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Banking parallels

• Evan Davis | Notes on Real Life |
• 19 Feb 08, 09:22 AM

Nationalising a bank is a big deal. But it is not unprecedented.

It is worth reading the history of Continental Illinois, nationalised by the in 1984.

You can get the full story from the FDIC itself (pdf link). But let me give you a potted account.

The Bank was the biggest in Chicago and the seventh biggest in the US. It had grown very fast and had received glowing approvals from Wall Street observers in earlier years. (Not dissimilar of course, to Northern Rock which had, for example, been rated a “buy” by Deutsche Bank analysts less than two years ago when its share price was around £11).

A few voices had suggested that Continental Illinois was in fact simply engaging in an ancient banking technique for achieving short term growth – that of taking bigger risks than more cautious rivals would countenance.

Problems first surfaced in 1982 with the collapse of Penn Square Bank in Oklahoma. Continental Illinois lost more than any other bank, having participated in careless oil and gas loans.

Its share price dipped and its credit rating was downgraded. As a result, it became dependent on tapping the foreign money markets for its financing, borrowing short term to keep costs down.

It was not a bank that had secured a very large retail deposit base.

By the spring of 1984, problems in Continental’s loan book were mounting and rumours surfaced of problems. On May 9th, a Reuters journalist asked the bank whether it was true that it was on the road to bankruptcy (the suggestion was dismissed as “totally preposterous”). Foreign depositors didn’t wait to find out how preposterous it was, they started to withdraw their cash.

Even the Chicago Board of Trade Clearing withdrew $50 million and quickly the bank became victim to an “electronic bank run”.

The Federal Reserve ended up supporting the Bank through its “discount window”, but more support was needed.

On May 17th, the FDIC announced that all deposits at the Bank would be guaranteed. Extra federal support was provided, and some assistance from other banks too.

While this bought time, a permanent solution was sought.

The preferred option was for a private takeover of some kind, but it could not be arranged.

In the end, the FDIC itself constructed a complicated arrangement that involved it taking 80% of the equity, with the bank continuing to operate.

You don’t need me to tell you that there are some parallels to Northern Rock here: the bank run, a deposit guarantee, a delay while private solutions are sought, and nationalisation.

And that sequence is not fortuitous. At each stage of the process, there are only a limited number of options, and the ones chosen (then and now) are chosen for a reason – that the others look even more unattractive.

The good news is that when the last pieces of Continental Illinois were eventually sold off (seven years later!) the FDIC had apparently netted a profit. Whether that profit truly compensated for the state’s backing I’m not sure.