Stock Market Reaction to Regulatory Action in the Continental Illinois Crisis

Abstract

Continental Illinois Corporation is a whose principal subsidiary is Continental Illinois National Bank, a wholesale unit bank.' In December 1983, it was the eighth largest in the United States and the largest in the Midwest. It had assets of $42.1 billion, 75% of which were financed by rate sensitive liabilities.2 Restricted by Illinois law from branching, Continental relied heavily on large deposits from other domestic banks (about 16%) and on foreign deposits (40%). These were liquid short-term deposits, and their withdrawal was the precipitating factor in the virtual collapse of the in May 1984. Moreover, insured deposits amounted to only $3 billion (Isaac 1984, p. 3). Thus Continental Illinois was bearing high liquidity risk and interest rate risk, relative to other money center banks. This study examines the stock market reaction to the Continental Illinois crisis and the regulatory action taken in response to that crisis. Through the use of stock market data, this study reveals that there was significant market response to the crisis in terms of both negative abnormal returns and positive abnormal volume of trading. The most significant effect was found in those banks that had a large amount of Latin American debt and other nonperforming assets. But while there was a clear market reaction to information revealed in the crisis about banks' asset quality and regulatory policy, depositors apparently did not withdraw funds in the massive way that regulators anticipated. * I am grateful for the comments and suggestions of Joseph Aharony, Gabriel Hawawini, Barbara Paul, Ramon Rabinovitch, Anthony Saunders, Henny Sender, and the referees of this Journal. 1. The distinction between the and the is an important regulatory issue in the Continental Illinois crisis and is discussed later (see Black, Miller, and Posner 1978; Swary 1983). The terms bank and holding company are used interchangeably. 2. For various measures of these risks and an industry comparison, see Bank Analysts' Quarterly Handbook (1984).