Abstract

Credit policy function used to be a shield against extreme risk when credit was the primary financial risk at financial institutions. The examples of Continental Bank and Penn Square Bank show that the failure of credit policy function can lead to disastrous results. With increased securitization, today's financial institutions derive a much larger proportion of their revenues from market risk. This has profoundly changed the composition and magnitude of total tail risk. Traditional risk management doesn't have an explicit focus on tail risk akin to credit policy's role. This has resulted in a relative decline of the tail risk watchdog function just when the need for such a watchdog role has increased. The net effect is that, while the evolution of revenue models has increased tail risk, the watchdog role has not kept up with its critical need. As a result, most financial institutions are more vulnerable to extreme tail risk now than they were many years ago.

Keywords

Tail risk; Credit policy; Financial risk; Market risk; Continental Bank; Penn Square Bank

Prologue

2.1. Credit Policy: A Watchdog Function without Any Glamor

2.2. Credit Policy Role at Continental Bank

2.3. Evolution of Revenue Models and the Watchdog Function

2.4. Could the Problems of 2008 Have Been Avoided?

Epilogue

References

Credit policy function used to be a shield against extreme risk when credit was the primary financial risk at financial institutions. But with the proliferation of market risk, there has been a relative decline of the tail risk watchdog function in relation to the total tail risk. This has made financial institutions with large market risk more vulnerable to exposure from extreme tail risk.

Prologue

Following the beautiful weather of the previous day, it seemed like a pretty dull start to a day, with sprinkles off and on that morning. There was a chill in the air, with the morning temperature in the low 40s. The city that never sleeps was up and getting started, when someone may have muttered:

“Hey, isn’t that Lew Preston, president and CEO of J. P. Morgan? And over there, isn’t that Charles Sanford, president of Bankers Trust walking this way? And there is Paul Volcker, chairman of the Federal Reserve Board. Here comes John McGillicuddy, chairman of Manufacturers Hanover Bank. There across the street—stepping out of a car—is Tom Theobald, vice chairman of Citicorp. Isn’t that Walter Shipley, president of Chemical Bank, coming to the same building? There goes Thomas Labrecque, president of Chase Manhattan Bank. Over there, isn’t that Sam Armacost, president of Bank of America? That’s Tony Solomon, president of the Federal Reserve Bank of New York. Over there, that’s Gerry Corrigan, president of the Federal Reserve Bank of Minneapolis. There’s Bill Isaac, chairman of the FDIC. And isn’t that Todd Conover, comptroller of the currency? What’s going on?”

Actually, the sighting of any one of them—titans of the financial industry—wouldn’t have been that unusual in downtown New York. However, all of them at one place? But hardly anyone noticed. Considering that all the bigwigs of the financial industry were there, someone may have asked how come no one was there from Continental Illinois Bank—a peer of this group by size? Actually, that was not an oversight.

And the meeting was not to celebrate something; the mood was far from celebratory that morning, on May 16, 1984. Following a discussion over lunch the previous day with Bill Isaac, Todd Conover, and Don Regan, secretary of the treasury, Paul Volcker had requested this early morning meeting. It was called to plan the rescue of Continental Illinois Bank.

It would have been natural for someone to say: “Hey, wait a minute! Continental Illinois Bank? Isn’t that the 7th largest bank in the country? Just over five years ago, didn’t Dun’s Review name it as one of the five best-managed companies in the country? Didn’t a Salomon Brothers analyst, barely two years ago, call it ‘one of the finest money-center banks going’? And just four months ago, the bank announced earnings of $25 million and paid a dividend of $.50 per share in the 4th quarter of 1983!”

Actually, the seeds for the looming disaster were sown a few years before, when the fortunes of Continental became somewhat tied to the events in the late 1970s in Oklahoma City, OK. Following the oil crisis of 1973, crude oil prices began their upward climb from around $3.50 per barrel in 1971–1972 to over $37 per barrel by 1980. The oil industry, often mentioned as the energy sector in the banking world, was hot. Penn Square, a small bank in Oklahoma City, decided to catch the wave by making energy-related loans in amounts disproportionate to its size and capital base. Its loan portfolio grew from about $35 million in the mid 1970s to over $500 million by 1980. This was only what was on its books. Actually, it originated a much larger volume, and sold them as “loans participation” to other banks.

By the mid-1970s, Continental Illinois was a successful large bank with solid conservative roots in the Midwest. Beginning in 1975, it embarked on an aggressive growth strategy too. The energy sector provided the wave it rode to become the seventh largest bank in the United States. By 1981, it was the largest commercial and industrial lender in the United States.

One thing made Continental unique in comparison to other large banks. New York and California banks had extensive branch networks, allowing them to have a very large portion of their deposits from their branch network. State banking laws restricted a bank in Illinois to only one branch. Therefore, a very large portion of Continental’s deposits—over 80% by 1982—came from the CD market, which—because of its global reach—attracts tremendous amounts of liquidity, but is also very rate-sensitive and volatile in uncertain times.

After peaking around $37 per barrel in 1980, crude oil prices began a sustained decline that caused the collapse of the energy sector as the crude prices dropped to around $30 per barrel by 1982. The loans that were made in anticipation of high oil prices, and which fueled the growth in profits, turned sour. In July 1982, Penn Square Bank failed because of huge losses from the energy sector. This impacted other banks, such as Continental. Continental’s energy loan portfolio was in trouble not only because of its own originated loans, but also because it had to recognize almost $500 million in losses on the loans purchased from Penn Square. By the summer of 1982, the problems were quite evident. In August 1982, Continental’s credit rating was downgraded, and its share price declined by over 30% to $16 per share.

The financial environment was not looking good. The Penn Square failure, accompanied by the Lombard-Wall bankruptcy and the Mexican and Argentine debt crises, had made the market very nervous. Several other large companies, such as International Harvester, were struggling. Continental had significant exposure to all of them. Somehow, Continental managed to survive the crisis in 1982–1983 and began a comeback, with its share price reaching $26 per share around mid-1983. However, despite the confidence expressed by the markets, the problems at the bank were not abating. Nonperforming loans had continued to grow. Even though the bank reported a profit in the 4th quarter 1983, it was done only with the help of one-time gains on asset sales and supported by profits from its credit card business. Things were looking grim, and the morale was pretty low. One of the news reporters noted an example of gallows humor among bank employees: “What’s the difference between the Titanic and Continental Bank? The Titanic had a band!”

By May 1, 1984, questions surfaced about Continental’s going-concern ability and fueled the nervousness of large depositors, with Penn Square losses still fresh in their memories. Barely two years ago, the regulators had not come to the rescue of Penn Square, and its large uninsured depositors had suffered huge losses. To address the rumors, on May 8, Continental issued a press release denying any possibility of bankruptcy. This had the opposite of the intended effect, with the Japanese and European institutions withdrawing large amount of funds from the bank. On May 10, the Comptroller of the Currency, after consultation with Continental, issued a press release that it was “not aware of any significant changes in the bank’s operations, as reflected in its published financial statements, that would serve as a basis for these rumors.” Once again, the statement—meant to calm the nervousness—had the opposite effect. By next morning—Friday, May 11—it was clear that something drastic needed to be done. By afternoon, the Fed announced a line of credit of $4.5 billion from 16 banks. However, by Monday morning, nothing seemed to be working for Continental, and the run on its deposits was picking up momentum. The market’s view was that Continental was not a going concern anymore.

Regulators recognized that the Continental problem was not like any other bank failure. Penn Square—for example—was allowed to fail with losses for uninsured depositors. This...