its office had not requested assistance for or even discussed Continental with any bank or securities firm. Additionally, it was noted, the OCC could find no basis for the rumours concerning the bank’s fate.
On 10 May 1984, OCC examiners established an on-site presence in Continental’s trading rooms in Chicago and London so they could closely monitor the bank’s rapidly deteriorating funding situation. Initial reports from OCC examiners indicated that major providers of overnight and term funds were failing to renew their holdings of the liabilities of the bank and the bank holding company, Continental Illinois Corporation. The bank was forced to repay the deposits in eurodollar and domestic markets. In the absence of other funding sources, Continental was forced to approach the Federal Reserve Bank of Chicago.
From 12 to 14 May, a safety net of 16 banks put together a $4.5 billion line of credit for Continental. By 15 May, the safety net began to unwind because of a lack of confidence. On 16 and 17 May, the Comptroller and staff held meetings with Continental, other money centre banks and regulatory agencies in Chicago, New York and Washington to consider alternatives. A temporary assistance package was drawn up.
On 17 May the Comptroller, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Bank announced a financial assistance programme. The package had four features. First, there was a $2 billion injection of capital by the FDIC and seven US banks, with $1.5 billion of this coming from the FDIC. The capital injection took the form of a subordinated demand loan and was made available to CI for the period necessary to enhance the bank’s permanent capital, by merger or otherwise. The rate of interest was 100 basis points above the 1-year Treasury bill rate. Second, 28 US banks provided a $5.5 billion federal funds back-up line to meet CI’s immediate liquidity requirements, to be in place until a permanent solution was found. It had a spread of 0.25% above the Federal funds rate. Third, the Federal Reserve gave an assurance that it was prepared to meet any extraordinary liquidity requirements of CI. Finally, the FDIC guaranteed all depositors and other general creditors of the bank full protection, with no interruption in the service to the bank’s customers.
In return for the package, all directors of CI were asked to resign and the FDIC took direct management control of the bank. The FDIC bought, at book value, $3.5 billion of CI’s debt. The Federal Reserve injected about $1 billion in new capital. The bank’s holding company, CI Corporation, issued 32 million preference shares to the FDIC, that on sale, converted into 160 million common shares in CI and $320 million in interest-bearing preferred stock. It also had an option on another 40.3 million shares in 1989, if losses on doubtful loans exceeded $800 million. It was estimated they exceeded $1 billion. Effectively, the bank was nationalised, at a cost of $1.1 billion. A new team of senior managers were appointed by the FDIC, which also, from time to time, sold some shares to the public (Kaufman, 2002,
p.425).
Over the next two months, the regulators held meetings with both domestic and
foreign financial institutions and other parties interested in merging with or investing in Continental. Early on, it was apparent that it would be difficult to achieve a private sector solution. But any private sector/government-assisted transactions were likely to be too
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costly for the FDIC. Throughout this period, the OCC held several meetings with senior bank management and various members of the bank’s board of directors. There were also numerous internal planning sessions. Intensive monitoring of the bank’s funding continued and a joint OCC/FDIC review of the loan portfolio was conducted.
On 26 July the long-term solution was announced, subject to shareholder approval on 26 September. It was intended to restore Continental to health and to allow it to continue to operate without interruption. Two key elements made up the plan: changes in top management and substantial assistance. The solution resulted in the creation of a smaller and more viable bank. Management was removed, and shareholders incurred substantial losses, but all depositors were protected. Major disruption to the financial system was avoided. Upon implementation of the long-term solution, Continental would be well capitalised, with stronger assets and management. It was to be returned to private ownership at the earliest possible date. According to Kaufman (2002), by 1991 it was back in private hands, and in 1994 it was taken over by BankAmerica Corp.
10.7.5. Concluding Remarks
Continental Illinois got into problems for a number of reasons. First, it lacked a rigorous procedure for vetting new loans, resulting in poor quality loans to the US corporate sector, the energy sector and the real estate sector. This included participation in low quality loans to the energy sector, bought from Penn Square. Second, CI failed to classify bad loans as non-performing quickly, and the delay made depositors suspicious of what the bank was hiding. Third, the restricted deposit base of a single branch system forced the bank to rely on wholesale funds as it fought to expand. Fourth, supervisors should have been paying closer attention to liability management, in addition to internal credit control procedures.
Regulators were concerned about CI’s dependence on global funding. This made it imperative for the Fed and FDIC to act as lender of last resort, to head off any risk of a run by foreign depositors on other US banks. Continental Illinois was also the first American example of regulators using a ‘‘too big to fail’’ policy. The three key US regulatory bodies were all of the view that allowing CI to go under would risk a national or even global financial crisis, because CI’s correspondent bank relationships left it (and the correspondent banks) highly exposed on the interbank and Federal funds markets. The regulators claimed the exposure of 65 banks was equivalent to 100% of their capital; another 101 had between 50% and 100% of their capital exposed. However, Kaufman (1885, 1994) reports on a Congressional investigation of the collapse, which showed that only 1% of Continental’s correspondent banks would have become legally insolvent if losses at CI had been 60 cents per dollar. In fact, actual losses turned out to be less than 5 cents on the dollar, and no bank suffered losses high enough to threaten their solvency. The Economist (1995) argues that regulators got their sums wrong, and reports that some privately believed the bank did not need to be rescued. However, it is worth noting that the correspondent banks were not privy to this information at the time of the crisis, and would have been concerned about
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any losses they incurred, even if their solvency was not under threat. Given the rumours, it was quite rational for them to withdraw all uninsured deposits, thereby worsening the position of CI.
Furthermore, the episode did initiate a too big to fail policy, which was used sporadically throughout the 1980s. Some applications were highly questionable. For example, in 1990 the FDIC protected both national and off-shore (Bahamas) depositors at the National Bank of Washington, ranked 250th in terms of asset size. The policy came to an end with the 1991 FDIC Improvement Act (FDICIA), which required all regulators to use prompt corrective action and the least cost approach when dealing with problem banks. However, the ‘‘systemic risk’’ exception in FDICIA has given the FDIC a loophole to apply too big to fail.59
Questions
1.In the context of this case, explain the meaning of:
(a)‘‘an aggressive lending strategy’’;
(b)safety net;
(c)lifeboat rescue operation;
(d)the case for 100% deposit insurance;
(e)a policy of ‘‘too big to fail’’;
(f)regulatory forbearance, with reference to the OCC.
2.Do you agree that a bank should exploit a situation where its competitors are suffering from financial distress?
3.Why was Continental’s ratio of non-interest expenses to average assets and net interest margin below that of its peer group average?
4.Does the Continental case demonstrate there is no place for niche markets in banking?
5.List the (a) managerial factors, (b) macroeconomic factors and (c) other factors which contributed to the collapse of Continental. Rank these factors in order of importance and give reasons for your ranking.
6.With respect to the various runs on Continental:
(a)Why did the bank experience a run in 1982 and how did it manage to survive without recourse to official assistance?
(b)Why was the run in 1984 more devastating, ultimately leading to the demise of Continental as it was known?
7.After the break-up of Continental, the Bank of America became the subject of market rumours reminiscent of the Continental case. Why was the Bank of America able to withstand these rumours but not Continental?
8.Explain how the following regulatory changes might have prevented the collapse of Continental:
(a)The Federal Deposit Insurance Corporation Act, 1991.
10.8. Bankers Trust: From a Commercial/Investment Bank to Takeover by Deutsche Bank60
Relevant Parts of the Text: Chapters 1, 2, 3, 5, 9.
By the end of 1987, Mr Alfred Britain III retired after 12 years as CEO of Bankers Trust. His successor, Mr Charles S. Sanford Jr, based on results, believed that the bank had fully completed the transition from a money centre commercial bank to a global wholesale financial services company, able to compete with the best of the international merchant and investment banks. The stock yielded a 41% return on equity before extraordinary allowance for credit losses, up from 34% in 1984, which, at the time, was already the highest of all money centre banks.
In the late 1980s, media and analyst attention was fixed on BT’s remarkable performance, focusing on how a mediocre money centre bank could transgress commercial banking standards to earn such extraordinary returns. Most of the financial press and Wall Street believed that BT had done a wonderful thing. Analysts from two investment banks at the time characterised BT as the most sophisticated US merchant bank, claiming the bank ‘‘epitomizes the dedication to merchant banking that its peers and competitors will have to strive to attain’’, and from another investment bank: ‘‘Bankers Trust is positioning itself to be a true investment bank’’. One of the well known specialist banking news journals said ‘‘Bankers Trust Co has one of the most clear cut images in banking – a big time, self-created international merchant bank, financier of leveraged buy-outs, underwriter of corporate bonds, invader of Wall St turf.’’
These plaudits were consistent with Mr Sanford’s beliefs. But like any other successful institution, BT was not without its critics. BT’s reputation for being one of the most aggressive financiers of leveraged deals (about $3 billion in LBO debt in the 1980s), with a substantial portfolio of real estate and LDC loans, triggered many arguments that its real credit exposure had been masked by exceptional, yet possibly tenuous, trading profits. Some of this cynicism was related to actions taken in the second quarter of 1987 when, in line with other New York banks that wrote their Latin American exposure down to 75% of book, BT increased its allowance for credit losses by $700 million. However, it still earned an overall profit, because of trading.
The critics’ fears were heightened in 1987, following an earnings announcement, when BT’s share price dropped substantially. Concerns were again raised in 1989, profits of 1988 turned to losses of $980 million because of an additional $1.6 billion provision against Third World debt and $150 million charge for bad credits. Based on 1989 earnings, and its competitive bearing in investment banking, some critics were of the view that BT had made insignificant progress since 1984 on its declared road to becoming a global merchant bank.
There is little doubt that BT had established itself as a visionary in the field of banking, but its aggressiveness in volatile high margin businesses, coupled with its decentralised structure, left BT vulnerable. Notwithstanding the protests of BT’s management, who insisted they
60 The first part of this case originated from the New York University Salomon Center Case Series in Banking and Finance (Case 07), authored by A. Sinclair, R. Smith and I. Walter. It was revised and updated by S. Heffernan for her 1996 book, and it has been revised again for Modern Banking (2004).
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‘‘never bet the bank’’, not all observers believed the BT strategy had maximised shareholder value-added. The jury was still out on whether BT had achieved its goal of becoming a global merchant bank. It would be important to observe BT’s performance when the chips were down: the bank had not yet been tested in a recession.
This case is about the trials and tribulations of Bankers Trust through the 1990s, culminating in its being acquired by the German power house, Deutsche Bank. How did a bank which had, apparently, transformed itself into a new breed of investment bank (in all but name) end up being taken over? Has it been a good acquisition for Deutsche Bank? In answering these questions, students will see how events of the 1980s and 1990s transformed the US and global banking scene.
10.8.1. The Evolution of Bankers Trust
In the late 1970s, BT was a typical money centre bank,61 strapped with credit losses arising from recession and the Real Estate Investment Trust crisis. It continued to operate a progressive retail and commercial domestic banking business, with an international focus. But capital requirements, together with provisioning for bad debt, meant the bank would be constrained in any attempt to operate in all markets. BT emerged from the 1970s wounded but still viable, and this position had a profound effect on its strategic focus. BT was placed fifth in the New York market. It had a 200-plus retail bank network, but it was widely accepted that to remain competitive over the next decade, BT would require a substantial investment in new technology, such as ATMs and information systems, and human resources. A retail banking network would be a source of low-cost funding for the bank, though ceilings on deposits rates were, officially, to be phased out by 1986, and they had already become largely ineffective. For these reasons, BT decided to focus on wholesale and corporate banking.
To disengage itself from retail banking, BT sold off its metropolitan retail branches, its credit card business, and four upstate New York commercial banking subsidiaries (which also had branches) between 1980 and 1984. These operations represented $1.8 billion in assets and were profitable at the time they were sold. BT earned $155.3 million, which it invested in its merchant banking business.
The bank was reorganised around four core businesses:
žCommercial banking;
žCorporate finance;
žTrust services;
žResource management.
Each of these new businesses was headed by an executive vice-president, who reported to a new ‘‘Office of the Chairman’’, shared by Mr Sanford (president), Mr Al Brittain (chairman) and Mr Carl Mueller (vice-chairman). BT itself was divided into two principal
61 The term ‘‘money centre commercial bank’’ was used to describe large (in terms of assets) US commercial banks that were headquartered in a key city – mainly New York (e.g. Chase Manhattan, Citibank) but also in Chicago (Continental Bank) and Los Angeles (at the time, Bank of America). Their main business was retail and wholesale banking. There were no banks with a nation-wide branch network because of restrictions (at the time) on interand even intrastate branching. By the late 1990s, the term had disappeared, due to changes in US regulation and structure (see Chapter 5).
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units, Financial Services and ProfitCo (see below). The shift from money centre commercial banking to international merchant banking prompted changes in the way BT approached its business, especially in terms of management of the balance sheet, funding, costs and investment philosophy.
In the middle was the merchant bank – its balance sheet relationship was shared with commercial banking, but the bank’s origination and distribution functions were more common to investment banking. The model adopted by BT was to combine deposit-taking and lending functions, and the broad relationship list of a commercial bank with the origination and distribution functions of an investment bank. BT had implemented several changes to achieve this objective.
žMarketing efforts were targeted at the institutional sector, redirecting resources to large and middle market corporations, financial institutions and governments.
žBT initiated an aggressive commercial origination and loan-sale programme to control balance sheet growth, emphasise fee-driven business and distribute risk.
žAn investment banking emphasis was placed on corporate finance activities.
žA target of 20% return on equity was established as a benchmark to monitor corporate performance and measure risk-adjusted return in all business segments.
žA new incentive compensation scheme was developed to motivate employees to seek out new businesses and profit opportunities in line with corporate goals.
žOrganisational changes relating to client and interdepartmental relationships, risk-taking, management hierarchy and business development were implemented.
10.8.2. The Organisational Framework
In 1984, BT was divided into two main units – Financial Services and ProfitCo.
Financial Services
The merchant bank, with about 5500 employees, was headed by Mr Ralph MacDonald. It consisted mainly of three functional units.
žCorporate finance: headed by Mr David Beim, it provided merchant banking services to clients in the USA and Western Europe.
žEmerging markets: headed by Mr George Vojta, it provided merchant banking services in Latin America, Eastern Europe, Africa and the Middle East.
žGlobal markets: headed by Mr Eugene Shanks, it had world-wide responsibility for capital market based businesses and products. Securities dealing, foreign exchange, interest rate protection and similar areas all came under global markets, as did merchant banking in Asia/Pacific and Canadian markets.
Some interdisciplinary functions, such as loan distribution, reported jointly to corporate finance and global markets. Financial services did not handle either deposits or operating services, which were dealt with by ProfitCo. Another 1000 staff were attached to the
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corporate staff and 3000 employees were based outside the USA. The corporate level was responsible for:
žTreasury – BT’s own funding and risk management.
žCredit policy – controlled credit risk in all business lines and provided some administrative support activities.
ProfitCo
ProfitCo offered transaction processing, fiduciary and securities services, investment management and private banking. About half of BT’s staff (6500) worked for ProfitCo.
BT’s Fiduciary Services Department was reorganised into ProfitCo in 1984, as part of BT’s decentralisation plan. Staff functions were shifted to line functions, with responsibility for earning profit. This elicited a process which effectively created many separate and divisible business segments; for each segment, it was possible to measure profitability against some external measure. It was believed this ‘‘profit centre’’ approach would improve the competitiveness of the service business by allowing BT to attract and motivate highquality personnel. The entrepreneurial structure was supposed to encourage staff to achieve management responsibility, though it did put pressure on line management personnel to support their existence.
ProfitCo consisted of four departments:
žFastCo: Offered institutional fiduciary and securities servicing to both domestic and overseas clients. Within FastCo, there existed several groups which engaged in traditional trust business:
–Investment Management Group: managed several billion dollars in pension, thrift and employee-benefit plan assets. It ranked as one of the top US firms in custody and clearing.
–Employee Benefit Group: the largest provider of non-investment services, such as administrative and record-keeping services for pension and employee benefit plans.
–The Trust and Agency Group: served as a trustee for public bond issues, and offered other services. Operation of the Securities Processing Group was a marked departure from customary trust activities.
žInvestment Management: This department was concerned with institutional money management, especially in the passive investment area. There was a considerable advantage for clients in having both corporate trust and investment management centralised with the same provider. It made BT one of the largest US institutional money managers.
žPrivate Banking: This department targeted high net worth individuals, offering traditional trust services and other commercial banking services. The objective was to offer banking services to upscale customers, cross-marketing a range of fiduciary, banking and investment services. The emphasis was on personal service, offering high-quality investment-related products to clients. It had six New York City branches, one upstate New York branch and one branch in Florida.
žGlobal Operations and Information Services (GOIS): GOIS offered funds transfer, cash management, trade payments and related informational services to world-wide institutional clients. It was extensively involved in dollar-related clearing services, and
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in trade-related and securities-related payments. As part of its strategy to encourage entrepreneurship, GOIS was treated as a separate business with a separate sales force, product management capabilities and guidelines for profit. GOIS effectively centralised BT’s transactions processing, and was kept separate from the commercial banking function.
Each business within ProfitCo was characterised by a strong level of recurring income. They were similarly organised with a sales/relationship manager, product managers who were involved in marketing, and an attendant product delivery function. The banking segment was a good source of business – products and services were cross-marketed to institutions and clients who were being serviced by other parts of BT. Though each business was operated independently within BT, ProfitCo operated the bank’s back office systems, especially global market activities. ProfitCo provided the data centre for most of BT’s business segments.
10.8.3. Bankers Trust: Activities
Resource Management (RMD)
Located on Wall Street, RMD can be traced back to 1919, when BT was successful in the bond business. The Glass Steagall Act largely put an end to BT’s underwriting activities. The bank was limited to underwriting and dealing in US government securities and general obligation bonds issued by state and local governments. BT continued to underwrite allowable securities and manage its own portfolio of government securities. This portfolio had made up a large part of BT’s asset base, and was a major source of liquidity. However, in the 1960s, BT, like many commercial banks, began to rely on short-term borrowed funds such as negotiable CDs, bankers acceptances and commercial paper as a source of funds and liquidity.
Short-term funding was handled within the global markets group. The corporate treasurer managed aggregated risks involving both interest rate sensitivity and liquidity on a global basis. Capital budgeting decisions were reviewed at the highest level and ALM conducted on an aggregate basis, bringing people from each business segment together to communicate actual and prospective trends in the corporate risk profile. Often, however, the aggregate risk profile was very different from the individual parts because some risk was diversified away through position taking within each business. The emphasis was on slow balance sheet growth, encouraging an integrated approach to balance sheet funding.
Preceding organisational changes within the fiduciary function, RMD was preparing to compete with investment banking firms for both business (trading securities and underwriting) and people. Mr Charlie Sanford was placed in charge of the department and created a plan to compete on a par with investment banking firms. Traders and other professionals were hired and by 1980, Mr Sanford believed he had a top-rated trading capacity.
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Trading
Proprietary trading was the key capital market activity which helped BT sustain a record of positive profits for nearly two decades without a single quarterly loss in the foreign exchange or securities trading markets. By the end of the 1980s, management estimated that 60% of the bank’s assets were liquid. The objective was to raise that figure to 80%.
Proprietary trading, and trading on behalf of BT customers, added a new dimension to the challenge facing management regarding long-term profitability and success. Consistent with its organisational layout, the trading function was operated very much like a business. Each trading division was structured to promote profitable activities and was supported by sophisticated information systems, large geographically dispersed staffs, and an emphasis on communication. Management believed constant communication provided the opportunity for new avenues of profit, with risk diversification the underlying objective. Additionally, the goal of consistent profitability was to generate asymmetric profit and losses. The management directive was twofold: (i) losses should be taken early – as soon as they were evident and (ii) when gains were made, they should be protected.
At the same time, management gave traders who proved themselves full rein to play their positions. In theory, no trader could commit more than a predetermined level of capital, but once that capital was earned back, the trader could play his/her position to amounts limited by accumulated profits. This meant there were single positions which exceeded a billion dollars. BT’s reputation for taking the right positions encouraged herd instinct behaviour: traders at rival firms would take the same positions, which would magnify the extent BT moved the market.
Commercial Paper
Mr Sanford believed part of the BT strategy should be to offer a wide range of institutional financial services on a global basis. The execution of this strategy involved BT’s participation in the domestic commercial paper market, an area normally reserved for investment banks. In 1978, BT began to act as an agent for corporations issuing commercial paper, thereby challenging Glass Steagall – the bank convinced the Federal Reserve that commercial paper was a short-term loan, not a security.
Derivatives and Risk Management
In 1978, BT improved on its internal risk management by establishing the Bankers Trust Futures Corporation. It operated on the emerging futures and options markets, to provide innovative hedging programmes to customers. It was the second subsidiary of a US banking company to receive full certification as a futures commission merchant.
Mr Sanford introduced RAROC, or risk-adjusted return on capital, defined as total risk-adjusted returns divided by total capital (see Chapter 3), a risk measurement system. The idea was to have a common measure of risk for all BT operations, thereby ensuring an efficient allocation of capital. A risk factor was assigned to each category of assets based on the volatility of the asset’s market price. For example, a CD trader who ended the day with a long position in 60-day paper would be assigned a risk-adjusted amount of capital based
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on the risk factor for this maturity. Performance was assessed by dividing the trader’s profit by the amount of capital allocated. An example of the distribution of capital appears below:
Division
Amount ($mn)
% of total
Global Markets (credit)
211
4.9
Global Markets (market)
206
4.8
Other (credit)
2 811
65.3
Other (non-credit)
1 080
24.1
In addition to being at the centre of a framework for risk management, RAROC was also used for:
žComparison of the performance of different parts of the BT business.
žPortfolio management for determining areas that appeared most appropriate for investment or divestment.
Corporate Finance
BT had shifted its focus to wholesale corporate banking and the institutional market, and needed to develop a competitive corporate finance capability that would make up the core of the merchant bank. The corporate finance department’s reorganisation began in 1977. Two individuals with extensive Wall Street experience were hired, Mr Carl Mueller and Mr David Beim.
The corporate finance division had five lines of business.
žThe Capital Market Group: This section acted as financial advisor or agent for corporations in the private placement of their securities with insurance companies, pension funds and other financial institutions. The group was strongly affiliated with global markets and BT’s London merchant bank, Bankers Trust International. It maintained a role in eurosecurities offerings and dealt extensively with interest rate and currency swaps.
žThe Lease Financing Group: Arranged large leases, placing the assets with other institutions and within BT. It served as an advisor to the lessor and/or lessee in transactions.
žThe Venture Capital Group: This group made equity and other investments for the holding company (Bankers Trust New York Corporation). Most of the transactions were part of the leveraged buyouts and expansion financing, rather than de novo financing of companies. BT developed a special product niche in structuring leveraged buyouts.
žThe Public Finance Group: This group acted as a financial advisor, underwriter or sales agent of tax-exempt financing for public and corporate issuers.
žLoan Sales: In 1984, as part of its merchant banking strategy, BT expanded its loan sales programme. One of the first commercial banks to be actively engaged in securitisation, the bank believed that in some cases, it could achieve superior returns on equity by originating and selling loans, rather than holding them on its own books. Loan securitisation also helped to stabilise balance sheet growth, maintain high liquidity levels, and meant the
