Author Archives: Banking Blogger

Lessons from ‘Too Big to Fail’ in the 1980s

Can a bank run be stopped? Government guarantees and the run on Continental Illinois

Mark A Carlson (Bank for International Settlements) and Jonathan Rose (Board of Governors of the Federal Reserve)

Abstract: This paper analyzes the run on Continental Illinois in 1984. We find that the run slowed but did not stop following an extraordinary government intervention, which included the guarantee of all liabilities of the bank and a commitment to provide ongoing liquidity support. Continental’s outflows were driven by a broad set of US and foreign financial institutions. These were large, sophisticated creditors with holdings far in excess of the insurance limit. During the initial run, creditors with relatively liquid balance sheets nevertheless withdrew more than other creditors, likely reflecting low tolerance to hold illiquid assets. In addition, smaller and more distant creditors were more likely to withdraw. In the second and more drawn out phase of the run, institutions with relative large exposures to Continental were more likely to withdraw, reflecting a general unwillingness to have an outsized exposure to a troubled institution even in the absence of credit risk. Finally, we show that the concentration of holdings of Continental’s liabilities was a key dynamic in the run and was importantly linked to Continental’s systemic importance.

URL: http://EconPapers.repec.org/RePEc:bis:biswps:554

Distributed on NEP-HIS 2016-4-16

Review by Anthony Gandy (ifs University College)

I have to thank Bernardo Batiz-Lazo for spotting this paper and circulating it through NEP-HIS, my interest in this is less research focused than teaching focused. Having the honour of teaching bankers about banking, sometimes I am asked questions which I find difficult to answer. One such question has been ‘why are inter-bank flows seen as less volatile, than consumer deposits?’ In this very accessible paper, Carlson and Rose answers this question by analysing the reality of a bank run, looking at the raw data from the treasury department of a bank which did indeed suffer a bank run: Continental Illinois – which became the biggest banking failure in US history when it flopped in 1984.

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For the business historian, the paper may lack a little character as it rather skimps over the cause of Continental’s demise, though this has been covered by many others, including the Federal Deposit Insurance Corporation (1997). The paper briefly explains the problems Continental faced in building a large portfolio of assets in both the oil and gas sector and developing nations in Latin America. A key factor in the failure of Continental in 1984, was the 1982 failure of the small bank Penn Square Bank of Oklahoma. Cushing, Oklahoma is the, quite literally, hub (and one time bottleneck) of the US oil and gas sector. The the massive storage facility in that location became the settlement point for the pricing of West Texas Intermediate (WTI), also known as Texas light sweet, oil. Penn Square focused on the oil sector and sold assets to Continental, according the FDIC (1997) to the tune of $1bn. Confidence in Continental was further eroded by the default of Mexico in 1982 thus undermining the perceived quality of its emerging market assets.

Depositors queuing outside the insolvent Penn Square Bank (1982)

Depositors queuing outside the insolvent Penn Square Bank (1982)

In 1984 the failure of Penn would translate into the failure of the 7th largest bank in the US, Continental Illinois. This was a great illustration of contagion, but contagion which was contained by the central authorities and, earlier, a panel of supporting banks. Many popular articles on Continental do an excellent job of explaining why its assets deteriorated and then vaguely discuss the concept of contagion. The real value of the paper by Carlson and Rose comes from their analysis of the liability side of the balance sheet (sections 3 to 6 in the paper). Carlson and Rose take great care in detailing the make up of those liabilities and the behaviour of different groups of liability holders. For instance, initially during the crisis 16 banks announced a advancing $4.5bn in short term credit. But as the crisis went forward the regulators (Federal Deposit Insurance Corporation, the Federal Reserve and the Office of the Comptroller of the Currency) were required to step in to provide a wide ranging guarantee. This was essential as the bank had few small depositors who, in turn, could rely on the then $100,000 depositor guarantee scheme.

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It would be very easy to pause and take in the implications of table 1 in the paper. It shows that on the 31st March 1984, Continental had a most remarkable liability structure. With $10.0bn of domestic deposits, it funded most of its books through $18.5bn of foreign deposits, together with smaller amounts of other wholesale funding. However, the research conducted by Carlson and Rose showed that the intolerance of international lenders, did become a factor but it was only one of a number of effects. In section 6 of the paper they look at the impact of funding concentration. The largest ten depositors funded Continental to the tune of $3.4bn and the largest 25 to $6bn dollars, or 16% of deposits. Half of these were foreign banks and the rest split between domestic banks, money market funds and foreign governments.

Initially, `run off’, from the largest creditors was an important challenge. But this was related to liquidity preference. Those institutions which needed to retain a highly liquid position were quick to move their deposits out of Continental. One could only speculate that these withdrawals would probably have been made by money market funds. Only later, in a more protracted run off, which took place even after interventions, does the size of the exposure and distance play a disproportionate role. What is clear is the unwillingness of distant banks to retain exposure to a failing institution. After the initial banking sector intervention and then the US central authority intervention, foreign deposits rapidly decline.

It’s a detailed study, one which can be used to illustrate to students both issues of liquidity preference and the rationale for the structures of the new prudential liquidity ratios, especially the Net Stable Funding Ratio. It can also be used to illustrate the problems of concentration risk – but I would enliven the discussion with the addition of the more colourful experience of Penn Square Bank- a banks famed for drinking beer out of cowboy boots!

References

Federal Deposit Insurance Corporation, 1997. Chapter 7 `Continental Illinois and `Too Big to Fail’ In: History of the Eighties, Lessons for the Future, Volume 1. Available on line at: https://www.fdic.gov/bank/historical/history/vol1.html

More general reads on Continental and Penn Square:

Huber, R. L. (1992). How Continental Bank outsourced its” crown jewels. Harvard Business Review, 71(1), 121-129.

Aharony, J., & Swary, I. (1996). Additional evidence on the information-based contagion effects of bank failures. Journal of Banking & Finance, 20(1), 57-69.

Models of Safe Banking? The European Savings and Cooperative Banks

Savings banks and cooperative banks in Europe

By: Dilek Bülbül, Reinhard H. Schmidt and Ulrich Schüwer (all at Goethe University Frankfurt am Main)

Abstract: Until about 25 years ago, almost all European countries had a so-called three pillar banking system comprising private banks, (public) savings banks and (mutual) cooperative banks. Since that time, several European countries have implemented far-reaching changes in their banking systems, which have more than anything else affected the two pillars of the savings and cooperative banks. The article describes the most important changes in Germany, Austria, France, Italy and Spain and characterizes the former and the current roles of savings banks and cooperative banks in these countries. A particular focus is placed on the German case, which is almost unique in so far as the German savings banks and cooperative banks have maintained most of their traditional features. The article concludes with a plea for diversity of institutional forms of banks and argues that it is important to safeguard the strengths of those types of banks that do not conform to the model of a large shareholder-oriented commercial bank.

URL: http://econpapers.repec.org/paper/zbwsafewh/5.htm

Review by Anthony Gandy

In recent years I have had the pleasure of teaching banking strategy and banking regulation to professional bankers, the vast majority from the Anglo-Saxon sphere. This is a real challenge, they have greater experience of retail, business and corporate banking than I will ever obtain. However, one thing I do know is that they struggle to cope with the concept that the listed, publicly traded, universal bank is not the only institutional model in town. It is of course not the dominant model in many countries. There are real rivals many different backgrounds that challenge the listed banks and have many strengths; to a large degree these strengths maybe due to the restrictions placed upon them.

Summary

The paper Bülbül, Schmidt and Schüwer is a White Paper (No. 5) on Policy from the Center of Excellence SAFE – Sustainable Architecture for Finance in Europe (Goethe University Frankfurt) and was distributed by NEP-HIS on 2014-01-17. It outline the characteristics of savings banks (those with a public ownership foundation, even if that is no longer the whole case) and cooperative banks across Europe and detail the history of these two institutional forms in German, Austria, France, Spain and Italy. Clearly the primary example is Germany where the three-tier banking structure is live and well (if we exclude a few issues!). In Germany there is a co-existence of public savings banks, cooperative banks and private banks. In other regimes the model has changed, but in the case of say France, the cooperatives are incredibly strong even if some of the localism of these institutions has now been lost.

The authors define seven features of savings banks; however, through the passage of reform (some they argue may have been misguided) only the first two are now common across the markets they have reviewed:

  1. A focus on savings and savings mobilization
  2. A clear regional and even local focus
  3. They were/are “public” banks owned or sponsored by a public body in a specific region or locality, and those authorities had/have “obligations” in respect of these local institutions
  4. They are organised under a “public” law, though the authors do not really define this
  5. They were expected to support the local economy and the local people and financially sustainable enterprises
  6. They were expected to adhere to the region or locality of the sponsoring public body – thus avoiding competition between such banks
  7. Maybe most importantly they were part of a “dense and closely cooperating networks of legally independent institutions that constitute a special banking group”

While, to all intense and purposes the seven criteria still hold good in Germany for savings banks, elsewhere it now tends to be just the cooperative banks which maintain the sense of locality, network and non-competition between local and regional players. Even here though, many cooperatives look and act like major national banking groups, some are even competitors in the investment banking markets.

The authors review the two hundred year history of the German savings and cooperative banks, and that of other nations. Though, of course, this is done very swiftly given the space limitations they have. They also try to illustrate how changes in the system has led to weaknesses in some industries which have moved away from the German model. As is outlined in the discussion below, the end of cooperation and coordination of between savings banks in Spain, where local savings banks did not compete in other regions, has had enormous consequences.

While the history is brief, it is informative. I for one was not aware that Raiffeisenbank was named in honour of Friedrich Wilhelm Raiffeisen who in the 19th Century established the concept of rural cooperative banks networked to centralised services organisations. The name is also common to Austrian cooperative banks and is the foundation of the movement elsewhere. I feel I should have known this. The history, especially in recent years is also important in showing why Germany has performed differently in this sector than other countries which ostensibly had similar three-tier frameworks in the past.

In the other country reviews, the focus is more on the last twenty five years. In France for example the cooperative banks have come to dominate much domestic and even international banking. They absorbed the smaller French public savings institutions (through the mergers which resulted in Banque Populaire Caisse d’Epargne (BPCE)) while Crédit Mutuel (CM) and incendie-du-credit-lyonnais[1]Crédit Agricole (Credit A) have acquired a number of private banking groups building corporate and investment franchises. Of course the ultimate expression of this was Credit A’s acquisition of, how shall we put it, the accident prone Crédit Lyonnais giving it stake in corporate and international banking in France.

The author conclude by reviewing (as they do also in the country reviews, especially in the German one) past and current literature on whether public savings banks and cooperatives are inefficient, not incentivised to be competitive or even whether they carry higher risk. Their conclusion is that older research which support these points have now been supplanted by newer research which invalidates these arguments, especially in the light of recent events.

Discussion

One could argue that the case they make in their paper that German local public savings banks did not suffer to any large degree in the financial crisis could be countered by two points. Firstly, while the local savings banks had little exposure to securitised markets or to southern European debt, the structure of their industry would not really allow this anyway. These banks are local, however, they also provide funds to the Landesbanken which act as the central services and, effectively, the centralised treasury. It is they which then use funds to access corporate, investment and international markets. As the authors have point out, the Landesbanken have been hard hit in the financial crisis. Effectively the savings bank and the cooperative banking sector disaggregate the banking activity network into those which take in deposits and fund local projects and those which play a centralised role supporting the local institutions with an infrastructure and acting as their representatives in international wholesale markets. So they do not make perfect comparators to the more integrated large commercial banks. Secondly, while German has suffered from exploring the deposits of its savings banks and other banks abroad to fund various assets, the local German economy has not suffered, so the savings and cooperative banks have not been tested at local level, not this time around anyway.cartoon120621_2_full_600x400[1]

Secondly, the Italian section is a maybe little brusque. While savings banks and cooperatives along the German model have existed since the late 19th century, it is stated that they have not really established themselves to such a large extent and have been privatised. However, some of the arguments put forward for the benefits of public savings and cooperative banks are that they maintain localism. While Italy has clearly done much to privatise and get local politics out of their banks, they still certainly maintain more local banks than say a UK or Ireland as a proportion of their banking industry. In addition, while the word “Foundations” is mentioned iceberg-montepaschi[1]once, we rather skip over the important role they play in the governance and ownership of certain Italian banks in which the Foundations play such a large role and which still own a large proportion of the bank, including and rather notably the oldest of them all, Banca Monte dei Paschi di Siena, which so obviously faces an existential crisis.

Policy and Teaching

The public savings industry which the authors really find was badly hit by financial crisis was the Spanish one. However, they make a very interesting point that the industry in Spain had already abandoned many of the seven characteristics of public savings banks the authors identified. Indeed they make the very strong case that by allowing the savings banks in Spain to become national and to expand in areas they had little experience, they were attracted to the booming area of commercial mortgages, the vast majority used to fund the property bubble which would so damage Spain when it burst.

This last point is an interesting one as it shows the consequences of changing a system of ownership and governance under pressure to reform for only one reason, in this case the European standardised view of competition. Given banks are at the heart of the monetary system, consequences elsewhere in the economy have to be considered. Until the 1970s the Spanish savings banks were public institutions and somewhat politicised. Accession to the EU in 1986 brought pressure to reform and to liberalise, and yet while elements of competition were reformed, the governance of these institutions was not improved; fiefdoms remained, spurred on by growing competition. Of course the EU is hardly to blame for house price falls of up to 53.5% in Spain, but it does emphasise the importance of working through the long term consequences of policy changes which may interact with other events.

This paper not only gives teaching staff the opportunity to expose students to other banking governance and ownership possibilities, it discusses how changes to the model once common to all public savings and cooperative banks have potentially undermined some of their advantages and led to unintended consequences. It will be in the student reading list next year for sure.