-181, Title IX, 97 Stat. 1153) condified at 12U5.C 3907, directs the Comptroller of the Currency to establish minimum levels of capital for national banks and to require them to achieve and maintain adequate capital. The Office also is required to analyze capital adequacy in taking action on various types of applications such as mergers and branches and in conducting the Office's supervisory activities related to the safety and soundness of individual banks and the banking system. This proposal: (a) Defines capital; (b) establishes required minimum capital ratios; (c) establishes procedures to set higher required minimum capital ratios for an individual bank; and (d) establishes procedures for issuing a directive to require a national bank to achieve and maintain the minimum capital ratios applicable to it. DATE: Comments must be received by November 5,1984. ADDRESSES: Comments should be sent to Docket No. 84-29, Communications Division. Office of the Comptroller of the Currency, 490 L'Enfant Plaza, S.W., Washington, D.C. 20219. Attention: Lynnette Carter. Comments wiii be available for inspection and photocopying. Comments specifically addressing the information collection requirements in §§ 3.7 and 3.12 should be submitted to: Office of Management and Budget, 726 Jackson Place, N.W., Washington, D.G. 20500, Attention: Desk Officer for the Office of the Comptroller of the Currency. Those comments also should be directed to the Comptroller's Office at the above address. FOR FURTHER INFORMATION CONTACT: Susan K. Fetner, National Bank Examiner, or John H. Noonan, Director, Commercial Examinations Division (202 447-1164), or Dorthy A. Sable. Senior Attorney (202 447-1880). SUPPLEMENTARY INFORMATION:. Background Capital performs several very important functions in banking institutions. It absorbs losses: helps to maintain confidence in individual banks and the banking system as a whole; and supports growth. Capital also provides protection to depositors in the event of a threatened insolvency. The Office of the Comptroller of the Currency (Office) has always had a strong concern for the maintenance of adequate capital in individual banks and in the banking system. The protection of depositors and fostering of stability in the financial system are critical to the mission of the Office and capital adequacy plays a key role in the policies and programs used in performing the Office's supervisory functions. A determination of capital adequacy in one of the major objectives of a bank examination and is one of the five components which form the basis of the Uniform Financial Institution Rating System used by the Office in determining the condition of individual banking institutions. Additionally, by enacting the International Lending 384 Feafcgai Register / Vol. 49, No. 172 / Tuesday, September 4. 1984 / Proposed Rules Supervision Act of 1983 (12 U.S.C. 3901 et seq.) (ILSA) Congress has explicitly recognized the importance capital adequacy assumes in the safe and sound operation of the nation's banking system. Although there is widespread agreement as to the importance of adequate capital, there has been vigorous debate over the years among regulatory authorities, bankers, industry analysts and other regarding what constitutes and adequate level of capital. There is general agreement that the capital of any given bank should be sufficient to maintain public confidence in the institution; support the volume, type and character of the business conducted; provide for the possibilities of loss inherent therein: and permit the , bank to continue to meet the reasonable credit requirements of the area served. The quantification of this into an appropriate capital ratio has, however, been the subject of much controversy. Bank capital ratios, relating the amount of bank capital to bank assets, vary in response to differential growth rates in the numerator—bank capital, and the denominator—bank assets. The growth rate of bank assets is affected by the rate of inflation, credit demand, innovations in bank asset and liability management, and the real rate of growth in the economy. The growth rate of bank capital is a function of the rate of return on assets, the retention rate of earnings, and net new issues of capital securities. The "adequacy" of these bank capital ratios is affected by the economic environment in which banks operate and the magnitude of risk inherent in the structure and operating characteristics of individual institutions. Several factors have emerged over the past few years which are accentuating the potential demands on bank capital. The decrease in banks' net interest margins, together with a weakening of loan portfolios brought about by shocks in the domestic and world economy have caused a decline in bank . profitability and increased levels of risk within the system. The competition for financial services has intensified on both an intraindustry and interindustry basifc placing additional pressures on. bank profitability. Further, because of the growing interdependehcy within the system, problems in one institution can have repercussions on other institutions, arguing for stronger capital levels in both individual banks and the system as a whole. Increasing levels of off-balance sheet risks are also a factor in the need for higher capital. The Comptroller, the Board of Governors of the Federal Reserve System (FRB) and the Federal Deposit 34839 provide protection against unforeseen Insurance Corporation (FDIC) have adversities. previously adopted and published capital guidelines which, together with The Proposal the efforts of banks to achieve them, -v The regulation would apply to have been successful recently in national banks and banks located in the preventing a decline in bank capital District of Columbia. The regulation ratios. These policies, while similar, would not apply to bank holding have not been completely uniform and companies; however, when considering have allowed for some disparity in the the condition of or an application from treatment of federally regulated banks. banks which are subsidiaries of holding Section 908 of ILSA (12 U.S.C. 3907) companies, the activities and condition directs the federal banking agencies to (including capital adequacy) of the bank "* * * cause banking institutions to holding company will be considered by achieve and maintain adequate capital the Office. Although the proposed by establishing minimum levels of capital for such banking institutions and regulation would not apply to federal branches and agencies, the Office is by such other methods as the considering imposition of a comparable appropriate Federal banking agency capital equivalency deposit requirement deems appropriate." ILSA also for federal branches and agencies (see encourages uniformity among the Issues for Comment No. 10). agencies in imposing requirements under the Act. Therefore, pursuant to Under the proposed regulation, the the Office's authority under ILSA and minimum acceptable ratio of total the authority contained in the National capital to total assets would be* Banking Act, the Office is proposing a established at six (6) percent (%) and the regulation on capital requirements. The minimum ratio of "primary " capital to FRB and the FDIC also have issued adjusted total assets would be similar capital proposals for comment. established at five and one-half (5 %) The proposed regulation is intended to percent (%). These ratios would apply to implement the provisions of the ILSA, well-managed banks of all sizes which foster further improvement in bank have no material weaknesses. Based on capital ratios, and eliminate the the December 31.1983 Call Reports, disparities in treatment of federally approximately 95% of all national banks regulated banks with respect to capital had a primary capital ratio in excess of adequacy. The proposed regulation also 6%, a level which would exceed the sets forth the procedures, pursuant to primary capital requirement established the authority contained in ILSA, for by this regulation. In addition, most of issuing directives to require banks to the larger multinational and regional achieve and maintain adequate capital. banks (which generally have lower capital ratios than smaller banks) had The proposed regulation will primary and total capital ratios which supplement rather than replace, the would exceed the minimum Office's supervisory evaluations of requirements. A few large banks will be capital adequacy. The process of faced with a relatively large dollar determinig the adequacy of a bank's shortfall in their capital accounts. While capital on an ongoing basis begins with the OCC expects that all banks will a qualitative evaluation of the critical make every effort to achieve compliance variables that directly bear on the as rapidly as possible, the Office will institution's overall financial condition. consider the individual circumstances These variables include the quality, and the ability of each bank to achieve present value, type and diversification compliance. of assets; historical and prospective earnings; liquidity (with emphasis on The proposed regulation represents a asset/liability management); the quality change from the interagency guidelines of management; and the existence of issued by the OCC and the FRB in other activities which may expose the December 1981 and amended in June of bank to risks, including off-balance 1983. Regional and multinational banks sheet items, the degree of leverage and would be subject to an increase in the risks undertaken by the parent company primary capital ratio from 5% ot 5 Ve f% or other affiliates. Banks with significant while community banks would have weaknesses in one or more of these their minimum primary capital ratio areas will be expected to maintain lowered from 6% to 5Vt%. The new total higher capital levels than the minimums capital ratio, as proposed, would be 6%. set forth in the regulation. In addition, Previously, the guidelines had used a the OCC stresses that the capital zone concept based on asset size, to requirements set forth in this proposed determine the nature and intensity of regulation are minimums and that all supervisory action for a particular banks are encouraged to maintain institution. Multinational and regional higher levels of capital in order to banks were presumed to have 385 34840 Federal Register / Vol. 49, No. 172 / Tuesday, September 4, 1984 / Proposed Rules inadequate total capital if below a 5Vfe% ratio, and community banks were presumed under capitalized if below 6% total capital. The zone concept provided some guidance for bankers and regulators in monitoring total capital levels and consideration is being given to continuing use of the zones in conjunction with a minimum capital requirement. (See Issues for Comment, No. 9). Because not all banks will have the secondary capital differs from that required ratios at the time the final rule contained in 12 CFR 7.1100 (See Issues becomes effective, or be able to achieve for Comment, No. 1). the ratios quickly thereafter, the rule Minimum Capital Ratios provides that a bank in compliance with The proposal would require banks to an acceptable plan to achieve the ratios have and maintain a ratio of total will not be considered to be in violation capital to total assets (as defined) of at of the regulation. least 6% and a ratio of primary capital to Finally, the Office has reserved the adjusted total assets of at least 5Y2%. authority to permit a bank to operate These ratios would apply to all national with capital ratios below the minimums banks, regardless of size. However, the when, in the opinion'of the Office, the Primary Capital Definition Office would retain the right to establish circumstances justify such action. This higher ratios for individual banks whose provision might apply for example, to a Primary capital in the proposed circumstances warrant a stronger regulation is defined as the total of situation in which a bank in compliance capital base. In addition, banks which common and perpetual preferred stock, have entered into, or subsequently enter with the minimum ratios would not be in capital surplus, undivided profits, into a written agreement or which are or compliance if it undertook a proposed contingency and other capital reserves, acquisition which would dilute its become subject to a cease and desist a limited amount of mandatory capital or increase its assets. Such an order under 12 U.S.C. 1818 (b) or (c) convertible debt (as defined), minority acquisition,,however, may be necessary requiring higher minimum capital ratios interests in consolidated subsidiaries, or desirable to alleviate a troubled or net worth certificates and the allowance for die bank, must achieve and maintain emergency situation involving another 1 those higher ratios. Similarly, if higher for loan and lease losses; minus minimum capital ratios have been or are bank. In such circumstances, when the intangible assets. The term mandatory Office believes that the acquisition required as a condition for approval of convertible debt is defined to include should be approved, it may specifically an application, the bank will be only those subordinated debt authorize the acquiring bank to have governed by those ratios. instruments that mandatorily convert capital ratios below the minimums into the issuing bank's common or The ratios must be achieved as of during a specified period of time, i.e., the perpetual preferred stock. The definition each Call Report date and will be time necessary for the bank to absorb intentionally doesjiot include calculated in terms of the bank's the acquisition and increase its capital subordinated debt that merely requires reported total capital to its reported to again meet the minimums specified in the issuer to sell stock in sufficient average total assets and its primary the regulation. This provision is not capital to average total assets as amounts to replace the debt obligation, intended to authorize banks below the adjusted. During the following quarter, even though these instruments are required minimums to continue to the bank must maintain this ratio. If considered as primary capital under operate with lower capital ratios or to total assets increase, on average, during OCCs present guidelines. Furthermore, authorize banks to reduce their capital. the quarter, the bank must increase- its for purposes of meeting the minimum capital (unless it is already above the primary capital requirements of this Minimum Capital Ratios for an minimum) before the upcoming Call proposed regulation, mandatory Individual Bank ( convertible debt would be included only Report date, in order to be in As noted above, the general minimum to the extent of 20% of primary capital compliance with the required ratios as captial ratios are intended to apply to exclusive of such debt The proposed of the Call Report date for that quarter. sound banks without any significant regulation limits the amount of Banks which are not able to achieve risks or problems. Higher minimum mandatory convertible debt that-would .the ratios by the effective date of the captial ratios may be appropriate or be included in measuring primary final rule will be required to submit to capital because, while these instruments the Office an acceptable plan to achieve necessary for individual banks depending upon their circumstances. the minimum capital ratios within a contain many of the features of equity The International Lending Supervision reasonable time. The plan itself must be capital, they do not represent equity Act specifically provides the submitted within 60 days after the until actually converted. Comptroller with the authority "to effective date of the final rule and must The proposed definition of primary establish such minimum level of capital set forth the means and time frames in capital thus also differs from that for a banking institution as the [Office], which the bank will achieve the contained in 12 CFR 7.1100 which minimum ratios. The Office understands in its discretion, deems to be necessary defines capital for statutory and - or appropriate in light of the particular that banks that will need to raise or supervisory purposes. The Office willgenerate a substantial amount of capital circumstances of the banking amend that interpretive ruling upon institution." 12 U.S.C. 3907(a)(2). Higher to achieve the ratios will require a adoption of a final regulation under this reasonable period of time in which to do minimum ratios may be estabished for a proposal (see Issues for Comment No. bank and required as a part of a written so and the Office will take this into 1). agreement or a cease and desist order account in reviewing individual bank Secondary Capital Definition under 12 U.S.C. 1818 (b) or (c). or as a plans. Rather than a formal approval or condition for approval of an application. acceptance process, the proposed rule The definition of secondary capital In addition, the proposed rule provides that the bank may consider its would include mandatory convertible establishes a procedure for setting plan acceptable to the Office unless it is debt that is not included in primary higher required minimum capital ratios notified to the contrary. It should be capital (in excess of 20%), intangible for an individual bank. This part of the noted, however, that under this assets, and, subject to certain rule sets out examples of situations restrictions in 12 CFR 7.1100, limited life provision, the Office may subsequently when higher minimum capital ratios require changes in a bank's plan, such preferred stock and subordinated notes may be necessary or appropriate and as an acceleration of the time schedule, and debentures. As in the case of examples of the factors which the Office in the event of changed circumstances. primary capital, the definition of 386 f e d e r a l Register / Vol. 49, No. 172 / Tuesday. September 4, 1984 / Proposed Rules may consider in deciding what a bank's minimum capital ratios should be. These examples are not intended to be exclusive because it is not possible to predict in advance each situation in which higher capital ratios may be necessary or every factor which should be considered in a particular situation. The procedure provides for written notice from the Office to the bank indicating the capital ratios which the Office believes are appropriate for the bank, the date when they should be achieved, and an explanation of why those ratios are considered appropriate. The bank will have thirty days in which it may respond to the Office in writing. After the close of the bank's response period, or after the bank's response is received, if sooner, the Office will consider any response from the bank. Unless further information or clarification of the bank's response is required, or the time periods are extended for good cause, the Office will reach a decision within thirty days after the close of the response period and will advise1 the bank in writing whether higher capital ratios will be required for it and. if so, what those ratios are and when they must be achieved.The Office also may require the bank to submit an acceptable plan to achieve the required ratios established for it. This procedure is intended to provide an informative and fair, but relatively uncomplicated and prompt method of addressing an individual bank's need for higher capital levels. provisions for the directive; and/or may include a plan to achieve the bank's required minimum captial ratios. The response should include any information which the bank would have the Office consider in deciding whether to issue a directive or what the provisions of the directive should be. Failure fo respond within the allotted time period will be deemed to be a waiver of any objections to the proposed directive. After the close of the bank's response period, or after receipt of the bank's response, if sooner, the Office will consider the bank's response and will decide whether to issue the directive as originally proposed or in modified form. Unless the time periods are extended by the Office, for example, in cases where additional information or a clarification of the bank's response is needed, the Office will issue the directive, or notify the bank that a directive will not be issued, within thirty days after the close of the bank's response period. The terms of the directive will vary in each individual case. The directive may order the bank to achieve and maintain its required minimum capital ratios-by a specified date; comply with a previously submitted plan to achieve those ratios; submit and comply with an acceptable plan to achieve the ratios; reduce assets or the rate of growth of assets, or restrict dividends in order to achieve its required capital ratios; or a combination of any of the above or similar actions. A directive, or any plan submitted pursuant to a directive, is enforceable to the same extent as an effective and Directives outstanding order issued pursuant to 12 A directive is a form of order U.S.C. 1818(b) which has become final specifically authorized under the In addition, violation of a directive may International Lending Supervision Act, result in civil money penalties against 12 U.S.C. 3907(b)(2). Issuance of a the bank or its officers, directors, directive of discretionary when a bank employees, or other persons does not have or maintain capital at or participating in the conduct of its affairs. above the level required for it, whether Because of the critical importance of under the general minimum capital adequate capital to the soundness of a ratios set forth in the rule, under a bank's operations, the procedure for decision establishing higher minimum issuance of a directive has been capital ratios for the bank, under the designed to reach a resolution in a terms of a written agreement under 12 prompt, but fair manner and the Office U.S.C. 1818(b). or as a condition for intends to actively seek enforcement of approval of an application. A directive directives in the event of also may be issued when a bank has noncompliance. failed to submit or is not in compliance Issues for Comment with an acceptable plan to achieve its required minimum capital ratios. Comments are requested on the Under the proposal, the Office will proposal and specifically on the notify a bank in writing of the Office's following issues: intention to issue a directive to the (1) Whether the definitions of capital bank. The notice will include reasons for and its components should be the same the action and the contents of the for the purposes of determining capital proposed directive. The bank will have adequacy and for statutory purposes, thirty days in which to respond in such as the lending limits in 12 U.S.C. 84. writing to the notice. The response may The Office adopted one definition for state why a directive should not be both purposes in Interpretive Ruling 12 issued; may propose alternative CFR 7.1100 and believes that the 34841 definitions in this proposed regulation also should govern the determination of capital for both supervisory and statutory purposes since a common definition would avoid complexity and confusion. (2) Whether higher minimum capital ratios are appropriate or feasible. The Office believes that the minimum capital ratios proposed are appropriate for the banking industry in general and are feasible to achieve and maintain. However, the Office solicits comment on whether higher minimum ratios than those proposed should be required now or required in the next year or two, and whether and when it would be feasible for banks to achieve such higher capital levels. (3) Whether the proposed regulation should "grandfather" capital components now-considered primary capital but which would not be included in primary capital under the proposed regulation. The proposed regulation would not change a bank's total capital. However, some items currently included in primary capital—by Interpretive Ruling 12 CFR 7.1100 or bank practice— would instead be included in secondary capital. One such item is mandatory convertible debt which must be repaid through the sale of common or perpetual preferred stock. This type of mandatory convertible debt, commonly referred to as "equity commitment notes" has been issued by sorae>national banks with the Office's approval. Under the proposed regulation, this type of debt would continue to be counted as capital but it would be considered secondary capital The Office believes that banks should be able to continue to include in their primary capital, previously approved and issued equity commitment notes or other similar instruments. Therefore, as a transitional rule, such instruments would be included in primary capital to the extent previously authorized, during the original effective term of the instruments. The other item included in secondary • capital in the proposed regulation is intangible assets. While the Office has not ruled previously that this item is included in primary capital the Office is aware that banks commonly do not exclude intangible assets in calculating primary capital. Comment is requested on the effect on individual banks if intangible assets are excluded from primary capital and, alternatively, the extent to which intangible assets should be includable in primary capital. (4) Whether the reserves for loan and lease losses should be excluded from capital. Since the amount of a bank's reserve for loan and lease losses is 387 34842 . Federal Register / Vol. 49, No. 172 / Tuesday, September 4, 1984 / Proposed Rules , specifically tailored to its loss While asset composition, including risk experience as well as estimated and liquidity, will be considered in an potential losses on particular assets, it Office decision to require capital ratios can be argued that all or at least a above the minimums for an individual portion of the reserve should not be bank, the Office solicits suggestions on considered as capital because it will be ways in which the general minimum depleted. Traditionally, however, these requirements or other regulatory reserves have been-considered as requirements could encourage high capital since they perform one of quality, liquid bank assets. For example, capital's primary functions, i.e., to serve should relatively risk free or liquid as a cushion against losses. The Office assets be excluded or discounted in requests comment on whether all or any computing total assets, with higher portions of loan and lease reserves minimum capital ratios required for the should be excluded from the definition remaining risk assets? of capital (8) Whether the capital ratios should be calculated on the basis of average or (5) Whether limits should be placed actual total assets. The proposed ratios on the amount of subordinated notes are minimum^ and banks are and debentures and limited life encouraged to maintain higher levels of preferred stock that is included in capital However, the Office does not secondary capital. Limits may include want to require banks at the margin to such factors as requiring a minimum make calculations prior to each increase original maturity, discounting the in their asset portfolios. Similarly, the amount that is included in secondary capital based on the remaining maturity, Office wishes to minimize the likelihood of inadvertent or technical violations. and a percentage limit on the aggregate Therefore, in order to avoid these ^amount that can be included in problems, yet assure that the ratios are 'secondary capital. Certain limits now maintained on a relatively constant are imposed in 12 CFR 7.1100 and the basis, total and primary capital would Office believes that those or similar be computed as of each Call Report date restrictions should be placed on these and the capital ratios calculated based types of instruments when they are on average total assets (or average total included in a bank's capital assets less intangible assets) for that (6) Whether limits should be placed Call Report period. Capital and average on the amount of secondary capital that total assets already are required to be can be included in total capital For stated in Call Reports, however, the example, should secondary capital be limited to an amount equal to 50 percent capital ratios would not need to be stated. of primary capital as is now the case under 12 CFR 7.11007 Because the During the following quarter, to components of secondary capital do not comply with the regulation, the bank provide the same degree of protection need only maintain its capital at the obtained through primary capital the levels necaessary to meet the minimum Office believes that a limit on secondary ratios based on the average total-assets capital is warranted, at least when figure in its most recent Call Report determining total capital (capital and However, if the bank's assets, on surplus) for statutory purposes. (See average, increase during the quarter, it Issue no. 1). The Office requests must correspondingly increase its comment on the effects such a limit capital (if at the minimum level) before would have, given the proposed the end of the quarter so that it will be definitions of primary and secondary in compliance with the required capital. minimum ratios as of the Call Report date for that quarter. Use of the average (7) Whether the minimum capital total assets figure therefore, should requirements should be tailored to the risk composition and liquidity of assets. eliminate the potential for inadvertant violations and simplify banks' internal The proposed minimum capital requirements are neutral with respect to procedures for compliance. the composition of a bank's assets, i.e., The Office is concerned, however, the same capital ratio is required for that some banks may have total assets both liquid and illiquid assets and for as of the Call Report dates or otherwise both high and low risk assets. The that are substantially higher than their average total assets so that the bank, Office is concerned that this neutrality while technically in compliance with the may not provide an incentive for banks regulation, actually is defeating its to enhance or maintain the liquidity or purpose, i.e., to assure that banks have quality of their assets. Asset liquidity is the minimum adequate level of capital important since it offers banks an to support their operations. Therefore. alternative to reliance on short term Call Report and examination data on funding, with its inherently volatile total assets will be reviewed and conditions, to meet liquidity needs. compared with the reported average total assets figure, where there is significant disparity-between these figures on a repeated basis, the bank may be required to maintain its minimum capital ratios on a constant basis in relation to its actual total assets. The Office seeks comment on the average total asset method or alternative methods to achieve compliance with the regulation. (9) Whether the zone concept provides useful guidance to banks. The Office is considering whether to issue guidelines in conjuction with the final version of the regulation concerning the degree and type of administrative action which would correspond to particular capital ratio zones. Although these guidelines would be primarily for internal agency purposes, they would be published for the information of bank management. Under the zone concept, the Office would consider banks having a total capital ratio in excess of 7% to be adequately capitalized, absent special circumstances. Banks having a total capital ratio between 8-7% would be monitored to determine whether their capital is adequate in light of the quality of assets, management strength, and other factors. Banks having a total capital ratio of less than %% (the minimum required in the regulation) would be presumed to be undercapitalized and would be subject to appropriate supervision and administrative action. The proposed regulation itself indicates the range of adminsitrative or supervisory actions which the Office may take if a bank does not have the minimum capital ratios required for it or has not submitted or complied with an acceptable plan to achieve those ratios. Since the appropriate supervisory action necessarily must be determined on a case-by-case basis, the zone concept as a guide for adminstrative actions may not be particularly useful. However, comment on the past or possible future usefulness to the banking industry of the zone would be of assistance to the Office. (10) Whether the minimum capital requirement should apply to federal branches and agencies. Under 12 U.S.C. 3102(g), federal branches and agencies are required to maintain capital equivalency deposits which, at a minimum, equal 5% of liabilities. The statutory minimum is roughly equivalent to the 5% minimum primary capital requirement for regional and multinational banks in the Office's current guidelines. However, the International Banking Act oi 1978 (IBA) also mandates competitive equality 388 Federal Register / Vol. 49, No. 172 / Tuesday, September 4, 1984 / Proposed Rules between national banks and federal branches and agencies. Because the operations of federal branches and agencies are not inherently either more or less risky than those of national banks, the Office believes that federal ' branches and agencies should be subject to comparable capital adequacy requirements. However, since the IBA requires that the capital equivalency deposit consist of cash or investment securities and be computed as a percent of liabilities, a capital-to-assets ratio would be difficult to implement. Alternatively, comparability could be attained by requiring capital equivalency deposits for federal branches and agencies equal to at least 5 V % of liabilities, rather than the 2 current 5%. The Office requests comments on this and other means of establishing relatively comparable capital requirements for federal branches and agencies. Regulatory Flexibility Act Pursuant to section 605(b) of the Regulatory Flexibility Act (Pub. L. 96354. 5 U.S.C. 601 etseq.) the Comptroller of the Currency has certified that the proposed regulation, if adopted, will not have a significant economic impact on a substantial number of small entities since nearly all small banks (those with total assets of less than $1 billion) already meet or exceed the primary and total capital ratios proposed in the regulation. Executive Older 12291 The Comptroller of the Currency has determined that the proposed regulation is a "major rule" and a regulatory impact analysis has been performed in connection with the Office's consideration of this rule. In reviewing the impact of the proposal, the analysis considered that: (1) 151 national banks have a shortfall, at a minimum, of $3.3 billion in primary capital; (2) 89 of those banks, plus an additional 111, have a shortfall, at a minimum, of $2.4 billion in secondary capital; (3) 266 national banks meet both minimums, but face credit and other risks that warrant higher capital ratios (the amount of capital they must raise cannot be easily estimated); (4) Underwriting costs associated with raising needed capital could approach $200 million, the precise amount depending on the volume of funds raised in capital markets as opposed to the use of retained earnings; and (5) Until capital ratios are met, dividend payouts could be lower than historical averages. 34843 Sec. However, OCC believes the costs of the proposed mandatory minimum 3.4 Reservation of Authority capital ratios are outweighed by the benefits. These benefits cannot be easily - Subpart B—Minimum Capital Ratios 3.5 Applicability quantified, but include: 3.8 Minimum Capital Ratios (1) An increased capacity, especially 3.7 Plan to Achieve Minimum Capital Ratios among large banks, to withstand losses 3.8 Reservation of Authority associated with credit and other risks Subpart C—Establishment of Minimum that are a normal part of banking; Capital RatkM for an Individual Bank (2) Increased stability in our financial 3.9 Purpose and Scope system; and 3.10 Applicability (3) Increased capacity to fund 3.11 Standards for determination of economic growth. Appropriate Individual Minimum Capital The Office is especially interested in Ratios receiving additional information bearing 3.12 Procedures on the benefits and costs of this 3.13 Relation to Other Actions proposal. A copy of the regulatory impact analysis may be obtained from 3.14 Remedies the Office's Communications Division under procedures set forth in 12 CFR Subpart 6—Issuance of a Directive 4.17 and 4.17a. 3.15 Purpose and Scope 3.16 Notice of Intent to Issue a Directive Paperwork Reduction Act 3.17 Response to Notice The potential paperwork burdens 3.18 Decision 3.19 Issuance of a Directive contained in this rule pertaining to: (1) 340 Amendment of Time Periods The preparation of a written plan to 3.21 Change in Circumstances increase capital by a national bank that 3.22 Relation to Other Administrative does not have the minimum capital Actions ratios specified in the regulation or Authority: 12 U.S.C 1 et seq.; 12 U.S.C 93a. individually required for it and (2) the . 161 and 1818; and 12 U.S.C 3907 and 3909. written response which a bank may Subpart A—Authority and Definition* make to the Office when notified that higher minimum capital ratios may be §3.1 Authority. required for it; have been submitted to This part is issued under the authority the Office of Management and Budget of 12 U.S»C 1 et. seq., 93a, 161 and 1818; for review pursuant to 44 U.S.C. 3504(h). and the International Lending List of Subjects in 12 CFR Part 3 Supervision Act of 1983 (Pub. L. 98-181, Tide IX, 97 Stat 1153), 12 U.S.C. 3907 Banks, Banking, Primary, Secondary and 3909. and total capital, Minimum capital 53-2 Definition* ratios, Procedures for establishing higher minimum capital ratios for an For the purposes of this Part individual bank, Enforcement of (a) "Bank" means a national banking minimum capital ratios, Issuance of association or a District of Columbia directives. bank. This proposal does not duplicate, (b) "Intangible assets" means those overlap, or conflict with any existing assets within the definition of this term federal laws and regulations governing in the "Instructions—Consolidated national banks with the exception of Reports of Condition and Income" (Call Interpretive Ruling 12 CFR 7.1100 which Report). will be amended accordingly following (c) "Mandatory convertible debt" adoption of the final version of this means subordinated debt instruments proposed regulation. which require the issuer to convert such offerings into either common or Authority and Issuance -perpetual preferred stock by a date at or Accordingly, pursuant to authority before the maturity of the instrument. under 12 U.S.C. 93a, 3907, and 3909. the The maturity of these instruments must Comptroller of the Currency proposes to be 12 years or less. add a new Part 3 to Title 12 of the Code (d) "Primary capital" means the sum of Federal Regulations, as follows: of (1) and (2) below, minus intangible assets: PART 3—MINIMUM CAPITAL RATIOS; (1) Common stock, perpetual preferred ISSUANCE OF DIRECTIVES stock, capital surplus, undivided profits, Subpart A—Authority and Definition* reserves for contingencies and other capital reserves, net worth certificates Sec. issued by the Federal Deposit Insurance 3.1 Authority Corporation, minority interests in 3.2 Definitions consolidated subsidiaries, and 3.3 Transitional Rule 389 34844 • Federal Register / Vol. 49, No. 172 / Tuesday, September 4, 1984 / Proposed Rules allowances for possible loan and lease losses; and (2) Mandatory convertible debt to the extent of 20% of the sum of (1); (e) "Secondary capital" means the sum of: mandatory convertible debt that is not included in primary capital, intangible assets, and limited life preferred stock and subordinated notes and debentures having an original weighted average maturity of at least seven (7) years, subject to the amortization schedule set forth in 12 CFR 7.1100(f)(2). (f) "Total assets" means the average total assets figure required to be computed for and stated in a bank's most recent quarterly "Consolidated Report of Condition and Income" (Call Report), plus the allowance for possible loan and lease losses. "Adjusted total assets" means total assets minus intangible assets. (g) 'Total capital" means the sum of primary capital and secondary capital. §3.3 Trsminonel Rule. Funding instruments approved by the Office as primary of secondary capital and issued prior to the effective date of this regulation may continue to be included, to the extent previously authorized, in a bank's primary or secondary capital as the case may be, during the original effective term of the instrument. §3.6 Minimum Capitai Ratios. A bank must have an maintain total capital equal to at least 6 percent of total assets and primary capital equal to at least 5Vfc percent of adjusted total assets. §3.7 Plan to Achlava Minimum Capitai ratios. Any bank having total or primary capital ratios less than the minimums set forth in § 3.6 shall, within 60 days of the effective date of this regulation, submit to the Office a plan describing the means and schedule by which the bank shall achieve the minimum capital ratios. The plan may be considered acceptable unless the bank is notified to the contrary by the Office. A bank, in compliance with an acceptable plan to achieve the minimum capital ratios will not be deemed to be in violation of § 3.6. }3J Reservation of Authority. When, in the opinion of the Office the circumstances so require, a bank may be authorized to have less man the minimum capital ratios in § 3.6 during a time period specified by the Office. Subpart C—Establishment of Minimum Capital Ratios) for an Individual Bank Notwithstanding the definitions of "primary capital" and "secondarycapital" in § 3.2 (d) and (e), the Office may find that a newly developed or modified funding instrument constitutes or may constitute "primary capital" or secondary capital" and the Office may permit one or more banks to include funds obtained through such instrument as primary or secondary capital, permanently or on a temporary basis, for the purposes of compliance with this Part or for other purposes. S3.9) Purpose and Scope. The rules and procedures specified in this subpart are applicable to a proceeding to establish required minimum capital ratios for an individual bank above the ratios that would otherwise be applicable to the bank under i 3.6. The Comptroller is authorized under 12 U.S.C. 3907(a)(2) to establish such minimum capital requirements for a bank as the Office, in its descretion, deems necessary or appropriate in light of the particular circumstances of that bank. Proceedings under this subpart may be initiated to require a bank to maintain existing capital ratios which are above those set forth in § 3.6 or other legal authority, as well as to require a bank to reach higher minimum capital ratios. Subpart B—Minimum Capitai Ratios §3.10 §3.4 Reservation of Authority. §3.5 Applicability. This subpart is applicable to all banks unless the Office determines, pursuant to the procedures set forth in Subpart C. that different minimum capital ratios are appropriate for an individual bank based upon its particular circumstances, or unless different minimum capital ratios have been established or are established for an individual bank in a written agreement or a temporary or final order pursuant to 12 U.S.C. 1818 (b) or (c), or as a condition for approval of an application. Applicability. Higher minimum capital ratios may be required for an individual bank when the Office believes that the bank's capital is or may become inadequate in view of its circumstances. For example, higher capitai ratios than those required in § 3.6 may be appropriate for. (a) A newly chartered bank; (b) A bank in need of special supervisory attention; (c) A bank which has or is expected to have losses resulting in capital inadequacy; (d) A bank having a high proportion of off-balance sheet risk in relation to other assets and liabilities or a low proportion of liquid assets; (e) A bank undergoing expansion, either internally or through acquisitions; or (f) A bank which may be adversely affected by the activities or condition of its holding company, affiliate(s), or other persons or institution which which it has significant business relationships. § 3.11 Standards for Determination of Appropriate Individual Minimum Capital Ratios, The appropriate minimum capital ratios for an individual bank cannot be determined solely through the application of a rigid mathematical, formula or wholly objective criteria. The decision is necessarily based in part on subjective judgment grounded in agency expertise. The factors to be considered in the determination will vary in each case and may include, for example: (a) The conditions or circumstances leading to the Office determination that higher mimimum capital ratios are appropriate or necessary for the bank; (b) The exigency of those circumstances or potential problems; (c) The overall condition, management strength, and future prospects of the bank and, if applicable, its holding company and/or afnHate(s); (d) The bank's liquidity, capital and other ratios compared to the ratios of its peer group; and (e) The views of the bank's directors and senior management. §3.12 Procedure*. (a) Notice. When the Office determines that minimum capital ratios above those set forth in % 3.6 are necessary or appropriate for a particular bank, the Office will notify the bank in writing of the proposed minimum capital ratios and the date by which they should be reached (if applicable), and will provide an explanation why the ratios proposed are considered necessary or appropriate for the bank. (b) Response. (1) The bank may respond to any or all of the items in the notice. The response should include any matters which the bank would have the Office consider in deciding whether individual minimum capital ratios should be established for the bank, what those capital ratios should be. and, if applicable, when they should be achieved. The response must be in writing and delivered to the designated OCC official within 30 days after the date on which the bank received the notice. (2) Failure to respond within thetime period specified in paragraph (b)(1) of 390 Federal Register / V o l 49, No. 172 / Tuesday. September 4. 1964 / Proposed Rules this section shall constitute a waiver of any objections to the proposed minimum capital ratios or the deadline for their. achievement. • (c) Decision. Within 30 days after the close of the bank's response period, the Office will decide, based on a review of the bank'8 response and other information concerning the bank, whether individual minimum capital ratios should be established for the bank and. if so. the ratios and the date the requirements will become effective. The bank will be notified of the decision in writing. The notice will include an explanation of the decision, except for a decision not to establish individual minimum capital requirements for the bank. (d) Submission of plan. The decision may require the bank to develop and submit to the Office, within a time period specified, an acceptable plan to reach the minimum capital ratios established for the bank by the date required. (e) Amendment of time periods. The Office may shorten the time periods specified in this subpart (1) When, in the opinion of the Office, the condition of the bank so requires, provided that the bank is informed promptly of the new time periods; or (2) with the consent of the bank. In its discretion, the Office may extend the time periods for good cause. In particular, the time period for the Office's decision may be extended if, after receipt of the bank's response, further clarification or information is required, or there is a material change in the circumstances affecting either die bank's capital adequacy or its ability to achieve the proposed minimum capital ratios by the proposed date. (f) Change in circumstances. If. after the Office's decision in paragraph (c) of this section, there is a change in the circumstances affecting the bank's capital adequacy or its ability to reach the required minimum capital ratios by the specified date, either the bank or the Office may propose to the other a change in the minimum capital ratios for the bank, the date when the minimums must be achieved, or the bank's plan (if applicable). The Office may decline to consider proposals that are not based on a significant change in circumstances or are repetitive or frivolous. Pending a decision on reconsideration, the Office's original decision and any plan required under that decision shall continue in full force and effect. §3.13 Relation to other action*. In lieu of. or in addition to. the procedures in this subpart, the required minimum capital ratios for a bank may be established or revised through a written agreement or crease and desist proceedings under 12 U.S.C. 1818(b) or (c) (12 CFR 19.0-18.21), or as a condition for approval of an application. §3.1* 34845 Notice of Intent to issue a directive. The Office will notify a bank in writing of iis intention to issue a directive. The notice will state: (a) Reasons for issuance of the Subpart D—Enforcement directive; and (b) The proposed contents of the § 3.14 Remedies. A bank mat does not have or maintain, directive. the minimum capital ratios applicable to § 3.17 Response to notice. it, whether established in Subpart B of (a) A bank may respond to the notice this regulation, in a decision pursuant to by stating why a directive should not be Subpart C, in a written agreement or temporary or final order under 12 U.S.C. issued and/or by proposing alternative contents for the directive. The response 1818 (b) or (c), or in a condition for should include any matters which the approval of an application, or a bank bank would have the Office consider in that has failed to submit or comply with an acceptable plan to attain those ratios deciding whether to issue a directive and/or what the contents of the will be subject to such administrative directive should be. The response may action or sanctions as the Office include a plan for achieving the considers appropriate, including minimum capital ratios applicable to the issuance of a Directive pursuant to bank. The response must be in writing Subpart E. other enfoscement action, and delivered to the designated OCC assessment of civil money penalties, official within 30 days after the date on and/or the denial, conditioning, or which the bank received the notice. revocation of applications. Failure to achieve or maintain the minimum (b) Failure to respond within the time primary capital ratio also may be the period specified jn paragraph (a) of this basis for an FDIC action to terminate section shall constitute a waiver of any federal deposit-insurance. See 12 CFR objections to the proposed directive. 325.4(c). §3.18 Decision. Subpart E—Issuance of a Directive §3.15 Purpose and Scope. -This subpart is applicable to proceedings by the Office to issue a directive under 12 U.S.C. 3907(b)(2). A directive is an order issued to a bank that does not have or maintain capital at or above the minimum ratios set forth in § 3.6, or established for the bank under subpart C by a written agreement under 12 U.S.C. 1818(b). or as a condition for approval of an application, A directive may order the bank to (a) achieve the minimum capital ratios applicable to it by a specified date: (b) adhere to a previously submitted plan to achieve the applicable capital ratios; (c) submit and adhere to a plan acceptable to the Office describing the means and time schedule by which the bank shall achieve the y applicable capital ratios; (d) take other action, such as reduction of assets or the rate of growth of assets, or restrictions on the payment of dividends, to achieve the applicable capital ratios; or (e) a combination of any of these or similar actions. A directive issued under this rule, including a plan submitted under a directive, is enforceable in the same manner and to the same extent as an effective and outstanding cease and desist order which has become final as defined in 12 U.S.C. 1818(k). Violation of a directive may result in assessment of civil money penalties in accordance with 12 U.S.C. 3909(d). After the closing date of the bank's response period, or receipt of the bank's response, if earlier, the Office will consider the bank's response, and may seek additional information or clarification of the response. Thereafter, the Office will determine whether to issue the directive as-originally proposed or in modified form. A directive will be issued, or the bank advised that the Office has decided not to issue a directive, within 30 days after the closing date of the bank's response period as set forth in § 3.17 unless the response period, or the time for the Office's decision, is extended under § 3.20. § 3.19 Issuance of s directive. (a) A directive will be served by delivery to die bank. It will include or be accompanied by a statement of reasons for its issuance. (b) A directive is effective immediately upon its receipt by the bank, or upon such later date as may be specified therein, and shall remain effective and enforceable until it is stayed, modified, or terminated by the Office. § 3^0 Amendment of time periods. (a) The Office may shorten the time periods specified in this subpart: (1) When, in the opinion of the Office, the condition of the bank so requires, provided that the bank shall be 391 34846 Federal Register / Veil. 49. No. 172 / Tuesday, September 4, 1984 / Proposed Rules informed promptly of the new time periods; (2) With the consent of the bank; or (3) When the bank already has advised the Office that it cannot or will not achieve its applicable minimum capital ratios. (b) In its discretion, the Office may extend the time periods for good cause. In particular, the time period for the Office's decision may be extended if, after receipt of the bank's response, further clarification or information is required, or there is a material change in the circumstances affecting either the bank's capital adequacy or its ability to achieve the minimum capital ratios applicable to it by the specified date. § 3.21 Change in Circumstances. Upon a change in circumstances, a bank may request the Office to reconsider the terms of its directive or may propose changes in the plan to achieve the bank's applicable minimum capital ratios. The Office also may takesuch action on its own motion. The Office may decline to consider requests or proposals that are not based on a significant change in circumstances or are repetitive or frivolous. Pending a decision on reconsideration, the directive and plan shall continue in full force and effect S&22 Rtatton to Other A d m t i t l t u B y Action*. A directive may be issued in addition to. or in lieu of, any other action authorized by law, including cease and desist proceedings, civil money penalties, or the conditioning or denial of applications. The Office also may, in its discretion, take any action authorized by law, in lien of a directive, in response to a bank's failure to achieve or maintain the applicable minimum capital ratios. Dated: August 29.1984. C. T. Conover, Comptroller of the Currency. (FR Doc M-233U Fifed «~31-«.-ft4»aal MUlNQ COCC 4S10-3S-M DEPARTMENT OF TRANSPORTATION Federal Aviation Administration 14 CFR Part 71 [Airspace Dock* No. 84-AGL-7] Proposed Alteration of Transition Area AQINCV: Federal Aviation Administration (FAA), DOT. ACTION: Notice of proposed rulemaking. S M A Y . This notice proposes to alter U MR* the Monroe, Michigan, transition area to accommodate a new RNAV Runway 20 instrument approach to Custer Airport. The intended effect of this action is to insure segregation of the aircraft using these approach procedures in instrument weather conditions from other aircraft operating under visual weather conditions in controlled airspace. OATC Comments must be received on or before October 4.1984. ADDftiss: Send comments on the proposal in triplicate to FAA Office of Regional Counsel, AGL-7, Attention: Rules Docket Clerk, Docket No. 84AGL-7,2300 East Devon Avenue, Des Plaines, Illinois 6001& The official docket will be available for examination by interested persons in the office of the Regional Counsel, Federal Aviation Administration. 2300 East Devon Avenue, Des Plaines, Illinois 60018. An informal docket will also be available for examination during normal business hours in the Airspace,. Procedures, and Automation Branch, Air Traffic Division, Federal Aviation Administration, 2300 East Devon Avenue, Des Plaines, Illinois 60018. PON RJRTHIft INFORMATION CONTACT: Edward R Heaps, Airspace, Procedures, and Automation Branch, Air Traffic Division, AGL-630, FAA, Great Lakes Region, 2300 East Devon Avenue, Des Plaines, Illinois 60018, telephone (312) 694-7360. SUPPCIMSNTANV INWMWsATHWC The development of a new RNAV instrument approach procedure requires that the FAA alter die designated airspace to ensure that the procedure will be contained within controlled airspace. The additional airspace designated will be approximately a 1.5 mile expansion to me existing transition area excluding that portion which overlies the Detroit Michigan, 700-foot transition area. The minimum descent altitudes for this procedure may be established below the floor of the 700-foot controlled airspace. Aeronautical maps and charts will reflect the defined areas which will enable other aircraft to circumnavigate the area in order to comply with applicable visual flight rule requirements. Comments Invited Interested parties are invited to participate in this proposed rulemaking by submitting such written data, views, or arguments as they may desire. Comments that provide the factual basis supporting the views and suggestions presented are particularly helpful in developing reasoned regulatory decisions on the proposal. Comments are specifically invited on the overall regulatory, economic, environmental, and energy aspects of the proposal Communications should identify the airspace docket and be submitted in triplicate to the address listed above. Commenters wishing the FAA to acknowledge receipt of their comments on this notice must submit with those comments a self-addressed, stamped postcard on which the following statement is made: "Comments to Airspace Docket No. 84-AGL-7." The postcard will be date/ time stamped and returned to the commenter. All communications received before the specified closing date for comments will be considered before taking action on the proposed rule. The proposal contained in this notice may be changed in the light of comments received. All comments submitted will be available for examination in the Rules Docket both before and after the closing date for comments. A report summarizing each substantive public contact with FAA personnel concerned with the rulemaking will be filed in the docket Availability of NPRM Any person may obtain a copy of this notice of proposed rulemaking (NPRM) by submitting a request to the Federal Aviation Administration, Office of Public Affairs, Attention: Public Information Center. APA-430.800 Independence Avenue. SW., Washington. D.C 20591, or by calling (202) 426-8058. Communications must identify the notice number of this NPRM. Persons interested in being placed on a mailing list for future NPRM's should also request a copy of Advisory Circular No. 11-2, which describes the application procedures. The Proposal The FAA is considering an amendment to § 71.181 of Part 71 of the Federal Aviation Regulations (14 CFR Part 71) to alter the transition area airspace near Monroe, Michigan. Sections 71.171 and 71.181 of Part 71 of the Federal Aviation Regulations were published in FAA Order 7400.6, Part 1 dated January 3,1984. List of Subjects in 14 CFR Part 71 Transition areas, Aviation safety. The Proposed Amendment PART 71—(AMENDED) Accordingly, pursuant to the authority delegated to me. the Federal Aviation Administration proposes to amend 392 GE0RGE HANSEN - l0AHO BETHUNE. ARK. STEWART B McKINNEY. CONN NORMAN 0. SHUMWAY. CALIF fPANK AN-MNZ.O III t-ARHOU. r.i;BeAPO JR «> NOBMAN E :. «WOUflS 11.1 O o U . PARNAfO. JR^G« - E0 J 0 Y M rv^o«AR ^ U.S. HOUSE OF REPRESENTATIVES E£S££EH^ SUBCOMMITTEE ON FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE OAV.OORE.ER. CALIF. BRUCE F VENTO. MINN GEORGE C WORTLEY NY CHARLESTSTHUM^ NV S'^XLANEAELXNC BA1NEY PRANK. MASS OF THE JHSiHiT CALF COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS THOMAS H CARPER, DEL NINETY-EIGHTH CONGRESS WASHINGTON, D.C. 2 0 5 1 5 S e p t e m b e r 1 1 , 1984 Honorable C. Todd Conover Comptroller of the Currency 490 UEnfant Plaza, S.W. Washington, D.C. 20219 Dear Mr. Conover: To assist this Subcommittee in its inquiry into the circumstances that made it necessary to provide federal assistance to Continental Illinois Corporation (CIC) and Continental Illinois National Bank (CINB), you are asked to appear before the Subcommittee on Financial Institutions Supervision, Regulation and Insurance on September 19, 1984, at 10:00 am, in Room 2128 of the Rayburn House Office Building. In your testimony, you are requested to provide the information and respond to the questions enumerated below: (1) Provide a tabulation of the annual rates of asset growth, the ratio of primary capital (or comparable measures in earlier years) to total assets, the ratio of classified assets to gross capital funds, the ratio of purchased funds to total deposits, the ratio of rate sensitive deposits plus purchased funds to total deposits, the ratio of reserve for possible loan losses to total loans, and the return on average assets, since 1970 for CINB, for its peer money center banks as a group, and for all national banks as a group. (2) What is the current condition of the portion of the banking industry for which you, as Comptroller of the Currency, are responsible? (3) After the failure of Franklin National Bank, the Office of the Comptroller of the Currency undertook an extensive internal review of its examination and supervision practices and procedures. One of the principal recommendations of the Haskins and Sells study was the establishment of the National Bank Surveillance System. How was this system applied in the examination and supervision of CINB? Do you intend to modify the NBS System as a result of the CINB experience? What modifications do you anticipate will be made? 393 (4) As required by the provisions of the International Lending Supervision Act of 1983, the OCC has recently announced a proposed rule addressing the capitalization of national banks. Under the proposed rule, what amounts of capital would be regarded as adequate, marginal, or inadequate? (5) With respect to each examination of CINB since 1977, how was CINB's high growth corporate plan announced in 1976, its growing dependence on purchased funds, and its high level of criticized and classified assets incorporated in evaluating its capital adequacy both in absolute terms and with respect to its peer money center institutions? Do you intend to modify OCC capital adequacy evaluation standards as a result of the CINB experience? If so, what modifications do you expect will be made? (6) The management practices and financial soundness of Penn Square National Bank had a significant effect on the well-being of CINB. The problems in Penn Square were well known to OCC supervisory officials two full years before it failed. Explain in detail the examination findings and supervisory actions taken to correct Penn Square's problems in the three years preceding its failure and what actions OCC took to isolate Penn Square's problems from other commercial banks. What actions, for example, did your office take to notify OCC examiners working in banks with close ties with Penn Square of the loan management and soundness problems in that bank? (7) Possibly the most knowledgeable individual in the OCC concerning CINB is Senior National Bank Examiner, Richard Kovarick. He was Examiner-in-Charge of the 1977 and 1982 examinations and participated in the 1979 and 1981 examinations. In his 1982 Letter to the Board of Directors, he wrote: "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 reflection 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." 394 The problems referred to by Mr. Kovarick were noted repeatedly by earlier examiners but were not viewed as being significant. What actions are being taken within OCC to assure that such management practices are effectively addressed before they become safety and soundness problems? (8) What role did the OCC have in the development of the CIC/CINB Assistance Program? Review the chronology of the Assistance Program's development. (9) Were all public statements made by you or your agency regarding the soundness of CINB consistent with the information you or your agency had at the time the statement was made? (10) The cost of funds in open financial markets is closely related to the risk of nonpayment. Other things being equal, the cost of funds for those financial institutions the public views as being so large the government cannot allow them to fail will decline relative to the cost of funds for institutions not so viewed. In this respect, what are the long term implications of the Assistance Program for the competitive relationship between large and small banks and between bank holding company affiliated and non-affiliated businesses? In accordance with Committee rules, please deliver 175 copies of each prepared statement to Room B303 Rayburn before 12:00 p.m. on September 17, 1984. Your prepared statement will be distributed to all Members of the Subcommittee in advance of the hearing and will be included in its entirety in the hearing record. Sincerely, Fernand 3. St Germain Chairman F3StG:jDc INQUIRY INTO CONTINENTAL ILLINOIS CORP. AND CONTINENTAL ILLINOIS NATIONAL BANK THURSDAY, OCTOBER 4, 1984 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON F I N A N CIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE, COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS, Washington, DC. The subcommittee met, pursuant to call, at 10:25 a.m., in room 2128, Rayburn House Office Building, Hon. Fernand J. St Germain (chairman of the subcommittee) presiding. Present: Representatives St Germain, Annunzio, Hubbard, Barnard, Vento, Patman, Lehman, Carper, Wylie, Hansen, Leach, McKinney, McCollum, and Wortley. Also present: Representative Thomas J. Ridge of the full committee. Chairman S T GERMAIN. The subcommittee will come to order. We resume hearings this morning on Continental Illinois National Bank with testimony from its largest single stockholder, the Federal Deposit Insurance Corporation. It may not have filtered through the ranks of the bureaucracy yet, but the Continental Illinois failure will have a lasting and heavy impact on the entire Federal financial regulatory system— and the public's acceptance of its role. It raises fundamental questions about the fairness, cost and, most of all, the efficacy of a regulatory system built on the quicksand of secrecy, procrastination and expediency. The Federal Deposit Insurance Corporation is revealed not as the solid cornerstone of confidence, but as the linchpin in the Federal Government's most costly and grandiose corporate welfare program. The FDIC finds itself not in its traditional role as champion of the small independent banks, but as the cashier in a fail-safe program for the biggest of our big banks—direct Government intervention t h a t is certain to distort the marketplace in favor of the big and against the small. Perhaps FDIC looks on itself as an unwilling partner forced to accept and pay the bills of its profligate fellow regulators. If t h a t is the case, this hearing provides an excellent opportunity to set the record straight. FDIC did have its moments of glory as the regulators sat around in those long agonizing, hand wringing sessions about their problem in Chicago. (395) 396 Reading the examination reports, FDIC's supervisory personnel did spot the severity of the problems. In May 1983, ignoring the Comptroller of the Currency's lukewarm rating of a " 3 , " (risks above normal) the FDIC declared the bank a full scale " 4 " (serious financial weakness) and threw the illustrious name of Continental on the agency's infamous list of problem banks. At this point, FDIC looked like the star performer among the regulators. But, what did FDIC do with the information? Our investigators cannot find any alarms, red flags, or other signals t h a t warned anyone t h a t FDIC had found a rotten apple—a large rotten apple. Apparently, even the State banks—for which FDIC has a primary regulatory role—didn't get any signals, and the examiners appeared to have stood silently while they continued to move deposits into Continental—increasing FDIC liability in an institution they knew was a problem bank. In the final analysis, the supervisory personnel who insisted on the " 4 " rating might as well have stayed in bed for all the good their findings did. A bailout of this magnitude raises monumental questions of public policy. Many of these questions, unfortunately, have been shrouded in the secrecy of the regulatory agencies and the seeming willingness of so many to accept at face value the ex post facto rationalizations t h a t pour so freely in the background briefings and mimeographed handouts. Even if one believes—and this takes some believing—that the regulators performed brilliantly, one surely must still question the power, the inordinate power, t h a t is assumed by these agencies. Billions of dollars are committed, banking policy is changed, the marketplace redefined, without public hearings, without votes, without any of the checks and balances t h a t we accept in our system. Perhaps all these gentlemen are the wisest of the wise and above reproach, but even such personal credentials would be a frail peg on which to hang such massive governmental power in a democracy. The only thing t h a t appears to top the magnitude of the outlays to save Continental is the mountain of misinformation, distortions, and half-truths t h a t seem to surround every aspect of this case. At times, the multibillion dollar bailout has been described as virtually cost-free. Even more frequently, the domino theory has been floated, suggesting t h a t 75 or more banks would have failed had the regulators not staffed the bucket brigade. In fact, the regulators briefed Members of both the House and Senate in July and used the domino theory as the centerpiece of their contention t h a t "we had no choice." Variations on the theme have been repeated time and again in major publications. Unless one assumes t h a t all the assets of Continental—and they were considerable—would have been vaporized overnight and t h a t the entire support mechanisms of the regulatory system would have disappeared, the numbers are nothing less t h a n absurd. Unless they are more incompetent t h a n we suspect, the agencies knew full well t h a t the domino theory was concocted. At most— and this stretches a pessimistic scenario pretty far—may be a half dozen institutions would have been on the edge of a failure line. A more reasonable analysis suggests t h a t these troubles could have been handled by the emergency mechanisms of the Federal regula 397 tory system—incidentally at a fraction of the bailout costs of Continental. The number of dominoes is probably close to zero. At least one publication, I am happy to note, did question the domino theory. Associate Editor Sanford Rose wrote in Tuesday's edition of the American Banker: "It now appears t h a t top bank regulators were something less t h a n candid when they said t h a t a significant number of small U.S. banks would fail unless Continental Illinois was bailed out." And Mr. Rose concludes: * * * the American public has the right to a little more honesty from its public officials than it apparently got in this sordid episode." We have been analyzing the regulators' domino theory and will be developing these facts fully during the hearing. We can assure the American Banker that there is plenty of evidence to support Sanford Rose's conclusion. The idea t h a t the bailout is a painless cost-free exercise should be thrown in the same pile with other unsupported rationalizations. Yes, Continental could have a substantial budget impact— conceivably amounting to as much as $3.8 billion according to the Congressional Budget Office. Unfortunately, FDIC's liquidation and bailout estimates often have a way of growing after the initial optimistic projections. When United American Bank and the other Butcher banks failed in Tennessee in 1983, the forecasts were t h a t the FDIC would get out of t h a t mess with costs of $400 million or less. Just last week, banking publications carried reports of estimates t h a t FDIC's actual cost could probably top $1 billion—more t h a n 100 percent above those well publicized and rosy predictions of 1983. The same people who came up with the United American projections programmed the same computer in calculating the costs of the Continental collapse. In hopes of dampening the public's concerns over cost, the regulators have suggested t h a t all this was being paid for with "play" money out of someone's Monopoly game. The insurance premiums which support, in part, the Government's guarantees to banks are paid ultimately by the customers of those institutions in the form of higher fees and interest rates. More important, it is absurd to think t h a t the premiums begin to pay the value of the full faith and credit of the Federal Government which stands behind—and provides the real strength for the insurance funds. The FDIC has a direct draw on the Treasury of $3 billion and when t h a t is exhausted additional sums will have to be appropriated out of tax moneys. This idea t h a t somehow the FDIC's funds are bankers' money is disturbing. Taking some of these statements literally, there is a clear suggestion t h a t the FDIC and the bankers have a perfect right to go off in the corner and d i w y up the insurance fund in any manner t h a t appears expedient. Such a mind-set, I fear, pervades the Federal bank regulatory system—a feeling t h a t everything operates on an agency-constituency relationship—the rest of the Federal Government and the public notwithstanding. Uncalculated in the cost figures of Continental is the liability incurred by the Federal Government in a fail-safe program for big banks as described by the Comptroller before this committee 2 weeks ago. Uncalculated also are the costs to smaller- and medium39-133 0 - 8 4 26 398 sized banks and their communities which must face the distinct competitive disadvantages of a federally inspired fail-safe program for the big banks. That famous level playing field was stood on its end by the Continental bailout. Support for Government programs depend in large part on the public's perception of how equitably those outlays are made in the economy. Clearly, fail-safe bailout policy for one class of banks and a hit and miss policy for the remainder of the industry is the very epitomy of unfairness and unequal treatment. But, the double standard does not apply simply to small banks. From 1981 through 1983 we had between 70,000 and 80,000 business failures, the highest rate in 50 years. Where were the Continental-style Government bailouts for all the small business people who saw their doors padlocked for the last time? All of us, I believe, would feel better if there was any strong evidence t h a t the regulators approached the Continental problems in a concerted, businesslike manner and based their decision on hardnosed data. In t r u t h and in fact, it appears that the three regulators made their initial decision to assist Continental with little in hand but the broad concept t h a t the bank was "essential" in a global sense. At this point, not even a contrived list of dominoes was in hand and apparently no cost analysis which would have given the regulators a clue as to what route might save the Federal Government money. It appears that the decision to bailout was made on high in the early hours without any hard facts or empirical evidence. After t h a t apparently the word went out to the bureaucracy to come up with numbers to rationalize the action for public consumption. Again, this entire process calls for greater openness. It cries out for a greater degree of truthfulness. It does not enhance the confidence of the American people in the Federal regulatory structure to have one of its officials issue misleading statements about the condition of the bank as the Comptroller did during the early stages of the rescue effort. It does not enhance the credibility of the agencies to float distorted or manufactured numbers suggesting t h a t the banking system would collapse like so many dominoes unless the money gates were opened wide. The Continental failure doesn't have many bright spots, but it does explode some myths. It certainly disabuses any thought that the regulators—faced with the debris of Penn Square—got their act together. It's the same timid, uncoordinated, secretive regulatory system. It certainly suggests t h a t one must take great care in accepting—on face value—stock tips coming out of the banking agencies or buying the sky-is-falling approach to public policy and outlays of Federal moneys. It ends the myth that there is a solid wall between the holding companies and their subsidiary banks. When the rescue squad raced into Chicago, it headed straight for the holding company and installed the life lines to the bank through t h a t structure. Ever since, the poor fellows at Treasury have been shredding old copies of speeches and testimony which assured the world t h a t there was a full and definitive separability between the holding company and the bank subsidiary. 399 Let's hope that a few other banking myths disappear before we end these hearings so that we can move the regulators back to the real world in which the American people reside. At this point, I would ask unanimous consent to place the report from the Congressional Budget Office at the conclusion of my statement, without objection. [The Congressional Budget Office report follows:] 400 CONGRESSIONAL BUDGET OFFICE U.S. CONGRESS W A S H I N G T O N , D.C. 2 0 5 1 5 Rudolph G. Penner Director October 3, 1984 Honorable Fernand 3. St Germain Chairman Committee on Banking, Finance and Urban Affairs U.S. House of Representatives 2129 Rayburn House Office Building Washington, D.C. 20515 Dear Mr. Chairman: As you requested, the Congressional Budget Office has prepared an analysis of the estimated federal budget impact of the financial assistance provided to Continental Illinois National Bank and Trust Company. There is much uncertainty about key factors in the analysis—especially the value of loans transferred to the FDIC and the future value of CI stock. Consequently, a single point estimate of the budgetary effects of the assistance plan is not feasible. Based on an assessment of various possible outcomes, CBO estimates that net federal outlays over the 1984-1990 period are likely to fall between -$0.2 billion and $3.8 billion. The outlays will be incurred by the FDIC and will appear on the unified budget. If you wish further details on this estimate, we will be pleased to provide them. Sincerely, ^vRudolph G. Penner 401 October 3, 1984 CONGRESSIONAL BUDGET OFFICE ANALYSIS OF THE FEDERAL BUDGET IMPACT OF ASSISTANCE TO THE CONTINENTAL ILLINOIS NATIONAL BANK AND TRUST COMPANY INTRODUCTION Over the past several months, agencies of the federal government have participated in efforts to maintain the viability of the Continental Illinois National Bank and Trust Company (CI). The assistance began with Federal Reserve loans to maintain the bank's liquidity and culminated in a long-term assistance plan announced on July 26, 1984 by the Federal Deposit Insurance Corporation (FDIC), the Comptroller of the Currency, and the Federal Reserve. CI stockholders approved that plan on September 26. At the request of Chairman St Germain of the House Committee on Banking, Finance and Urban Affairs, the Congressional Budget Office (CBO) has analyzed the rescue plan and has assessed its budget impact. There is much uncertainty about key factors in the analysis—especially the value of loans transferred to the FDIC and the future value of CI stock. Consequently, a single point estimate of the budgetary effects of the assistance plan is not feasible. Based on an assessment of various possible outcomes, CBO estimates that net federal outlays over the 1984-1990 period are likely to fall between -$0.2 billion and $3.8 billion. The outlays will be incurred by the FDIC and will appear on the unified budget. FDIC expenditures are not funded from general tax revenues, however. They are derived from a trust fund financed by insurance assessments paid by member banks. As a result, the cost of FDIC assistance will ultimately be borne by the banking system's depositors, borrowers, and/or stockholders. The loan activity of the Federal Reserve and the administrative expenses of both the Fed and the Comptroller of the Currency will not have any significant budgetary effects. The Fed loans are at rates approximating its normal earnings, while the administrative activities are estimated to cost less than $1 million in 1984 and to fall within the normal scope of agency activities thereafter. There are no off-budget expenses associated with the assistance plan. THE ASSISTANCE PLAN The financial portion of the permanent assistance program for Continental Illinois (CI) consists of a purchase of CI loans and equity by the FDIC, for a total of $4.5 billion. In addition, the Federal Reserve is continuing its lending to Continental to help maintain the bank's liquidity. 402 Loan Purchases The FDIC will purchase, for $3.5 billion, loans from CI with a face value of $5.7 billion. The loans will be transferred in two parts: the first group, with a face value of about $4.2 billion, was sold to the FDIC for $2.0 billion. The second group, with a face value of $1.5 billion, will be sold to the FDIC over the next three years for $1.5 billion. \J CI's selection of loans to be transferred is restricted in that: (a) loans must have been originated or committed prior to May 31, 1984, and (b) no loan to or guaranteed by a foreign government shall be transferred, except as agreed by the FDIC. The FDIC will pay the $3.5 billion purchase price by assuming $3.5 billion of CI debt to the Federal Reserve. The FDIC will pay interest to the Fed quarterly, and will also pass through as principal payments to the Fed any collections, over and above interest and other expenses, on the $3.5 billion portfolio of troubled loans, until the Fed loan is repaid. Five years after the agreement is implemented, the FDIC will be required to pay off any remaining principal on the $3.5 billion in Fed loans. At that time, the FDIC will be compensated for any losses incurred on the loans by receiving an option to acquire, at $.00001 per share, a portion of the 40 million shares of CI currently outstanding. If the losses are $800 million or more, the FDIC will acquire all 40 million shares. Equity Purchase The FDIC purchased $1.0 billion in preferred stock in CI, divided into two non-voting issues. One issue, of $720 million, is convertible (upon sale to a third party) into 160 million shares of newly authorized common stock. This preferred stock will be entitled to dividends equivalent to those paid on common stock (though none are anticipated for at least a year). The second issue, of $280 million, will pay dividends at an adjustable rate based on current rates for certain U.S. Treasury securities. This issue is callable at the option of CI and, for the first three years, the dividend is payable in cash or in additional adjustable rate preferred stock. THE BUDGET IMPACT While a number of federal agencies have played a role in developing the assistance plan, the direct budget impact derives from the actions of the FDIC. The Federal Reserve Board and the Comptroller of the Currency are also involved in the plan, but their activities will not have any significant budget effects. The rescue plan may also affect the American and international financial systems and the U.S. economy, which could, in turn, affect the federal budget. The direct budgetary effects are highly uncertain, and there is no reliable way to predict the nature or magnitude of possible secondary effects. J/ Instead of transferring loans, the bank has the option of paying all or part of the $1.5 billion in cash, but it is unlikely that this option will be exercised. This analysis assumes that the maximum amount of loans is sold. 2 403 The FDIC All of the significant budgetary consequences of the plan are related to the activities of the FDIC. Assistance to banks and administrative expenses paid from the FDIC trust fund appear as outlays in the federal budget when they are disbursed. On the other hand, earnings on the trust fund portfolio, recoveries on previous investments, and insurance assessments paid by insured banks reduce budget outlays when they are received. Each of the FDIC transactions in this plan has a direct impact on the unified budget. Fiscal Year 1984 Budget Impact. In May 1984, the FDIC provided $1.5 billion of a $2.0 billion loan to CI as part of a temporary assistance plan. 2/ This loan resulted in an initial $1.5 billion federal budget outlay. FDIC interest receipts were not significantly affected by this interim loan, because the interest payment by CI to the FDIC is approximately equivalent to the earnings the FDIC would have received on Treasury investments. The permanent assistance plan became effective after approval by the CI stockholders on September 26, 1984. Under that plan, the interim loan was repaid, and the FDIC completed the $1.0 billion equity purchase, resulting in net federal outlays of $1.0 billion in fiscal year 1984. 3/ Loan Purchases. By acquiring the CI loans (having a face value of $5.7 billion), the FDIC will receive any principal and interest payments made by the borrowers, and these receipts will reduce net outlays. On the other hand, the FDICs payments to the Fed to cover interest and principal on the $3.5 billion loan assumed from CI will increase FDIC outlays over the 19851989 period. It is likely that the receipts from the transferred loans will be less than the payments due to the Fed, and the difference between the two will be net additional outlays to the FDIC. The plan also requires the FDIC to pay CI the amount by which interest the bank paid to the Fed on $2.0 billion of its borrowings exceeds collections on the initial $2.0 billion in transferred loans from July 26, 1984 to the implementation date of the plan. 4/ This amount is expected to be about $24 million, and will be paid in fiscal year 1985. 2/ Another $0.5 billion was provided by a group of U.S. banks. 3/ This analysis is consistent with the budgetary treatment projected by the FDIC and used in the Administration's mid-session budget estimates released in August. Alternatively, it is possible to view the assistance plan as a $3.5 billion loan from the Fed to the FDIC, and $4.5 billion in direct assistance from the FDIC to CI. Under such an interpretation, the entire $4.5 billion would be recorded as an outlay in 1984, rather than being spread out over a five-year period, and the FDICs subsequent principal payments to the Fed would not be regarded as budget outlays. Total FDIC outlays over the 1984-1990 period would be the same with either treatment. kj This provision has an effect similar to that of transferring the first $2.0 billion in loans to the FDIC as of July 26, with the FDIC assuming $2.0 billion in CI loans to the Fed at the same time. 3 404 The value of the troubled loans acquired by the F D I C is the major uncertainty in the cost of the plan to the F D I C . CI has indicated that many of the loans will be for energy exploration and development activities, which have little prospect of success unless energy prices increase sharply. The transferred loans will also include real estate, shipping, and foreign private sector loans. All of the loans will be of poor quality on the date on which they are sold. According to the CI proxy statement, the loans will be administered to maximize recoveries to the F D I C over the five years prior to the valuation date. To reflect the uncertainty as to the amount of likely loan collections, the CBO analysis is based on three alternative scenarios: o an optimistic assumption--that the F D I C will collect $4.0 billion of principal and interest on the $3.5 billion in transferred loans. o a pessimistic assumption—that collections of principal and interest will total about $2.0 billion on the $3.5 billion in transferred loans. o a midpoint assumption--that collections of principal and interest will be about $3.0 billion on the $3.5 billion in transferred loans. The estimated range of $2 billion to $4 billion in collections is based on FDIC's historical rate of recovery on assets obtained from failed institutions and on information from knowledgeable individuals in government agencies and in the financial community. Because a significant portion of the loans are related to energy development activities, the collections are very sensitive to oil prices. This analysis assumes relatively stable oil prices over the next five years (consistent with CBO's baseline projections). Loan recoveries could be greater or less than projected if oil prices were to dramatically increase or decrease. A number of other factors affect the estimate of loan collections. On the pessimistic side, the loans are being specifically selected because of their expected poor performance; they include loans obtained from the Penn Square Bank and some foreign loans, which may be particularly difficult to collect. In addition, only the collections obtained in the first five years are applicable to the valuation date transactions. On the other hand, the F D I C is assuming these loans at a discount of close to 40 percent from the $5.7 billion face value. I t is possible, therefore, that the rate of collections on the $3.5 billion could exceed the 70-75 percent of book value the F D I C estimates to be its average historical rate. The analysis also assumes a relatively steady stream of F D I C loan collections and F D I C repayments to the Fed over the five-year period. I t is possible that these flows could be uneven. For example, the F D I C could sell some of the transferred loans and/or pay off the Fed loan early, resulting in large cash flows in a particular year. Table 1 shows the budget effects of the loan purchase transaction under each of the above assumptions. I t is displayed in two components, with outlays occurring at the end of the five-year period (the "valuation date") shown separately from those occurring at other times during the 1985-1989 period. Under the optimistic assumption, the F D I C would be able to pay 4 405 back about $2.7 billion in principal of the $3.5 billion Fed loan from its loan collections before the valuation date, and net FDIC outlays over the fiveyear period would be about $0.6 billion. Under the pessimistic assumption, $3.2 billion in principal would remain unpaid until the valuation date, and net outlays associated with the loan purchase transactions over the fiveyear period would be $3.1 billion. Under the midpoint assumption, the FDIC would repay $1.5 billion in principal from its loan collections before the valuation date, and net FDIC outlays from the loan transactions would be $1.9 billion from 1985 through 19S9. In all cases, some additional loan collections may occur after 1989, but the amounts are not likely to be substantial. TABLE 1. EFFECT OF LOAN PURCHASES ON FDIC OUTLAYS (By fiscal year, in billions of dollars) 1985-1989 Excluding Valuation Date Transactions Valuation Date Transactions Total 1985-1989 Optimistic: FDIC payments to Fed: Principal Interest FDIC loan receipts (net of expenses) 2.7 1.1 0.8 * 3.5 1.1 -fr.O — -fr.O Net FDIC outlays -0.3 0.9 0.6 0.3 1.5 3.2 0.1 3.5 1.6 -2.0 — -2.0 -0.2 3.3 3.1 1.5 1.3 2.0 * 3.5 IA -3.0 — -3.0 -0.2 2.1 1.9 Pessimistic: FDIC payments to Fed: Principal Interest FDIC loan receipts (net of expenses) Net FDIC outlays Midpoint: FDIC payments to Fed: Principal Interest FDIC loan receipts (net of expenses) Net FDIC outlays * Less than $50 million. NOTE: Details may not add to totals because of rounding. .5 406 Equity Purchases. The F D I C paid $1 billion for preferred stock--$720 million for preferred convertible into 160 million shares of common, and $280 million for floating rate preferred. Under the pessimistic and midpoint assumptions used in this analysis, the FDIC would acquire an additional 40 million shares of common stock at a total cost of $400, as a result of losses incurred on the acquired loans. (There could be a maximum of 240 million shares of common stock outstanding, which would occur if present shareholders exercise their right to acquire up to 40 million additional shares of CI.) In the optimistic case, the F D I C would acquire about 28 million shares. For the purpose of this analysis, CBO has assumed that the floating rate preferred stock would be sold in about three years, after accumulating dividends over that period in the form of additional stock. I t is likely that such stock could be sold at a negligible discount, because it will be earning rates equivalent to those of Treasury securities. On this basis, F D I C receipts from the sale are projected to be about $0.4 billion. The value of the remaining stock—the preferred stock convertible into 160 million shares of common, plus up to 40 million additional shares of common—will depend on the market price of CI common stock, which in turn depends on the success of the "new" CI and the market's assessment of its prospects. For the purpose of this analysis, CBO has assumed that the F D I C would sell its rights to 160 million shares in 2-3 years. 5/ (The additional shares would be obtained on the valuation date, and would probably be sold shortly thereafter.) The budget impact is estimated using optimistic, pessimistic, and midpoint assumptions, with prices of $7.00, $1.00, and $4.00, respectively, per share of common stock. Each stock price assumption represents a number of different possible combinations of the key factors that determine prices. As an example, the $4.00 price could be considered to represent a return on total assets of 0.6 percent, about what CI earned in 1979-1981 and typical for large banks over the past several years, applied to a projected asset base of about $27 billion and valued at six times earnings, currently typical for a large bank. The $7.00 price would represent assumptions on the high end of the industry's recent experience—for example, a return on assets of 0.7 percent and a price-earnings ratio of 8:1—applied to a larger asset base of $30 billion. The $1.00 price would represent assumptions on the low end of recent industry experience—for example, a return of 0.2 percent of assets and valuation at four times earnings—applied to $25 billion in assets. On this basis, the FDIC's receipts from the sale of the convertible preferred and common stock would range from $0.2 billion (pessimistic) to $1.3 billion (optimistic), with a midpoint of $0.8 billion--in addition to the $0.4 billion from the floating rate preferred stock. The budget impact of all the equity transactions, net of the $1.0 billion purchase price, is projected to range from a net outlay of $0.4 billion to a net receipt of $0.7 billion, excluding interest costs. These estimates are summarized in Table 2. 5/ The F D I C has indicated that it would sell the stock "as soon as practicable." I t is likely to wait, however, until CI's financial situation is stabilized in the hope of obtaining a high sale price. 407 TABLE 2. EFFECT OF EQUITY PURCHASES ON FDIC OUTLAYS Assumed market price per share of common stock (in dollars) Receipts from stock sales (in billions of dollars) Net gain (+) or loss (-) on equity purchases (in billions of dollars) Optimistic 7.00 1.7 0.7 Pessimistic 1.00 0.6 -CM Midpoint b.00 1.2 0.2 Net Effect _on FDIC Outlays. The overall budget im pact on the FDIC is summarized in Table 3. It includes the results of the loan and equity purchases, as well as dividend income 6/ and the loss of interest on the FDIC portfolio as a result of the outlays for CI assistance. Net outlays over the 1985-1990 period are projected to range from -$0.2 billion (using optimistic stock price and loan collection assumptions) to $3.8 billion (using pessimistic assumptions), with a midpoint estimate of $1.8 billion. These estimates do not include any change in the insurance assessments paid by member banks and retained by the FDIC. The assessment rate is set by statute, at 1/12 of 1 percent of total domestic deposits (after adjustment for deposits in transit), and it cannot be changed by the FDIC. If assessment income exceeds the amounts required to meet the FDIC's expenses and insurance losses and to maintain the trust fund at an appropriate level, banks generally receive a credit against their next year's assessments. While historically the rebate has been about 50 percent, the record number of recent bank failures has been reducing this percentage annually, so that a rebate toward the 1985 assessments is not expected, even without the CI transactions. Thus, FDIC expenses related to bank failures reduce potential credits toward FDIC's insurance assessments and lead to higher bank costs. These costs are passed on to depositors, borrowers, and/or stockholders. If the FDIC incurs losses in future years as a result of CI, as in the pessimistic and midpoint cases, it would reduce or eliminate insurance rebates that might otherwise be made. If losses exceed FDIC income, equity in the trust fund would be reduced. Over time, the FDIC recovers a majority of its losses through the bank assessments. There is no reliable basis for projecting when the FDIC would be able to replenish its trust fund from such assessments. 6/ Dividends are assumed to be paid starting in fiscal year 1986, at an annual rate of about 40 cents per share in the optimistic case and 20 cents per share in the midpoint case. No dividends are assumed in the pessimistic case. 7 408 TABLE 3. NET BUDGET IMPACT OF FDIC TRANSACTIONS (Outlays, by fiscal year, in billions of dollars) 198* Optimistic: Equity purchases (+) and sales (-) Net collections on transferred loans Interest and principal paid to Fed and CI Loss of interest on portfolio less cash dividends received NET OUTLAYS Pessimistic: Equity purchases (+) and sales (-) Net collections on transferred loans Interest and principal paid to Fed and CI Loss of interest on portfolio less cash dividends received NET OUTLAYS Midpoint: Equity purchases (+) and sales (-) Net collections on transferred loans Interest and principal paid to Fed and CI Loss of interest on portfolio less cash dividends received NET OUTLAYS * 1985- 19S9 Transactions Excluding on Valuation Valuation Date or Date Shortly Transactions Thereafter 1.0 -1.5 -0.2 -0.7 — -4.0 — -4.0 —- 3.7 0.9 4.6 — -0.1 — -0.1 1.0 -1.9 0.7 -0.2 1.0 -0.5 0.4 — -2.0 -2.0 —- 1.8 3.3 5.1 0.3 — 0.3 1.0 -0.4 3.2 3.8 1.0 -1.0 -0.2 -0.2 — -3.0 — -3.0 --- 2.8 2.1 4.9 — 0.1 — 0.1 1.0 -1.1 1.9 1.8 Less than $50 million. NOTE: Details may not add to totals because of rounding. Total 1984-1990 8 409 What is even harder to assess is the potential budget impact of the alternatives that were available to the FDIC. For example, in many similar situations involving smaller banks, the FDIC has closed the bank and merged it with an existing institution or created a new bank. The FDIC sought to make similar arrangements for Continental Illinois, but the bank size, the volatility of its funding sources, and the composition of its assets made finding a suitor difficult. The FDIC received one tentative offer to take ownership of the bank, but rejected it as too costly. Alternatively, the bank could have been closed and depositors paid off to the statutory limit. The FDIC would have been named receiver of the bank's assets, would have paid off depositors and creditors as necessary, and would have recovered as much of such payments as possible by liquidating the bank's assets. Insured deposits at that time were only $3 billion to $4 billion, and creditors (including the Federal Reserve) were owed in excess of $3 billion. The FDIC, along with financial institutions and other depositors with holdings in excess of $100,000, would have shared in any losses, which might have threatened the financial viability of some of the affected institutions. Once the FDIC had agreed to guarantee all deposits and general creditors, its direct liability in the event of a CI failure would have been about $38 billion, though its net liability after recoveries would have been considerably less. In either case, the failure of a bank of CI's magnitude might have caused a general loss of confidence in American banking institutions, and the long-term budgetary and economic impact, although impossible to measure, could have been enormous. The Federal Reserve Board While the Federal Reserve System is off-budget, the bulk of Federal Reserve earnings are returned to the Treasury and counted as miscellaneous receipts in the unified budget. Therefore, any activity which changes Federal Reserve earnings can be considered to have a revenue effect. The Federal Reserve's loans to Continental Illinois totaled about $7 billion in late August, and more may be made in the future. These loans do not appear to have affected the size of the Fed's portfolio. Federal Reserve earnings could be affected by any difference between the interest rate the Federal Reserve receives on the Continental loans and what it would have earned on alternative instruments. The rate paid by CI and the rate assumed by the FDIC (the three-month Treasury bill rate plus 25 basis points) are close to the rate the Fed might be expected to have earned on the mix of short-term Treasury securities it presumably gave up for the CI loans. Administrative costs associated with the rescue effort cannot be determined precisely, but they have been less than $1 million in 1984 and are not likely to be substantial in the future. Therefore, any revenue effect is expected to be negligible. Comptroller of the Currency The Comptroller of the Currency is the primary supervising agency of national banks, including CI. In order to monitor the financial condition of CI and assist in developing the rescue plan, the Comptroller has shifted some resources, primarily staff time, to assist with the CI effort, but does not expect total agency obligations to increase in 1984 or subsequent years because of activities related to CI. As a result, no significant budget impact is expected to result from the Comptroller's activities. 9 410 Chairman S T GERMAIN. Mr. Wylie. Mr. WYLIE. Thank you very much, Mr. Chairman. I have a much shorter statement with a slightly different view. I am pleased to have the opportunity to say to Chairman Isaac publicly what I have already said to him privately: t h a t I think his handling of the Continental situation was highly commendable given the choices t h a t were available to you and the amount of time you had to react. It has become a cliche to say t h a t the regulators had no choice but to act as they did in the case of Continental, and Chairman Isaac presents this argument forcefully in his statement today. What this subcommittee and the full Banking Committee must realize is t h a t if we want the regulators to have more choices, if we want large and small banks to be treated alike, and if we want to avoid bailouts of failed managers, it is up to us to make those options possible, and in general to enlarge the range of options available to meet unforeseeable circumstances. Chairman Isaac makes the point very well in his statement when he says, "While a great many people in and out of government deplore the necessity of Continental-type rescue efforts, few appear to be willing to make fundamental changes in the system t h a t gave rise to it." The task ahead is to reform the deposit insurance system and to improve the supervision of depository institutions with special attention to internal controls and capital adequacy. Chairman Isaac has submitted a thought-provoking proposal—the Federal Deposit Insurance Improvements Act of 1984, H.R. 5738—which I have introduced at his request. Tuesday's Wall Street Journal carried an article about an FDIC proposal to raise insured banks' capital to 9 percent by allowing subordinated debt securities to be converted. Additional proposals for long overdue regulatory reforms will be forthcoming, in particular from Vice President Bush's task force group on the regulation of financial services. Our task will be complicated by the need to implement any changes gradually, so t h a t the system can make an orderly adjustment. Ideally, the market should be on notice as to how the regulators will handle these situations which are foreseeable so that the damage done by rumors and reckless speculation can be contained. We have an opportunity to make a significant contribution to the safety and soundness of the banking industry on which the health of the entire economy depends. Although, Mr. Chairman, I personally was disappointed by your announcement of September 21 about enacting banking legislation this year, I respect your decision as being realistic and I do find comfort in your statement t h a t the House Banking Committee will consider these important issues in the next session. I want to assure you t h a t I offer you my full assistance and t h a t of my staff to get on with early hearings, not just on the subjects of loopholes and asset deregulation, but also on reforming our deposit insurance system and our Federal examination and supervisory system to assure the kind of financial system which can meet the challenges ahead and support a growing and vibrant American economy. Thank you very, very much for this opportunity. [The opening statement of Congressman Wylie follows:] 411 STATEMENT OF REP. CHALMERS P. WYLIE, OHIO SUBCOMMITTEE ON FINANCIAL INSTITUTIONS HEARINGS ON CONTINENTAL ILLINOIS OCTOBER h, 1 8 + 9* MR. CHAIRMAN: I AM PLEASED TO HAVE THE OPPORTUNITY TO SAY TO CHAIRMAN ISAAC PUBLICLY WHAT I'VE ALREADY SAID TO HIM PRIVATELY, THAT HIS HANDLING OF THE CONTINENTAL SITUATION WAS HIGHLY COMMENDABLE, GIVEN THE CHOICES THAT WERE AVAILABLE TO YOU AND THE AMOUNT OF TIME YOU HAD TO REACT. IT HAS BECOME A CLICHE TO SAY THAT THE REGULATORS HAD NO CHOICE BUT TO ACT AS THEY DID IN THE CASE OF CONTINENTAL, AND CHAIRMAN ISAAC PRESENTS THIS ARGUMENT FORCEFULLY IN HIS STATEMENT TODAY. WHAT THIS SUBCOMMITTEE AND THE FULL BANKING COMMITTEE MUST REALIZE IS THAT IF WE WANT THE REGULATORS TO HAVE MORE CHOICES THAN THEY HAD IN THIS INSTANCE, IF WE WANT LARGE AND SMALL BANKS TO BE TREATED ALIKE, AND IF WE WANT TO AVOID UNSEEMLY BAILOUTS OF FAILED MANAGERS, IT IS UP TO US TO MAKE THOSE OPTIONS POSSIBLE, AND IN GENERAL TO ENLARGE THE RANGE OF OPTIONS AVAILABLE TO MEET UNFORESEEABLE CIRCUMSTANCES. CHAIRMAN ISAAC MAKES THE POINT VERY WELL IN HIS STATEMENT WHEN HE SAYS, "WHILE A GREAT MANY PEOPLE IN AND OUT OF GOVERNMENT DEPLORE THE NECESSITY OF CONTINENTAL-TYPE RESCUE EFFORTS, FEWER APPEAR TO BE WILLING TO MAKE FUNDAMENTAL CHANGES IN THE SYSTEM THAT GAVE RISE TO IT." THE TASK AHEAD IS TO REFORM THE DEPOSIT INSURANCE SYSTEM AND TO IMPROVE THE SUPERVISION OF DEPOSITORY INSTITUTIONS, WITH SPECIAL ATTENTION TO INTERNAL CONTROLS AND CAPITAL ADEQUACY. CHAIRMAN ISAAC HAS SUBMITTED A THOUGHT PROVOKING PROPOSAL^ TJ^FEDERAL DEPOSIT INSURANCE IMPROVEMENTS 412 ACT OF 198^ (H.R. 5738) WHICH I INTRODUCED AT HIS REQUEST ON MAY 2k, 1984. TUESDAY'S WALL STREET JOURNAL CARRIED AN ARTICLE ABOUT AN FDIC PROPOSAL TO RAISE INSURED BANKS CAPITAL TO 9% BY ALLOWING SUBORDINATED. DEBT SECURITIES TO BE CONVERTED. ADDITIONAL PROPOSALS FOR LONG OVERDUE REGULATORY REFORMS WILL BE FORTHCOMING, IN PARTICULAR FROM VICE PRESIDENT BUSH'S TASK GROUP ON THE REGULATION OF FINANCIAL SERVICES. OUR TASK WILL BE COMPLICATED BY THE NEED TO IMPLEMENT ANY CHANGES GRADUALLY, SO THAT THE SYSTEM CAN MAKE AN ORDERLY ADJUSTMENT. IDEALLY, THE MARKET SHOULD BE ON NOTICE AS TO HOW THE REGULATORS WILL HANDLE THOSE SITUATIONS WHICH ARE FORESEEABLE, SO THAT THE DAMAGE DONE BY RUMORS AND RECKLESS SPECULATION CAN BE CONTAINED. MR. CHAIRMAN, WE HAVE AN OPPORTUNITY TO MAKE A SIGNIFICANT CONTRIBUTION TO THE SAFETY AND SOUNDNESS OF THE BANKING INDUSTRY, ON WHICH THE HEALTH OF THE ENTIRE ECONOMY DEPENDS. ALTHOUGH I PERSONALLY WAS DISAPPOINTED BY YOUR ANNOUNCEMENT OF SEPTEMBER 21ST ABOUT ENACTING BANKING LEGISLATION THIS YEAR, I RESPECT YOUR DECISION AS BEING REALISTIC, AND I DO FIND COMFORT IN YOUR STATEMENT THAT THE HOUSE BANKING COMMITTEE WILL CONSIDER THESE IMPORTANT ISSUES. I TRUST YOU WILL MAKE THESE HEARINGS ON THE FINANCIAL SERVICES INDUSTRY YOUR FIRST PRIORITY NEXT CONGRESS. I WANT TO ASSURE YOU THAT I OFFER YOU MY FULL ASSISTANCE, AND THAT OF MY STAFF, TO GET ON WITH EARLY HEARINGS, NOT JUST ON THE SUBJECTS OF LOOPHOLES AND ASSET DEREGULATION, BUT ALSO ON REFORMING OUR DEPOSIT INSURANCE SYSTEM AND OUR FEDERAL EXAMINATION AND SUPERVISORY SYSTEM TO ENSURE THE KIND OF FINANCIAL SYSTEM WHICH CAN MEET THE CHALLENGES AHEAD AND SUPPORT A GROWING AND VIBRANT AMERICAN ECONOMY. 413 Chairman S T GERMAIN. Thank you, Mr. Wylie. I would announce to the members of the subcommittee t h a t at this time we are going to ask one of our staff members, Mr. Dugger, accompanied by a gentleman who has been assigned to the committee by the GAO—along with others, GAO has provided facts and computer data, and so forth, to the committee staff t h a t has compiled and produced the drafts t h a t will be explained to us by Mr. Dugger. So, prior to Mr. Isaac's testimony we wish to get this into the record so Mr. Isaac could then comment on these numbers when he testifies subsequent to our discussion with Mr. Dugger and Mr. Bowser. I would ask the two gentlemen, Mr. Dugger and Mr. Bowser, to rise at this point. Do you swear t h a t the testimony you are about to give will be the truth, the whole t r u t h and nothing but the truth? Mr. DUGGER. I do. Mr. BOWSER. I do. Chairman S T GERMAIN. YOU may proceed, Mr. Dugger. TESTIMONY OF ROBERT H. DUGGER, SUBCOMMITTEE DEPUTY STAFF DIRECTOR: ACCOMPANIED BY GARY BOWSER, SENIOR AUDITOR, GENERAL ACCOUNTING OFFICE Mr. DUGGER. Mr. Chairman, and members of the subcommittee, you each have before you a copy of a committee staff report on the potential impact of a Continental bank failure on banks which had exposure in the form of deposits or Federal funds investments in that bank. This report, which I shall refer to as the staff report, attempts simply to clarify certain findings obtained last J u n e by the FDIC staff concerning the exposure of certain banks to a Continental bank failure. This report was prepared by the committee staff, but particular credit must go to the individual on my right, Gary Bowser, and his colleagues. Gary is a senior GAO auditor on assignment to the committee to assist us in carrying out the Continental inquiry. He and I together will attempt to answer any questions you may have at the conclusion of my brief presentation. Last May, Continental Bank's situation reached a point that the FDIC, Comptroller of the Currency and Federal Reserve concluded t h a t a $2 billion temporary assistance program had to be implemented on an emergency basis. The temporary assistance program went into effect on May 17. About 20 days later, as best we can determine, FDIC Chairman Isaac asked his staff to obtain information on the deposit and investment exposure of other banks in Continental. His staff produced two memoranda which appear in the appendix of the staff report, dated J u n e 20 and J u n e 22, about 34 days after implementation of the temporary assistance plan. Chairman S T GERMAIN. IS t h a t the assistance plan of May 10 or 15? Mr. DUGGER. May 17. These two memoranda have been referred to in official statements on a number of occasions. This may be because the memoranda contain the only extended discussion of any of the aspects of 39-133 0 - 8 4 27 414 Continental Bank on which the FDIC's essentiality finding was based. The information contained in the memoranda was referred to, for example, in the conference call made by Chairmen Volcker and Isaac and Comptroller Conover to the chairmen and ranking minority members of the House and Senate Banking Committees, the evening before the permanent assistance package was approved on July 26. The information in the memoranda was referred to again most recently by Comptroller Conover when he testified before this subcommittee 2 weeks ago. On t h a t occasion, Mr. Conover said "If Continental Bank had failed and had been treated as a payoff, certainly those 66 banks would have failed and probably a goodly number of the other 113 would have failed; if not immediately thereafter, certainly within some timeframe afterwards. So let us say t h a t we could have seen another 100 banking failures." This statement and others like it which attempt to justify the Continental assistance program failed to give appropriate weight to three important limitations in the analysis contained in the two FDIC memoranda prepared last June. The limitations appear to be the result of the FDIC staff providing Mr. Isaac only what he asked for and the brief amount of time available to them to perform t h a t very difficult task. The limitations are, first, the benefit of $100,000 in deposit insurance coverage is not incorporated in the analysis. Two, the benefit of the proceeds from a sale of Continental Bank's assets is also not incorporated in the analysis. Three, the deposit and investment data used in the analysis is as of April 30, a date prior to the enormous deposit outflows and public concerns about Continental Bank. To properly assess the impact of a Continental Bank failure on those banks with deposits in it or on the banking system generally, far more information t h a n is contained in the two FDIC memoranda would be needed. At a minimum, the effect of deposit insurance, asset sales, and deposit shifts after Continental's troubles became well known, should be included. To assist the subcommittee in its inquiry, the committee staff has recomputed the information in the two FDIC staff memoranda, this time to include the benefits of deposit insurance and asset sales. We have also requested the FDIC to provide information on the level of deposits as of J u n e 30 for those banks with significant exposures in Continental. The analysis, incorporating deposit insurance and asset sales, is in the report in front of you and reflected in the charts along the far wall. The J u n e 30 deposit information will have to await an opportuity to discuss it at a later date. It is simply not available this morning. The FDIC staff memoranda focused on the amount of demand deposits, time deposits and Federal funds invested by individual banks in Continental. The sum of these items is referred to as a bank's exposure. 415 The FDIC staff found that there were 113 banks with exposures in Continental amounting to between 50 and 100 percent of their equity capital. They found that 66 banks had over 100 percent of their equity capital exposed. From these facts, it has been concluded by various agency officials, as Mr. Conover did 2 weeks ago, that if Continental had failed, 66 banks would have had 100 percent of their capital wiped out and another 113 would have had their equity capital significantly impaired. That is, if Continental Bank had failed, it would have resulted in the failure of 179 banks with total assets of $17 billion. For this conclusion to be true, one must assume that the banks would not receive an insurance payment from the FDIC covering the first $100,000 of their deposits in Continental, and that in the subsequent liquidation of Continental Bank, there would be no recovery from the sale of Continental's assets. Chairman ST GERMAIN. Excuse me, are you saying that according to the FDIC's data, the assumption was apparently made that Continential's loans were valueless? Mr. DUGGER. That is correct. Chairman ST GERMAIN. SO you have to assume that out of all those assets, there would be nothing coming from them? Mr. DUGGER. Correct. Neither of these assumptions are true. And what considerations are included in an impact analysis, the number of banks that apparently would be seriously affected by Continental failure decreases significantly. Chris, could you bring the chart up, please? This chart and the analysis in the staff report reflect an initial subtraction of $100,000 from the insured deposits to account for FDIC deposit insurance. With this done, the number of banks with deposits exceeding 100 percent of capital drops to 65. The number of banks with deposits between 50 and 100 percent drops to 101. The number of banks in each of these categories, for various levels of recovery assumptions, is portrayed in this chart and in the report. You may find table 4 in the report particularly useful at this point. The top line of numbers in table 4 in the report corresponding to a recovery assumption of zero is what the FDIC staff would have obtained had they been asked to net out deposit insurance. On this chart, this is reflected as the number of banks at the zero recovery level, that is, at this point here, assumed percent of recovery, zero, the number of banks is about 65 with greater than 100 percent of assets at risk; and between 50 and 100 percent of assets, a number of 101 with deposit Mr. VENTO. Mr. Chairman, did you research what the cost of that would be? What would be the price to the FDIC insurance fund for that particular insurance? Do we have that information? Mr. DUGGER. I believe we will touch on that point in a moment. Mr. VENTO. Thank you. Mr. PATMAN. Could I ask a question at this point? Chairman ST GERMAIN. Could we allow him to finish. Then we will have questions and answers. Mr. DUGGER. With deposit insurance taken care of, the question becomes how much would the banks have received from the general liquidation of Continental Bank? This is a very difficult question 416 to answer. The only guide is the FDIC historical recovery rate from liquidating institutions much smaller than Continental. We have been told t h a t the FDIC historically has been able to recover from 72 to 74 cents on the dollar. You should be aware t h a t there are strong arguments justifying both higher and lower recovery levels in the case of Continental. Therefore, in the absence of any other indicator, the subcommittee may wish to consider accepting a level of 70 percent, a level somewhat below this FDIC historical performance for the purpose of discussion today. If this is done, the number of banks that would be seriously affected by a Continental failure is indicated in table 4 on the line corresponding to the 70-percent recovery level, and in this chart, as the point above the 70-percent recovery level, that would be right about here, at this level. In this context, assuming the banks in both groups, t h a t is groups between 50 and 100 and those above 100 percent of capital at risk, the number of banks with over 50 percent of capital at risk would be 28; the volume of banking assets would be $1.47 billion, or $1.5 billion. The amount of losses to those 28 banks would be $58 million. This is a very different assessment of the impact of a Continental Bank failure from the 179 banks with $17 billion in assets, and $1 billion in losses referred to by some agency officials. Chairman S T GERMAIN. Does that answer your question, Bruce? Mr. DUGGER. Before concluding, I would like to direct your attention to the two other aspects of the information staff developed which bear directly on the seriousness of the impact on the depositing banks and on the time sensitivity of the information. As you discussed on page 16 of the committee staff report, of the 179 banks with significant exposures in Continental, 58 had no uninsured deposits at all in Continental. This means that the exposure t h a t jeopardized the solvency of these banks was due entirely to their Federal funds investment in Continental Bank. Federal funds investments are uninsured overnight investments made by banks in other banks. They are generally made only on the basis of which bank is offering the highest overnight interest rate and are not indicative of what is generally understood as a correspondent banking relationship. Correspondent relationships involve provision of check clearing, cash handling, loan funding, and other banking services generally by a larger bank to smaller banks. A precipitous cutoff in a correspondent relationship could cause a hardship on a smaller bank. Ending a Federal funds investing relationship would cause no such hardship to the investing bank. It would simply invest its funds elsewhere. The amount of interest sensitive deposit and Federal funds investments in Continental are likely to have been sensitive to public concerns about t h a t bank and, therefore, the level of these exposures may have declined in May and June. It was for this reason t h a t the FDIC was asked to gather information concerning the J u n e 30 level of exposure. That completes our presentation of the staff report, Mr. Chairman. Gary and I will do our best to answer any questions you or the other members of the subcommittee may have. 417 [The staff report entitled "Continental Illinois National Bank Failure and Its Potential Impact on Correspondent Banks" follows:] 418 CONTINENTAL ILLINOIS N A T I O N A L BANK F A I L U R E AND ITS POTENTIAL IMPACT ON CORRESPONDENT BANKS STAFF REPORT TO SUBCOMMITTEE ON F I N A N C I A L INSTITUIONS SUPERVISION, REGULATION AND INSURANCE COMMITTEE ON B A N K I N G , FINANCE AND URBAN AFFAIRS October 4, 1984 This report is the result of staff findings to date and does not necessarily r e f l e c t the views of the Members of the Subcommittee. 419 CONTENTS Page Executive Summary 1 Section Statistical data on the number of banks, total assets, and amount of loss for those banks with an uninsured loss in excess of 50% of capital and those banks with exposure to CINB greater than $10 million with an uninsured loss less than 50% of capital. Recalculation of the effect of Continental Illinois National Bank's failure on correspondent banks. Cost analysis used by FDIC to determine the least costly method of assistance. Appendix 14 19 Memoranda: Robert V. Shumway, Director Division of Bank Supervision 420 Executive Summary This report discusses the potential impact of the liquidation of Continental Illinois National Bank on banks w i t h deposits and federal funds in Continental Bank. The report is divided into three sections. In the f i r s t section, we present (1) three charts which provide information on the number of banks, t o t a l assets, and the amount of loss as related to various percentages of recoveries f r o m that would have resulted from a possible Continental Illinois National Bank liquidation for those banks with an uninsured loss in excess of 50% of their equity c a p i t a l , (2) a table summarizing the data values used to produce the 3 charts, (3) a series of tables providing information on banks that had at least $10 million of funds invested in Continental Illinois Bank and a percent of exposure to capital less than 50%. The second section presents the Federal Deposit Insurance Corporation's calculation and the Committee's recalculation of the potential impact that the failure of Continental Illinois National Bank would have had on its "correspondent banks." The third section discusses the cost analysis that is normally used by the Federal Deposit Insurance Corporation to determine the least costly method of assistance. 421 Section 1 Statistical data on the number of banks, total assets, and amount of loss for those banks with an uninsured loss in excess of 50% of capital Statistical data on the number of banks with exposure to CINB greater than $10 million with an uninsured loss less than 50% of capital. 2 422 TABLE 1 NUMBER OF BANKS WITH AN UNINSURED LOSS IN EXCESS OF 53 PERCENT.OF CAPITAL 185180- 95-J 98 -1 85-j 88 H 75 H 49.5* TO 99. 4X 65 4, 60-j 55 A 50-J 40-4 35-J 30-1 25 H 20H 15 I 10H 5 GREATER THAN 99.4X % **v-m I 3-4- T — i — \ — i — i — i — i — i — i — i — i — i — i — i — i — i 8 (0 20 30 40 50 60 78 88 y T 98 . PERCENT OF RECOVERY Note: Ranges for points on the two lines were chosen to prevent overlap. Banks with ratios between 49.5 percent and 49.9 percent were included in the 50 percent category. Also, banks with ratios between 99.5 percent and 99.9 percent were included in the 100 percent category. 3 188 423 TABLE 2 TOTAL ASSETS OF BANKS WITH AN UNINSURED LOSS I N EXCESS OF 50 PERCENT OF CAPITAL DOLLARS 1 <> CM O-m MILLIONS 1 1 , 4 4 8 13,86818.2969.7249.1528.588T 0 T A L A S S E T S 8.8887.4366,864- \ 49.S% TO 99.4% 6.2925,7235,148- V \ 4,576J * 4,884- ^ k% 3,432- \ V 2,868- %K * 2,288- \ \ V **** V 1,7161,144- GREATER THAN 9 9 . 4 X V X 5723- —i—i—i—i—i—rr—i—i—i—i—i—i—i ^-irr^w ' i i " v 1Tr J < 18 2 8 3 8 4 3 5 0 6 0 7 0 8 0 9 0 1$*8 PERCENT OF RECOVERY Note: Ranges for points on the two lines were chosen to prevent overlap. Banks with ratios between 49.5 percent and 49.9 percent were included in the 50 percent category. Also, banks with ratios between 99.5 percent and 99.9 percent were included in the 100 percent category. 4 424 TABLE 3 THE AMOUNT OF LOSS FOR BANKS WITH AN UNINSURED LOSS IN EXCESS OF 53 PERCENT OF CAPIT; 567- 49.5* TO 99.4X 188 PERCENT OF RECOVERY Note: Ranges for points on the two lines were chosen to prevent overlap. Banks with ratios between 49.5 percent and 49.9 percent were included in the 50 percent category. Also, banks with ratios between 99.5 percent and 99.9 percent were included in the 100 percent category. 5 TABLE 4 NUMBER OF BANKS. AMOUNT OF ASSETS. AND UNINSURED LOSS UNDER VARIOUS RECOVERY ASSUMPTIONS NUMBER OF BANKS PERCENT GREATER OF RECOVERY THAN 99.4% 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 65 60 54 49 45 40 38 30 27 19 14 11 9 9 6 3 2 0 0 0 0 BETWEEN 49.5% & 99.4% 101 99 90 85 83 78 68 61 56 55 51 45 36 29 22 11 7 6 2 0 0 AMOUNT OF ASSETS (dollars in millions) GREATER THAN 99.4% $4,792 4,170 3,546 3,046 2,716 2,281 2,021 1,612 1,460 1,024 796 513 465 465 385 240 119 0 0 0 0 BETWEEN 49.5% & 99.4% $11,857 11,875 11,051 10,460 10,050 9,335 8,411 6,105 4,846 4,419 3,997 3,465 2,251 1,556 1,085 555 346 385 119 0 0 AMOUNT OF LOSS (dollars in millions) GREATER BETWEEN THAN 99.5% 49.5% & 99.4% $473 401 343 293 254 204 178 137 116 82 63 38 31 27 18 10 2 0 0 0 0 $554 555 509 473 441 408 349 273 227 203 174 146 96 61 40 21 13 9 1 0 0 to 426 TABLE 5 LISTING OF CORRESPONDENT BANKS WITH EXPOSURE TO CINB OF GREATER THAN 50 MILLION AND P ERCENT OF EXPOSURE TO CAPITAL LESS~THAN 50% (In Thousands: of Dollars) Bank No. 1 2 3 * 5 6 7 8 9 10 11 12 13 14 15 16 17 IS 19 20 21 Assets Demand Deposit Accounts Time Deposits Federal Funds Sold Exposure Capital S, 096,390 23,001,540 109,668,351 23,855,154 20,848,829 5,954,922 6,973,980 35,539,783 936,822 17,440,544 9,138,864 16,897,106 40,129,581 22,634,707 12,645,530 49,345,727 58,059,865 56,204,251 113,474,000 5,799,603 8,353,574 2,759 408 17,916 97,767 55,976 0 41 0 3,533 52 69 923 355 5,841 9,297 10,639 27,364 972 55Z 6,541 1,471 146 138,975 213,817 0 5,650 86,579 53,322 224,569 14,000 74,000 12,100 127,416 226,815 85,000 50,000 135,938 6,797 206,250 72,000 20,000 50,000 50,000 0 300,000 0 0 40,000 30,000 0 44,500 0 50,000 0 0 0 0 0 150,000 0 0 50,000 0 52,906 139,383 531,733 97,767 61,626 126,579 83,364 224,569 62,033 74,052 62,169 128,339 227,171 90,841 59,297 146,577 184,161 207,222 72,551 76,541 51,471 412,957 1,008,532 4,200,083 1,051,730 925,552 322,891 358,620 1,425,664 0 763,226 438,313 776,475 1,636,597 878,802 632,737 1,954,240 2,502,005 2,906,265 5,924,000 528,144 422,500 644,999,123 242,482 1,803.374 714,500 2,760,359 29,069,333 7 %of Exp. to Capital 13 14 13 9 7 39 23 16 0 10 14 17 14 10 9 8 7 7 1 14 12 427 TABLE 6 LISTING OF CORRESPONDENT BANKS 1 WITH EXPOSURE TO CINB OF 20 MILLION TO 49.9 MILLION AND PERCENT OF EXPOSURE TO CAPITAL LESS THAN 50% (In Thousands of Dollars; Bank No. 1 2 3 4 5 6 7 S 9 10 11 12 13 1* 15 16 17 13 19 20 21 22 23 Demand Deposit Accounts Time Deposits Federal Funds Sold Exposure 2,755,764 3,697,908 4,757,591 8,477,650 3,066,290 2,004,140 1,072,501 1,983,223 1,699,321 7,485,877 9,681,201 79,546,624 109,927 954,074 3,236,369 4,736,423 5,128,125 21,809,868 4,866,675 2,553,669 11,034,025 12,581,531 3,800.762 12,351 19 201 1 5,187 16,233 4,523 201 5 0 86 6,383 0 0 5,784 900 1,266 6,001 51 200 806 904 26 10,000 31,000 0 7,300 26,195 11,000 0 35,000 0 25,000 43,000 16,812 20,000 20,000 0 33,043 3,000 20,000 30,000 20,000 0 35,000 13,209 0 0 20,000 25,000 0 10,000 25,000 0 25,000 0 0 0 0 0 20,000 0 25,000 .0 0 0 25,000 0 10,000 22,351 31,019 20,201 32,301 31,382 37,233 29,523 35,201 25,005 25,000 43,086 23,195 20,000 20,000 25,784 33,943 29,266 26,001 30,051 20,200 25,806 35,904 25,235 105,318 217,050 207,275 438,220 174,839 112,882 72,770 117,031 102,740 498,067 904,847 3,662,570 0 53,615 125,080 218,338 331,543 930,407 220,810 132,316 331,902 529,659 193,728 197.039.548 61,128 _401,559 185,000 647,687 9,681,007 Assets Capital %of Exp. to Capital 21 14 10 7 IS 33 41 30 24 5 5 1 - 37 21 16 9 3 14 15 8 7 13 -ONOOO-vlONNMn-p-VjJIsJt- UJ •— NJI -P- NJ N* -P -P N> « • > - N f l \ i - * O i ' O O O i - u v O N v O * ' O N J O O U V » ) K » U ) 0 0 ( M N l O \ ( O U l ^ O O N ) O O N M C O \ j | N | 0 0 > 0 \ W U U - t O N V * i M O \ O W O O O O v O O O \ v J V » ) f r V * t - S i - O O K ) V j i O \ U i * , i - U i O - P l N ) O U i W K J h O O ^ - N O N U U f r O \ v O ^ * 0 0 \ U < r O O O O O N J O V O N W O U U W O O \ i - OO » Oo M M t U - N i i v 0 0 0 v 0 V 4 0 v W - t ? t - 0 \ O 0 N N 0 \ U * ' 0 0 N > - . 0 \ * ' * ^ O C 0 S V » ) * U ) O i U V J U V 0 * ' v « - p , v J N J h - s C W » - v j i t 0 \ U v C N j l j , l _ s j v > ) W 0 0 H - a \ 0 \ - l ? f f \ 0 0 0 \ W N J W U - f r M N J O O U » v C t - t 0 i - W 0 0 NV» NV» •-ON4T*— ON •— VJI » - • - K> N* K> •— N> » - N> ON l\> •— » N ) U O O -P v» 00 V * . p o* U - t ? ^ t - M * j i ^ » - K ) K J NOONOVjJVlvO O »— k v 0 O - P O * ^ O O O M O U W O N O O i W I M O i V 0 O * M 0 0 M O I 0 ' J i N W U O O O 0 0 * O O O O O O O O O O O O O O O looooooooooooo*- O O N i O O VJI O v » N> O N> V N^I U» O O O l O " 4 O O ^ N J O VJI O V - » i O 0 0 O 0 0 0 O O O v » » O 0 0 O ^ 1 0 O O O O O O 00 O NJ» O O O NJI U i OO OHO O O O O K > O N O O O O O V v i O O O O O O O OK» O O O O OVrt O ' O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O O [ O N ) O K i O O O O N v i O r o * - O N -