The Great Fall of Continental Illinois: A Story of Risky Loans and Disappearing Money

The financial world is a complex ecosystem, and sometimes, even the biggest players can stumble. The story of Continental Illinois National Bank, once Chicago's pride and the seventh-largest bank in the US, is a prime example. In 1984, Continental Illinois wasn't brought down by a daring heist or a computer glitch, but by a silent, insidious enemy i.e. a liquidity crisis.

Risky Loans and a Thirst for Growth:

In the late 1970s, Continental Illinois embarked on an aggressive growth strategy. They saw an opportunity and went all-in on commercial and industrial loans, which ballooned from $5 billion to over $14 billion in just five years. This rapid expansion fuelled their rise, but it also planted the seeds of their downfall. The bank became heavily invested in a specific sector that was oil and gas  which seemed like a sure bet at the time and somewhat led to concentration risk.

The Collapse of Penn Square and the Domino Effect (Systemic Risk):

Not all banks were pursuing riches from oil and gas, including Continental Illinois. Penn Square, a smaller bank with offices in Oklahoma, had grown to be a significant player in the funding of oil exploration projects. But many of these businesses failed when oil prices fell in the early 1980s. Regulators closed Penn Square in 1982 after it became insolvent due to an overwhelming amount of bad loans. Alas, Penn Square was intricately linked to Continental Illinois. They owned loans totalling more than $1 billion to Penn Square's oil and gas customers. Continental lost a huge amount of money when these loans fell into default. This wasn't an isolated incident either; during this time, loan defaults occurred at many other banks as well. But Continental's selective funding approach was what made it vulnerable.

A Funding Flaw – Too Few Deposits, Too Much Borrowing:

Unlike most banks that rely heavily on customer deposits, Continental had a smaller retail banking presence and a limited deposit base. To fuel their loan growth, they relied heavily on two primary sources:

• Federal Funds: Borrowing short-term cash from other banks.

• Certificates of Deposit (CDs): Issuing these time-bound investment instruments to attract larger deposits.

This strategy worked well initially. But when rumours about Continental's exposure to bad loans started swirling, it triggered a panic. Investors who had lent money through federal funds or CDs became nervous and wanted their money back – fast.

A Run on the Bank and a Desperate Scramble:

As fear spread, a classic "run on the bank" scenario unfolded. Depositors began withdrawing their CDs at an alarming rate. In just ten days, a staggering $6 billion vanished from Continental's accounts. With their usual funding sources drying up, Continental faced a liquidity crisis – they simply didn't have enough liquidity to meet their daily obligations.

Desperate for a lifeline, Continental turned to international money markets, borrowing at much higher interest rates. But this wasn't a sustainable solution.

The "Too Big to Fail" Dilemma and a Rescue:

The entire US financial system was seriously threatened by the possible collapse of Continental Illinois. Continental was seen as "too big to fail" because of its connections to other banks, which made it possible for its failure to have a cascading effect that would destroy the whole banking sector. In response to this dire situation, authorities intervened to stop a financial collapse. The Federal Deposit Insurance Corporation (FDIC) arranged for Continental to be bought out by another bank and provided financial support as part of a rescue plan. US banking regulations underwent a sea change as a result of this extraordinary intervention.

Lessons Learned from a Crisis:

The catastrophe involving Continental Illinois is a great reminder of the perils associated with taking on too much risk and depending too much on one industry (Concentration Risk). It also emphasises how crucial a robust investing prospect and diversified funding strategy are. The idea of "too big to fail" is still up for debate in the financial community, bringing up issues with moral hazard and possible government intervention in future crises. Examining past occurrences such as the Continental Illinois liquidity crisis helps us understand the intricacies of the financial realm. We can make better financial decisions and navigate the constantly changing economic landscape with the aid of these lessons.

Documentary/ Movie Recommended: Frontline- Breaking the Bank, S3.E21