Make No Mistake, Size Matters with Systemic Risk

Roy C. Smith

By Roy C. Smith

True, Basel III has toughened up both risk weightings and required capital levels, but will that be enough to prevent another systemic collapse?

By Roy C. Smith

In 2007, according to the McKinsey Global Institute, global financial assets had a combined market value of $202 trillion, a surprisingly large amount and equal to three and a half times’ global gross domestic product.

The following year, precipitated by a sharp and steady drop in liquidity supporting the $6 trillion securitised mortgage market, and accelerated by unpredictable government actions, a staggering $28 trillion plunge in the value of global equities occurred.

Prices of mortgage-backed securities dropped steadily as investors reacted to events that started in mid-2007. A May 2008 study by the Bank of England of $900bn of collateralised mortgage obligations estimated that the correct intrinsic value of the pool, using conservative assumptions, was 81% of par value but their market price was only 58%. By late September the price had dropped considerably further.

The market overreacted massively. The actual “default and near-default” rate of investment-grade structured mortgage debt, according to Standard and Poor’s, was less than 6.5% in 2008. The market movement, however, forced large-scale mark-to-market write-offs, resulting in unsupportable capital deficits among banks. Though highly leveraged, the banks were fully in compliance with Basel I rules applicable at the time.

Read full article as published in Financial News

Roy C. Smith is the Kenneth G. Langone Professor of Entrepreneurship and Finance and Professor of Management Practice.