A Welcome Shock to the System

THE FEDERAL Deposit Insurance Corporation shocked the banking industry in mid-December by requesting the removal of the 10 senior members of the 16-member board of directors of Continental Illinois Corporation, for decades one of the nation's most powerful banks. The move is the latest step taken by the FDIC following its bailout of Continental Illinois last spring, and, in view of its unconventional nature, should sound a warning to the entire industry. It should also raise questions about responsibility to shareholders and the accountability of directors for actions that might have catastrophic consequences.

Continental Illinois directors who were asked not to seek re-election at next spring's stockholders meeting include the vice chairman of the board of directors of International Business Machines and the chief executive officers of Borg-Warner, FMC Corporation, IC Industries, and Baxter Travenol Laboratories, individuals with extremely successful track records, none of whose companies had ever had serious problems. Yet, by exercising rights gained last spring when agreeing to bail out the bank, the FDIC has stunned Wall Street by ordering their quick removal.

Traditionally, bank directorships are honors bestowed on the brightest stars of the corporate world, since they don't really require extensive knowledge of the banking industry. Director's aren't required to attend board meetings, and in fact get paid up to a thousand dollars for each meeting they attend. Although it has taken government intervention to do it, the banking industry may finally realize, as a result of the FDIC's clear signal, that in accordance with the position of responsibility, board seats should be filled by men whose experience suggests true expertise in the field of banking and finance.

Continental Illinois got into all of its trouble as a result of over-aggressive lending practices--policies approved and acclaimed by these bank directors. For years, Continental Illinois had been the pride of Chicago, a premier banking institution, a leader in world finance. Fortune ranked it among the top 10 banks in all measures of financial soundness, including profits, assets, equity, and deposits. But all of these positive factors tempted the bank's directors to become more lenient when granting loans to creditors of questionable financial soundness. Continental Illinois's purchase of sour energy loans from a failing Penn Square Bank precipitated its own eventual demise, as did its involvement in the great rush into Third World financing of the 1970s.

By late 1983, the rising tide of loan write-offs and "negative profits" thrust Continental Illinois's woes into the national spotlight, causing the FDIC to worry about paying each of the bank's depositors up to $100,000 if the bank should fall, and sending shivers through a banking industry already experiencing the highest number of individual failures since the Great Depression. All of this attention accelerated the spiral as depositors panicked flocking to teller windows to withdraw accounts totaling millions of dollars.

In the first few months of 1984, two major events prevented the failure of one of the largest banks in the United States. Continental Illinois Chief Executive Officer Donald Taylor resigned, after just months on the job, and the FDIC injected $7 billion into the bank. In return for its financial support, the FDIC received the right to acquire full ownership of the bank from stockholders at a fraction of a penny per share if the bank should be unable to repay its loans, and the right to replace the bank's management at any stage of its supposed recovery.

Now, while still facing "negative profits," Continental Illinois has repaid almost half of its loans from the FDIC and from other banks that helped cover the initial rush on deposits. And it actually seems possible that the FDIC will never have to purchase full equity in, or nationalize, the bank. So, why has the FDIC waited until now to replace management? What will be the effect of the management shakeup? Will this set a positive example for the industry?

First, the FDIC's move should be perceived largely as a signal to the industry that board directorships should not be awarded as honorariums. One of the great risks a capitalist society faces is the uncertain stability and credit worthiness of its banking institutions. By refraining from nationalizing the industry, unlike most European socialist countries, the United States is placing great faith in the management of individual banks. The FDIC must use the opportunity of Continental Illinois's brush with disaster to remind bank directors of the trust placed in them. (The FDIC had to wait until media focus shifted away from the bank so the board shakeup would not cause further runs on deposits.)

Second, the FDIC may have created an unnecessary void in Continental Illinois's management by replacing more than half of the bank's board. Finding qualified replacements may be difficult, at least in the short run. However, this should be a temporary situation, a justified cost for attempting to discipline the industry. In fact, look for retired managers of other large money center banks and former government officials to populate Continental Illinois' board in the future.

Finally, the FDIC's move may have a measurable impact on bank management in the future. While shareholders--and depositors--may soon forget the Continental Illinois fiasco, directors will probably adopt more conservative lending and management policies. The real threat of the collapse of one of the country's largest banks is, in itself, a significant and continual warning. The possibility of being held responsible for such a failure should make directors more active in bank management and more responsible for their actions both to shareholders and to depositors.