Assessing Continental’s resiliency under new loss absorption rules

A retrospective analysis of the now-defunct commercial lender’s fate under the current financial regulatory regime shows that it would likely not have needed a federal bailout

Noted political scientist and scholar, Alexis de Tocqueville, once famously asserted that 'history is a gallery of pictures in which there are few originals and many copies'. This proclamation is no more accurate than when considered in the context of financial crises. While the recent financial crisis has engendered a broad and comprehensive set of regulatory changes in the US and internationally, financial crises have a long history. In the US, that history includes the Currency Panic of 1907, which prompted the creation of the Federal Reserve System, and the Great Depression, which led to the creation of the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the enactment of the Glass-Steagall Act. In addition, history is littered with events of varying dimensions that have garnered less attention, including the savings and loan crisis and the failure of individual financial institutions, such as Continental Illinois National Bank and Trust Company, both in the US, Herstatt Bank in Germany and Barings Bank in the UK. Retrospectively analysing these events provides constructive opportunities to measure the likely effect that current financial regulatory reforms would have had on historical events.

Much of the focus of recent changes in the US has been on developing a model for the resolution of a systemically important banking organisation through a single point of entry (SPOE) approach. In this regard, the bailout of Continental serves as an interesting test case for developing such a model. Continental suffered a run of wholesale depositors that began in May 1984. While initial efforts by the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency (the OCC, and together with the Federal Reserve and the FDIC, the US banking agencies) to stem the run failed, the run was finally stopped, and Continental was stabilised when it was recapitalised through a series of transactions that removed assets from its balance sheet and injected fresh capital through its parent holding company, Continental Illinois Corporation (CIC).

This $7.26 billion figure would have been sufficient to absorb losses from Continental’s loan portfolio and recapitalise a successor holding company

One of the tools that regulators have begun implementing in the US is total loss absorbing capacity (TLAC), which would require global systemically important banks (G-Sibs) to maintain a sufficient amount of long-term unsecured debt to ensure the existence of a mechanism for absorbing additional losses in order to recapitalise themselves without, according to Chair of the Board of Governors of the Federal Reserve System Janet Yellen, 'generating contagion across the financial system and damaging the economy'.

Final TLAC principles were first published by the Financial Stability Board on November 9 2015, for adoption at the G-20 summit. The Federal Reserve's proposal for a final TLAC rule in the US, however, has yet to be finalised. While Federal Reserve governor Daniel Tarullo, among others, has affirmed that the implementation of the TLAC proposal would directly address the so-called too-big-to-fail problem by 'making the failure of even the largest banks more manageable,' we are aware of no empirical analysis of the TLAC proposal's ability to enhance the resiliency of large financial institutions, when applied in the context of a prior bank failure. Here, we undertake such an analysis.

Although there are significant differences in the mechanics of the Continental bailout transaction and the mechanics of an SPOE resolution, there are similarities. As discussed further below, the Continental bailout is an example of funds being used to absorb losses and recapitalise a successor institution. The Continental bailout also demonstrates the effect of those actions on market confidence and the ability of the successor organisation to operate in the market.

Such a retrospective analysis is not without certain qualifications, however. First, Continental was not subject to current capital requirements, and therefore, the capital that Continental would have been required to hold must be projected based on available Continental balance sheet information. For this purpose, the below analysis utilises SEC disclosures from mid-1984 as a proxy for more detailed balance sheet information. While this article endeavours to project capital and TLAC for Continental under current requirements using conservative assumptions, the below projections of what Continental's capital and TLAC would have been may be higher or lower than would actually have been the case. Second, bank regulatory and supervisory requirements and techniques have evolved significantly since the time of the Continental bailout. Accordingly, it is likely that the risks that materialised as part of Continental's funding strategy (which relied heavily on short-term wholesale funding) and lending strategy (which concentrated on energy related loans) would have been mitigated by the current supervisory approach. Therefore, the funding pressures and losses experienced by Continental might well have been less under the current regulatory and supervisory regime, suggesting that the costs of the bailout might be less today than they were in 1984.

While the US banking industry experienced significant turmoil throughout the 1980s, the failure of Continental was not part of a broader financial crisis that precipitated the failure of other large banks at that time. The significant events that precipitated its failure began in the mid-1970s, when Continental's management developed an aggressive strategy to transform the once conservative bank into a commercial lending leader in the United States.

Continental's strategy had been viewed favourably by analysts and the market at large. By 1979, its stock had doubled in price as compared to its stock price in 1970, and by 1981, it had become the largest commercial and industrial lender in the US. During this time, the organisation largely surpassed its competitors in major financial benchmarks – for example, from 1977 to 1981, Continental's return on equity was 14.35%, second only to Morgan Guaranty. By the early 1980s, Continental had shed its conservative skin. As the Wall Street Journal noted, Continental's success was partially due to its ability to '[sell] the hell out of the corporate market by taking more than average risks in selected areas' including in the energy sector.

However, its growth and aggressive strategy were not without unintended, detrimental consequences. Continental's loan-to-asset ratio became significantly inflated, growing from 57.9% in 1977 to 68.8% in 1981, (the largest increase among the ten largest banks in the US), making Continental highly leveraged. Moreover, Continental was 'originating loans with lower interest rates than those on the books in 1978,' which reflected a below-market pricing strategy'.

Towards the end of 1981, it began to exhibit cracks – its second quarter earnings fell 12%, and several of its major customers (of which Continental held significant debt), including Nucorp Energy and International Harvester, had either lost substantial amounts of money or were facing near-bankruptcy. Additionally, the failure and eventual payoff of Penn Square Bank in July 1982, to which Continental had lent a significant amount of money, led to the downgrading of Continental and the slashing of its earnings estimates. These losses, coupled with Continental's exposure to the emerging markets crisis in the 1980s, created a growing negative sentiment in the financial industry. While Continental's stock price recovered marginally in 1983, Continental was still saddled with a significant portfolio of non-performing loans, and many of its largest institutional shareholders began divesting themselves of Continental's stock.

By 1984, Continental's non-performing loans had increased to $2.3 billion and its financial condition had declined. A run on Continental's deposits began in early May 1984, forcing Continental to borrow $3.6 billion at the Federal Reserve's discount window by the end of the first week to compensate for the loss of its deposits. The US banking agencies, together with a group of private sector banks, intervened shortly thereafter, providing Continental with a $2 billion assistance package in the form of interest-bearing subordinated notes, and the FDIC committed to guarantee all depositors and general creditors of Continental and to provide bank customers with uninterrupted service. A search for a suitable and willing merger partner proved unsuccessful, and the initial assistance package failed to stop the run on Continental's deposits.

The rescue package or bailout that stopped the run on Continental and stabilised Continental going forward was announced in July 1984 and implemented in September of that year. The rescue package involved a commitment of $4.5 billion by the FDIC in the form of the assumption of $3.5 billion of the Federal Reserve Bank of Chicago's discount window loan to Continental and an infusion of $1 billion of capital into Continental's parent holding company, CIC, to flow downstream to Continental in the form of equity. The assumption of the discount window loan was in exchange for loans held by Continental that had an unpaid principal balance of $5.2 billion. The note from Continental to the FDIC from the initial assistance package was repaid. Continental's executive management and board of directors were also removed. The terms of rescue also included an option by the FDIC to acquire stock in a new bank holding company that was formed to hold Continental. The options would compensate the FDIC for losses on the loans acquired from Continental. The FDIC reported that it had ultimately recovered $3.4 million from collections on the transferred loans and sales of Continental stock acquired in the transaction, resulting in a net cost to the FDIC of about $1.1 billion.

The TLAC proposal was published on November 30 2015 and represented the Federal Reserve's direct attempt to improve the resiliency and resolvability of G-Sibs under the US Bankruptcy Code and Title II of the Dodd-Frank Act. Under the proposal, the parent bank holding company of US G-Sibs (each, a covered BHC), as well as top-tier US intermediate holding companies of foreign G-Sibs (each, a covered IHC), would need to maintain outstanding minimum levels of TLAC and eligible long-term debt (LTD) to prevent a taxpayer-funded bailout. Thus, the US banking agencies would no longer face the same predicament as they did with Continental in the 1980s. The TLAC proposal would apply to eight US G-Sibs and US IHCs of foreign G-Sibs with $50 billion or more in US non-branch assets.

Under the TLAC proposal, a covered BHC would be required to maintain outstanding minimum levels of eligible external TLAC and eligible external LTD. The term 'external' means that the requirement would apply to loss-absorbing instruments issued to third-party investors, and therefore, 'the instrument would be used to pass losses from the banking organisation to those investors in case of failure'. Beginning on January 1 2019, covered BHCs would be required to maintain a minimum level of TLAC consisting of 16% of risk-weighted assets (RWAs) and then 18% of RWAs from January 1 2022 and beyond.

External TLAC. A covered BHC would be required to maintain outstanding minimum levels of eligible external TLAC of at least 18% of total RWAs (on a fully phased-in basis) and 9.5% of the covered BHC's total leverage exposure. A covered BHC's eligible external TLAC would consist of the sum of: (i) Common Equity Tier 1 (CET 1) capital and additional Tier 1 capital issued directly by the covered BHC; plus (ii) eligible external LTD. Eligible external TLAC would exclude certain liabilities, such as: (a) insured deposits, sight deposits and deposits with maturity of less than one year; (b) liabilities arising from derivatives or debt instruments with derivative linked features (eg, structured notes); (c) liabilities arising other than through a contract; (d) liabilities that are preferred to normal senior unsecured creditors; and (e) liabilities that, under the laws governing the resolution entity, are excluded from bail-in or cannot be bailed in without external risk of a successful legal challenge or compensation claim.

Eligible external LTD. A covered BHC would be required to maintain outstanding eligible external LTD that is at least equal to the greater of: (i) 6% of RWAs, plus the applicable G-Sib buffer (as discussed below); and (ii) 4.5% of total leverage exposure. Eligible external LTD includes debt that (a) is issued directly by the covered BHC; (b) is unsecured; (c) is plain vanilla; (d) is governed by US law; and (e) has remaining maturity of at least one year.

TLAC buffer. A covered BHC would be required to maintain an external TLAC buffer on top of the risk-based capital component of the external TLAC requirement, which would be equal to the sum of: (i) 2.5% of RWAs; (ii) any applicable countercyclical capital buffer; and (iii) the G-Sib surcharge, as calculated under Method 1 of the G-Sib surcharge calculations. The TLAC buffer would be able to be satisfied only with CET 1 capital.

In order to evaluate Continental's 1984 balance sheet in light of the TLAC Proposal, this article makes certain assumptions. Continental would have been considered a G-Sib, and therefore, the below analysis applies the fully phased-in required minimum TLAC requirement of 18% of RWAs. In addition to the minimum TLAC level, the calculation also must account for the G-Sib surcharge and capital buffers, and the below analysis assumes a G-Sib surcharge of 1% and an additional capital buffer of 2.5% of RWAs.

The Federal Reserve's August 2015 Final Regulatory Capital Rules provide for the methods to calculate the appropriate G-Sib surcharge, as well as a table setting out the top eight scores calculated for the eight G-Sibs. The below analysis assumes that the surcharge score for Continental, as the seventh largest bank in the US in 1984, would align with that of the seventh largest bank currently. As the seventh largest bank's score reflects a 1% surcharge, the below analysis maintains that assumption although it accounts for a slightly more conservative number due to Continental's reliance on mainly short-term wholesale funding. In addition to the 1% G-Sib surcharge, the below analysis includes an additional 2.5% of RWAs to account for the required capital buffer. Together, the G-Sib surcharge and the capital buffer increase Continental's 18% TLAC level to 21.5% of RWAs.

Table 1 presents Continental's balance sheet in 1984, together with the risk weights applied from the Final US Basel III Capital Rules, and the resulting RWAs.

Table 1

table-600.jpg Click on table to enlarge

Based on Continental's balance sheet, total assets were $39.6 billion in 1984. To determine Continental's RWAs, the Final US Basel III Capital Rules' standardised risk weightings have been applied to the line items on the balance sheet (as shown above). Applying these risk weightings, Continental's total RWAs would equal $33.8 billion. Based on the combined figure of 21.5% of RWAs, accounting for the minimum TLAC level, the G-Sib surcharge and the capital buffer, Continental's required loss absorbing capacity in 1984 would have been about $7.26 billion.

This $7.26 billion figure would have been sufficient to absorb losses from Continental's loan portfolio and recapitalise a successor holding company, which could have stopped the runs without the need for federal assistance in the form of capital contributions. In other words – no bailout. Although translating a historical assistance transaction into capital requirements is inherently subject to different approaches, at the time of the bailout, Continental had capital of its own of $1.728 billion. The FDIC contributed $4.5 billion in exchange for loans with an unpaid principal balance of $5.2 billion and a book value of $4.5 billion at the time. Even adding the $5.2 billion loan principal balance to the $1.728 billion in existing Continental capital yields a total of $6.928 billion, almost $330 million below the estimated capital number under current requirements. Using the book value of the transferred loans of $4.5 billion would yield an even greater excess in capital.

Notwithstanding the fact that economic events are notoriously fat-tailed, and historical comparisons present certain calculation issues, this analysis provides strong evidence that the requirements under the Regulatory Capital Rules and the TLAC proposal would have been sufficient to prevent the runs on Continental without the need for federal assistance in the form of capital contributions. While history tends to repeat itself, the need for bailouts for failing financial institutions does not need to follow this trend – the regulatory regime developed under the Regulatory Capital Rules and the TLAC proposal should be sufficient to withstand the next financial institutional failure, nullifying the need for taxpayer bailouts of large banking organisations in order to preserve market confidence.

By Oliver Ireland, partner (Washington DC), and Jared Kaplan and Elizabeth Schauber, associates (New York) at Morrison & Foerster