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Monday, June 14,2010

Phil AngeJides


Via E-mail and FedEx
Professor Randall Kroszner
Booth School of Business
University of Chicago
5807 South Woodlawn Avenue
Chicago, IL 60637

Hon. Bill Thomas

Vice Chairman


Follow-up to the Financial Crisis Inquiry Commission Forum

Dear Dr. Kroszner:
Brooksley Born

Byron S. Georgiou

Senator Bob Graham

The Financial Crisis Inquiry Commission thanks you once again for your
participation in the "Forum to Explore the Causes of the Financial Crisis" on
February 26 and 27, 2010.
Enclosed are follow-up questions which were posed by the Commissioners
during the forum, as well as additional questions which have arisen over the
course of our investigation which we would like your assistance in answering.

Keith Hennessey

COlli III issioller
Douglas Holtz-Eakin

Please respond to the questions by Friday, July 2,2010. If you have any
questions, or would like more information, please contact Scott Ganz at
1. During the forum, you described Federal Reserve Board research on
financial literacy. Can you provide the Commission with this research?

Heather H. Murren, CFA

Com missioner
John W. Thompson


2. You discussed the interconnectedness of financial institutions and how it
contributed to the financial crisis. Please describe the role of the over-the-counter
derivatives market in creating interconnections among firms.
3. You suggested that central clearing of over-the-counter derivatives might
be useful in diminishing problems related to interconnectedness. Please describe
the problems that central clearing would address. Did those problems contribute
to the financial crisis?

Peter J. Wallison



Wendy Edelberg

Wendy Edelberg

1717 Pennsylvania Avenue, NW, Suite 800 • Washington, DC 20006-4614

Executive Director

202.292.2799 • 202.632.1604 Fax

The University of Chicago
Booth School of Business
5807 South Woodlawn Avenue
Chicago, Illinois 60637-1610
Tel 773.702.8779
Fax 773.834.9134
Randall S. Kroszner
Norman R. Bobins
Professor of Economics

July 27, 2010

Wendy Edelberg
Executive Director
Financial Crisis Inquiry Commission
1717 Pennsylvania Avenue, NW
Washington, DC 20006

Re: Follow up to the Financial Crisis Inquiry Commission Forum

Dear Wendy:
Thank you for your letter with the follow up questions from the Commissioners to
the Financial Crisis Inquiry Commission Forum. I have attached a document with
responses to the three questions.
Please do not hesitate to be in touch for further clarification or information.

Dr. Randall S. Kroszner

Responses to Follow-up Questions from the Financial Crisis Inquiry Commission Forum
Randall S. Kroszner
Booth School of Business, University of Chicago

1. During the Forum, you described the Federal Reserve Board’s research on financial
literacy. Could you provide the Commission with this research?
Yes. Here is a list with links to some key pieces of recent research conducted by the staff
at the Federal Reserve Board and throughout the Federal Reserve System. Sandy Braunstein’s
testimony on “Financial Literacy” provides an overview of the research and of ongoing efforts
by the Federal Reserve to improve financial literacy.

Bell, C.J., Hogarth, J.M., and Gorin, D.R. Teaching for the Test, and Life Is the Final Exam.
Association for Financial Planning and Counseling Education 2009 Conference Proceedings, 2232.
Bell, C.J., Gorin, D.R., and Hogarth, J.M. Does Financial Education Affect Soldiers’ Financial
Behavior? Networks Financial Institute Working Paper 2009-WP-08, August 2009.
Bell, C.J., Gorin, D.R., and Hogarth, J.M. What Makes a Good Money Manager Good? Insights
from an Evaluation of a Financial Education Initiative. American Council on Consumer Interests
2010 Conference Proceedings (in press).
Braunstein, S. Financial Literacy. Testimony before the Subcommittee on Oversight of
Government Management, the Federal Workforce, and the District of Columbia, Committee on
Homeland Security and Governmental Affairs, U.S. Senate, Washington, D.C. April 29, 2009

Braunstein, S. and Welch, C. Financial Literacy: An Overview of Practice, Research, and
Policy. Federal Reserve Bulletin, November 2002, 445-457.
Choi, L. Outcomes and Evaluation in Financial Education. Federal Reserve Bank of San
Francisco. October 2008.
Choi, L. Bank Accounts and Youth Financial Knowledge: Connecting Experience and
Education. Federal Reserve Bank of San Francisco Working Paper 2009-07. September 2009.
Hilgert, M.A., Hogarth, J.M., and Beverly, S.G. Household Financial Management: The
Connection between Knowledge and Behavior. Federal Reserve Bulletin, July 2003, 309-322.


2. You discussed the interconnectedness among financial institutions and how it
contributed to the crisis. Please describe the role of over-the-counter derivatives in
creating interconnections among firms.
The over-the-counter (OTC) derivative market is one important channel through which
interconnections among financial services firms can be created. A “derivative contract” derives
its value based on the characteristics of an asset or security, for example, a stock or a bond. An
“OTC contract” is not traded on an organized exchange or cleared through a central counterparty
such as a clearinghouse. By interconnection, I mean that the evaluation of the safety and
soundness of one institution may depend crucially on the safety and soundness of others so that
there can be knock-on effects of concerns about the health of one institution on others.
To be concrete, I will focus on a prominent OTC derivative market, namely the credit
default swaps (CDS) market. The CDS market involves buying and selling insurance against the
default of a firm named in the CDS contract. Specifically, the seller of the contract (“seller of
protection”) promises to make a payment to the purchaser (“buyer of protection”) if the firm
named in the contract defaults on its bonds.
When a stock or bond is traded, the firm buying the security is not exposed to the risks of
the seller after the transaction is settled and the security is transferred, usually no more than a
few days. Derivative contracts, however, typically involve longer or ongoing relationships. In
CDS, the buyer is typically purchasing protection against default over a year or longer horizon.
It is this ongoing relationship that creates the interconnection between the buyer and seller. The
buyer is exposed to the risk that the seller may face financial difficulty over the life of the
contract and not be able to make-good on its promises. Thus, the buyer of the contract is
exposed to “performance risk” of the seller. In other words, the health of one institution will be
related to the ability of its counterparties over time to perform as promised on their contracts.
This performance risk exposure exists in all OTC derivative contracts but is particularly
acute in CDS. The circumstances that may cause the firm named in the CDS contract to default,
for example, may be precisely the same circumstances in which the seller of the protection faces
distress and cannot make the promised payment. In other words, the risks can be correlated.
Consider the case of an institution that hedged its bond portfolio by purchasing protection
in the CDS market against default of the bonds it holds. If the sellers of protection cannot make
the payments, then what had appeared to be a well-hedged position is now unhedged and the
institution is exposed to the risk of default on the bonds. Thus, what may have appeared to be a
sound institution may suddenly become much riskier due to concerns about the soundness of its
counterparties as a consequence of the interconnection in the OTC derivatives markets.
Interconnections created through the OTC derivatives markets also can increase the
correlation of risks making the system more fragile. If one large seller of protection faces
distress, then its counterparties all become riskier. That then also makes all counterparties of
these counterparties riskier. Since there is generally low transparency in OTC derivatives
markets, it is difficult for outsiders to know the counterparty exposures, even if the portfolio
positions are reported. In some cases, record keeping was so poor that individual institutions did

not even know internally their own counterparty exposures. Such circumstances can lead to a
market-wide loss of confidence and a freezing of markets. Participants become unwilling to
trade with each other because they cannot easily evaluate others riskiness. The loss of liquidity
further exacerbates the confidence problems in the markets as it becomes more difficult to know
what current market values of assets are when markets become illiquid, further eroding
confidence, etc.


3. You suggested that the central clearing of over-the-counter derivatives might be useful
in diminishing the problems related to interconnectedness. Please describe the problems
that central clearing would address. Did the problems contribute to the crisis?
Central clearing can address important problems that contributed to the crisis.
Central clearing can directly reduce interconnectedness among firms. The central
clearing counterparty, typically called a clearinghouse, acts as a guarantor of the performance on
derivative contracts. If, for example, a seller of protection in the CDS market were to experience
distress and be unable to make good on its promises to pay, the clearinghouse would make the
payment. With a clearinghouse as guarantor, concerns about the safety and soundness of an
individual institution thus will not have knock-on effects on its counterparties since they are not
exposed to performance risk. A credible central counterparty thus acts as a barrier that helps to
prevent the ripples of a failure of a market participant turning into a tidal wave that can sink
other institutions.
In the recent crisis, lack of a credible central counterparty increased interconnectedness
and contributed to the crisis. (See answer to #2 above for a definition of interconnectedness.)
During the crisis, in order to judge the soundness of an institution, market participants needed to
be able to evaluate the likelihood that the counterparties to the institution’s OTC derivatives
contracts would be able to make good on their payments. Such concerns about
interconnectedness were a motivation in the exercise of the Fed’s section 13(3) emergency
powers to avoid the collapse of Bear Stearns in March 2008.
Although information about risk exposures to a particular asset class, for example, may
be reported, the identities of counterparties are not. As noted in the answer to #2 above, given
the poor back-office record-keeping in some OTC markets, some institutions did not know
internally the extent of their counterparty exposure to particular firms. In addition, to assess the
soundness of the counterparties, it was necessary to know the soundness of the counterparties of
the counterparties, etc. throughout the chain of intermediation. Uncertainty about the ability of
counterparties to perform thus raised questions about the value of and risks in a financial
institution’s portfolio, e.g., if well-hedged positions suddenly might become unhedged due to the
non-performance of a counterparty.
The lack of transparency and knowledge contributed to a market-wide loss of confidence
since it became nearly impossible to obtain the information necessary to evaluate the exposure
to, as well as the soundness of, counterparties. Without this information, institutions with
significant participation in the OTC derivatives markets could become suspect, as well as those
with important dealings with such institutions, even if not directly through the OTC derivatives
markets. Such institutions then faced increasing difficulty obtaining funding for their positions
and some experienced “funding runs” (see Kroszner 2010 and forthcoming). Traditional funders
instead preferred to hold short-term Treasury securities. This preference can be so strong, as we
observed on a few days during the crisis, that investors were willing to take slightly negative
interest rates on short-term T-bills.


With the loss of confidence, markets can freeze as investors and institutions are unwilling
to transact given the high level of uncertainty. Bid-ask spreads widen and price discovery in
markets can break down, further contributing to the difficulty of evaluating the value of a
financial firm’s assets, hence its solvency.
With central clearing, however, market participants and supervisors can have much more
information about risk concentrations and counterparty exposures. Reducing or eliminating
counterparty “performance” exposure and increasing the information available in these markets
will make it easier to evaluate the safety and soundness of any individual institution, without
needing to know the safety and soundness of the counterparties. Central clearing thus can
mitigate problems associated with interconnectedness and make a market-wide loss of
confidence much less likely.
In addition, central clearing is much more likely to prevent building of excessive risk
concentrations in the first place. The clearinghouse would quickly become aware of rapid
changes in exposures of market participants and could undertake actions to try to limit them. If
CDS were centrally-cleared, there would have been much more uniform and consistently
enforced margin requirements. This would have slowed the growth of risk exposures at a seller
of protection, such as AIG, since AIG would have been required to post collateral and margin up
Supervisors also could have much more easily monitored risk concentrations, unlike in
OTC markets, and have become aware of risk exposures at institutions that the supervisor may
not directly regulate but that could have system-wide consequences. It was difficult for bank
regulators, for example, to observe the growing concentration of risks at AIG. Central clearing
thus makes it more likely the excessive concentrations of risk can be detected and defused
earlier, and thereby contribute to stability by improving the informational infrastructure of the
More broadly, central clearing tends to promoting greater standardization and
homogeneity of contracts and help to enhance the liquidity of these markets even in times of
As this discussion illustrates, a credible central counterparty can reduce precisely the
types of fragilities that can arise in an interconnected financial system and that contributed to the
severity of the recent crisis. The benefits of central clearing, however, rely crucially upon the
safety, soundness, and credibility of the central counterparty. Ensuring that the clearinghouses
are able to manage the risks of guaranteeing performance on, for example, large amounts of CDS
contracts, is necessary for them to be a stabilizing force in a crisis (see Pirrong 2008/2009).
Clearinghouses have a long history of dealing successfully with the interconnection issue
(Kroszner 1999 and forthcoming). In the 19th and early 20th centuries, futures markets struggled
with the challenges of trying to make contracts more readily tradable on exchanges by making
them more consistent and thereby more easily traded. The last major step toward full fungibility
of the contracts was limiting and homogenizing counterparty risk. Even if all of the other
features of the contract were identical, the potential for non-performance would vary with the

identity of the stability of the institution on the other side of the transaction – that is, counterparty
performance risk (see answer to question #2 above) – since the contracts were bi-lateral
obligations between the buyer and seller.
To solve this problem, the clearinghouse came to act as a guarantor of performance of all
the contracts, thereby eliminating the performance risk of individual counterparties. Central
counterparty clearing has been quite robust to stressful market conditions, allowing them to
operate through the Great Depression, World War II, and the failures of major market
participants in previous and the most recent crisis.
The clearinghouse generally runs a balanced book to try to avoid direct market exposure.
The clearinghouse requires margin to be posted by the members, thereby limiting leverage and
providing consistent treatment across market players. The clearinghouse also cumulates a
fraction of its clearing fees in a reserve fund. In the case of a member's default, the central
counterparty can draw upon the proprietary margin of the defaulting member, its own reserve
fund, pre-established lines of credit, and the assessment of members for share purchase.
Strong incentives, such as higher capital charges for OTC derivatives relative to
centrally-cleared derivatives, could motivate the major players in derivatives markets to migrate
existing contracts, to the extent possible, onto such platforms and to develop contracts with
sufficient standardization that they can be centrally cleared. To summarize, this would reduce
the likelihood of institutions threatening to become “too interconnected to fail” for two reasons:
the supervisors and exchanges can more readily monitor and prevent the buildup of exposures,
and the consequences of the failure of an institution is mitigated by the ability of the central
counterparty to reduce interconnections and hence the disruption of the markets. Naturally, the
extent to which the central counterparty will be successful will depend on its perceived ability to
withstand the failure of key players in the market. If the clearinghouse is not believed to be
sound, then the interconnection problem could become worse since so many institutions would
be relying upon its performance guarantees. Thus, the strength and credibility of central clearing
counterparties to manage risk in new areas such as CDS will be critical to their success in
mitigating fragilities associated with the interconnectedness.


Kroszner, Randall (1999), "Can the Financial Markets Privately Regulate Risk? The
Development of Derivatives Clearing Houses and Recent Over-the-Counter Innovations,"
Journal of Money, Credit, and Banking, August, 569-618.
Kroszner, Randall (forthcoming 2010) "Making Markets More Robust," forthcoming Benjamin
F. Friedman, editor, Reforming the Financial Markets Once the Crisis is Over, MIT
Kroszner, Randall (2010) “Interconnectedness, Fragility, and the Crisis,” prepared for the
Financial Crisis Inquiry Commission, February.
Pirrong, Craig (2008/2009), “The Clearinghouse Cure?,” Regulation Magazine, Winter, vol 31,
no 4.