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Remarks by
John P. LaWare
Member, Board of Governors of the
Federal Reserve System
to the
Academy for Advanced Studies
in Banking and Finance
Fairfield, Connecticut
July 9, 1993

Good afternoon to you all.

I hope that you are enjoying

your visit to the United States and that your study schedule has
not been so strict that you have not had a chance to meet some
people who live here and to have some fun while you are
discovering how Americans conduct the business of banking.


are very pleased to have you all with us and those of us who are
your guests today are anxious to be helpful to you and your
My assignment today is to discuss the reasons why some banks
fail, what the consequences of failure may be, how failures can
be limited by constructive supervision, and why a strong soundly
managed banking system is critical to the successful operation of
a market economy.
First, I will explain why banks are special among all
business enterprises.

Second, I will discuss very briefly two

failures of American banks which failed for different reasons.
Third, I will tell you what the consequences of those failures
were and what they might have been.

Finally, I will impress upon

you the importance of maintaining a safe and sound banking system


through a managed program of supervision, regulation and
examination by a suitably chartered government agency, whether it
be the central bank or an agency set up exclusively for
supervision and regulation of the banks.
Well, then, what makes banks special?
that they play in the economy.

It is the unique role

They are money managers in the

sense that they match the needs of those who have excess funds
with the need of those who require additional funds.
intermediaries between borrowers and lenders.

Banks are

Depositors lend

their money to banks in return for interest earned and services
rendered by the bank.

The bank, in turn, lends the depositors'

money to borrowers who are in need of extra funds, whether the
borrower is a government entity, a corporation, a partnership or
an individual.

The bank keeps the difference between what it

earns from lending and what it pays for deposits in order to pay
its own expenses and realize a return for those who have invested
in the shares of the bank —

i.e., the stockholders.


provide funds to the bank, the bank manages the investment of
those funds in loans or securities.
for the depositor.

The bank manages the risk

The shareholder provides capital to the bank

to absorb losses if managers of the bank make a mistake by taking
too much risk.

If the capital supplied by the stockholders is

not sufficient to cover the mistakes of management, then the bank
fails and both stockholders and depositors lose all or part of
what they had.

If the bank is successful, the profits belong to

the stockholders and the depositors' money is safe.
What makes banks special is that they are using other
peoples' money.

They use depositors' money to take risks and

they use stockholders' money to absorb losses if they take too
much risk.

If the depositor and stockholder lose all or most of

what they have because a bank fails, then they have less with
which to buy goods and services and make investments in other

If many banks fail at the same time, the effect

could be to damage the operation of the whole economy.

That, in

fact, is what happened in the United States between 1929 and 1933
and it had the effect of making the Great Depression much deeper
and longer-lasting than it might otherwise have been.
The lesson of the failure of thousands of banks was not lost
on the United States Congress.

In the 1930's, the Congress made

several laws strengthening the supervision and regulation of
banks and, perhaps most important, creating the Federal Deposit
Insurance Corporation to insure the deposits in banks.


purpose was to prevent runs on solvent banks by depositors who
were alarmed by bad news about other banks and were trying to
protect their money.

No bank can survive a sustained run,

because the assets, which are of essentially longer duration,
cannot be liquidated fast enough to pay all of the depositors in
a matter of hours or days.
With their deposits insured up to an amount which covered
most individual depositors completely, consumers maintained their
confidence that they would not be wiped out.

From the mid-1930's

until 1991, there were virtually no consumer runs on nationally
insured depository institutions in the United States.

And there

were very few failures of nationally insured banks between 1935
and 1985.

This system of deposit insurance is another thing

which makes banks special.

I will now briefly describe the failures of two large United
States banks.

The banks were very different in structure and the

methods for dealing with their failures by the United States
authorities were very different.

The consequences of their

failures were also potentially very different.

The two banks

were the Continental Illinois National Bank in Chicago, Illinois
which failed in 1984 and the Bank of New England Corporation in
Boston, Massachusetts which failed in 1991.
Continental Illinois had assets in excess of 40 billion
dollars in 1984.

It operated in the financial district of

Chicago under the laws of the State of Illinois which did not
allow banks to have branches.
little consumer deposits.

As a result, Continental had very

That is to say, insured deposits.


fact, consumer deposits were only about 10-12 percent of all

Continental was primarily a wholesale bank.

means it did most of its lending to large corporations.


And it

funded its lending with large uninsured corporate deposits and
funds in the form of negotiable certificates of deposit,
Eurodollars and subordinated debt.
In the late 1970's and early 1980's, the management of
Continental adopted a corporate strategy which we now believe led
to its later failure.

Management announced that it was

Continental's goal to become the largest lender to commerce and
industry in the United States.

That meant it was setting out to

take a share of business held by others like Bank of America,
Citibank, Morgan, Chase, Chemical and its nearby rival First
National Bank of Chicago.

In order to take loan business from another bank or to get
new loan business which might otherwise go to a competitor, a
bank must offer the borrower more favorable terms.

These may be

in the form of lower interest rates or easier repayment terms.
But there also may be lower credit standards which increase the
risk in the loan.

In Continental's case, there was also a

delegation of loan approval authority to less experienced

These officers also interpreted their opportunities

for promotion and higher pay as depending more on the quantity of
new loans they could produce than on the quality of the loans.
This is an almost perfect formula for disaster:


standards in order to win business; management emphasis on
quantity rather than quality; and delegation of lending authority
to inexperienced loan officers.
The energy business was booming in the early 1980's and
there was a tremendous demand for oil exploration and production

Some Continental officers established a close working

relationship with a small bank in the oil-producing section of
Oklahoma called the Penn Square Bank.

Continental assumed Penn

Square knew all there was to know about oil loans and agreed to
buy from Penn Square loans they could not keep on their own

Continental also took participation in Penn Square loans

in excess of Penn Square's legal limit.
Continental took Penn Square loans without any significant
credit analysis of its own and little attention to checking

Again, I must emphasize that one of the key

errors of management in the case of Continental was to abandon

good lending procedures and credit standards in a reckless
pursuit of new loans.
Continental's troubles began to show up when the Penn Square
bank failed due to losses on bad loans.

Some of those loans were

also believed to have been fraudulently made.

Obviously, many of

the loans sold or participated to Continental were also bad.


Continental was not the only victim of Penn Square's bad

There were several banks in other cities which also

participated in loans made by Penn Square or bought loans

Examiners found hundreds of millions of such tainted

loans on Continental's books.

In addition, there were many tens

of millions of dollars of other bad loans.

Energy loans and more

conventional commercial and industrial loans made under the same
system of inadequate credit policies, poor procedures and
unwisely delegated lending authority.
With the failure of Penn Square it became widely known and
reported in the press that a lot of Penn Square's bad loans had
gone to Continental.

The insured depositors at Continental were

unconcerned because the United States government fully guaranteed
the insurance which protected their deposits.

But the uninsured

depositors, general creditors and Eurodollar deposit holders
began to withdraw their support.
they were not renewed.

When term deposits came due,

Eurodollar contracts were closed out and

the bank found difficulty in raising federal funds in the
interbank market.
Continental not only had a potential capital deficiency due
to bad loans, but also a very real liquidity crisis due to a
corporate run on the bank by uninsured depositors and general



Continental borrowed heavily from the Federal

Reserve, as the central bank and lender of last resort, to meet
the liquidity crisis, but it soon became evident that the bank
could not meet the demands of its creditors and capital was
seriously impaired by realized and anticipated losses on bad
It might have been possible to close the bank and liquidate
it in an orderly fashion.

That would mean paying off insured

depositors and then selling or collecting the remaining assets of
the bank with the uninsured depositors and other creditors
sharing whatever losses were realized on liquidation.
another serious problem arose.


Continental was one of the

nation's leading correspondent banks with deposit accounts from
hundreds of banks all over the country, particularly from banks
in the states in the Middle Western United States near Chicago.
Many of these were small banks which maintained large accounts at
Continental to facilitate check settlements, securities
transactions, wire transfers and other routine business

For several hundred of these correspondent banks

the amount of their deposits with Continental exceeded their

If Continental were closed, they would be insolvent.

The prospect of the failure of so many banks at one time was

The result would have been serious losses to the

depositors and stockholders of the smaller banks and disruption
of commerce in the communities they served.

Furthermore, if the

bank had been closed by the authorities, many of the large
companies and banks both in the United States and in foreign
countries would have lost large amounts as their CDs, federal


funds loans, Eurodollar contracts and other claims were not

This might well have created a crisis of confidence

which would have caused them to close out claims on other U.S.
banks linked to the Penn Square Bank.

That would have seriously

destabilized the entire banking system.
The Federal Deposit Insurance Corporation, the Comptroller
of the Currency and the Federal Reserve Board determined that the
threat to the stability of the banking system was serious enough
to declare the Continental too big to fail.

Consequently the

Federal Reserve loaned several billion dollars to Continental to
meet its liquidity requirements and the Federal Deposit Insurance
Corporation injected several billion dollars of capital into the
bank, in effect replacing the private shareholders who were
virtually wiped out.

With the FDIC as the principal stockholder,

the bank was owned by a government agency which tended to restore

The FDIC then moved to replace the management and

the situation was stabilized.
Under new management, the loan problems were addressed, the
bank was significantly reduced in size and gradually returned to

It also paid off its loans to the Federal

New capital was brought in and the FDIC eventually sold

off its interest in a secondary offering, returning the bank to
private ownership.

In the process, a banking crisis was narrowly

averted and many depositors and institutions tied to Continental
through the interbank market were spared very large losses.
This history of Continental's troubles illustrates the
interdependence of banks and the importance of sound banks to the
proper functioning of the payments system and the economy as a


The failure of Penn Square was a direct cause of the

failure of the much larger Continental and, had Continental been
closed by the authorities instead of taken over as a going
concern, hundreds of other institutions might also have failed
with very serious consequences for the entire economy.
The other failure I want to describe to you is the Bank of
New England. It was a large regional bank holding company with
about $24 billion in assets.

The head office was in Boston,

Massachusetts, but it also had a large bank in Hartford,
Connecticut and subsidiary banks and branches over much of New

The bank had a proud tradition going back 150 years or

more and was the result of the consolidation by merger and
acquisition of many banks in the major cities of the region.
Bank of New England also was a case of mismanagement and
careless, perhaps even negligent, loan administration.

In the

1980's, New England, and California, were the nation's most
prosperous regions.

The computer industry, defense contractors,

health care providers, insurance companies, banks and
universities which were the core of the New England economy were
all booming.

To support these prosperous industries, real estate

development blossomed.

The demand for first class office space,

hotels, laboratories, manufacturing plants and multi-family
residential facilities seemed to be insatiable.

Several thousand

hotel rooms were added in Boston alone in the early 1980's and as
soon as a new office building was completed it was filled.


for first-class office space in Boston went from $15 per square
foot per year in 1978 to $35 per square foot by the mid-1980's.
And prices for single family houses quadrupled in ten years time.

To finance this real estate boom, banks entered into a
highly competitive bidding war to obtain the developers'

Banks were convinced that prices for real estate could

only go up and that a new building would be worth more than the
cost to build it by the time it was completed.

We have seen

construction loans made for 100 percent of the cost of

Therefore, the developer or builder had none of his

own money in the project.

In addition, banks would build into a

loan a contingency reserve of 5 to 10 percent to cover cost
overruns and finally they would lend the full interest to be paid
on the loan up to the time of completion.
Historically, banks would not finance speculative building

Instead they would require either a commitment for

permanent financing at the completion of the building or the
acquisition of the building on completion by an individual or
corporation of high credit standing.

These basic principles of

sound construction lending were abandoned or compromised by many
banks in the 1980's and the Bank of New England, fighting to
obtain a dominant market share in real estate finance in the
region, was one of the most aggressive banks to offer favorable
terms like those I have described in order to get the business.
And they succeeded.

Too well.

Their loan portfolio became

overloaded with real estate loans, bad ones as it turned out, and
when the New England economy went into rapid decline in 1989 and
1990, real estate prices declined even faster.
oversupply of available space.

There was an

House prices declined as much as

15 or 20 percent and first-class office space rent went from $35
per square foot back to $20 per square foot.

As a result, the buildings on which banks had loans were
unsold or unrented.

Developers were bankrupt and the loans on

the buildings were now far in excess of their market value.
loans could not be serviced from income.


They could not be sold

except at deep discounts which would result in heavy losses to
the bank holding the loan.
Perhaps hardest hit of all New England banks by these
circumstances was Bank of New England.

With its heavy

concentration in real estate loans and real estate related loans
it was particularly vulnerable to the turn of events.


inappropriate management strategy, bad credit policies and a
failure to make an accurate judgment of market conditions and the
risks in the marketplace all combined to put the bank in deep

Loan loss provisions to bring the loan portfolio into

some relation to actual value consumed earnings and invaded
Early in the crisis the directors of the bank assumed the
lead in trying to save it.

They organized several special

committees to oversee various parts of the bank.

They fired the

chairman and some other members of the senior management and
brought in a new chief executive officer to try to work the bank
out of trouble.

He did a remarkable job.

He sold assets, worked

down the problem loans and tried to improve the capital position
by negotiating with debt holders to convert their debt to equity.
He did reduce staff and shrink the bank to improve the capital
ratios and he stabilized the operation enough to pay off loans
from the Federal Reserve where the bank had been borrowing
steadily for six months due to the loss of corporate deposits.


But, in the end, the wounds were too deep, the losses too
great for the bank to survive.

The end came in January 1991.


spite of management's valiant efforts to keep the bank going,
events conspired to bring it down.

The New England economy

continued to decline and as a result the weakness in Bank of New
England's loan portfolio spread from real estate to other loan

As losses mounted, capital was further depleted.

Negotiations with debt holders collapsed.

The final blow was the

failure of the state deposit insurance system for credit unions
in the adjoining state of Rhode Island.

The press reports of

small depositors losing their money created a panic among Bank of
New England depositors.

Press reports of the bank's problems

combined with the Rhode Island mess resulted in the first
consumer run on a bank in more than fifty years.
Between opening on a Friday and closing at noon on Saturday,
consumers withdrew nearly $1.5 billion even though their accounts
were fully insured.

Under the circumstances, the authorities

decided the bank was no longer viable.

The Federal Deposit

insurance Corporation seized the bank and requested bids from
other banks who wished to take over the franchise of Bank of New
England subject to the FDIC assuming responsibility for bad

The successful bidder was Fleet —

holding company —

a Rhode Island bank

which assumed responsibility for all deposits

and acquired some of the loans which its analysts judged to be
Again the device of government takeover rather than
liquidation was chosen by the authorities because in their
judgment the shut down of Bank of New England in an already

seriously crippled New England economy would have been seriously
destabilizing and might have impaired the ability of other banks
in the region to fund their own operations.
The consequences of bank failures are serious no matter how
small or how large the bank and no matter how the failure is
resolved —

whether by liquidation or purchase of assets and

assumption of deposit liabilities.

In a small rural community

where the failed bank may be the only bank, the failure may
virtually bring commerce to a halt.

Any failure imposes personal

hardships on individuals as well as corporations.
people lose employment.


Some depositors lose money.

Stockholders lose their investment —

usually all of it.


who supplied goods and services to the bank lose a customer.
Those who used the bank as a source of financial support must now
establish sources of that support with another institution.
When one thinks of the consequences of the failure of a
major money center bank in New York, or London or Frankfurt or
Tokyo, it is not difficult to understand that there could be
worldwide repercussions with the real possibility of widespread
financial panic.
The whole rationale for supervision and regulation of the
banks is to avoid such consequences —

whether they be the

localized effects of a small bank failure or the earth-shaking
reverberations from the fall of one of the giants.
All through history, the most important reason for bank
failure has been bad loans or bad investments —

usually bad

Therefore, it is imperative that bankers exert their best

energies and judgment in managing the acquisition and

administration of loans.

Analysis of the borrower's ability to

repay must be thorough and accurate.

The loan must be

constructed so that the borrower can service it as to interest
and principal without impairing his normal pace and scope of

The risk inherent in the loan must be accurately

reflected in the interest and fees which the bank earns on the
loan during its life.
risk it is assuming.

The bank should be paid for the level of
And, since the best bankers sometimes make

mistakes, there must be sufficient capital to absorb losses and
yet sustain the bank's viability.

While all capital is

always available to absorb losses, it is prudent in good times to
set aside reserves over and above operating capital to absorb
expected losses.
Since governments, businesses and individuals are all
dependent on banks to facilitate payments and obtain credit, the
safety and soundness of the banking system is critical to the
proper operation of a nation's economy.
In order to assure that banks are operating in a safe and
sound manner, government must devise ways to monitor the banks
and create regulations for their operation which help them avoid

In the united States, we have both national and

state regulatory authorities and at both levels of government we
have established a monitoring system which is based on periodic
uniform reporting by the banks and on-site examination of the
banks by the regulatory agencies.
overdone it.

Some would argue that we have

That our banks are over-regulated to the point of

being smothered.
probably due here.

Indeed, some moderation of regulation is
But by and large our system has worked well

and you would do well to consider how it might be adapted to your
own situation.
In closing, my wish for all of you is that you will grow to
be full of the wisdom and judgment to guide your banks in safe
and sound operations for your own benefit and for the benefit of
your community and your nation.