Indeed, the recent global financial market problems were a salutary reminder that while the financial houses of the world may look in great order, there may still be rats gnawing away in the basement.

In fact, these problems highlighted key problems in the global financial system which we ignore at our peril.

In the simplest possible terms, basically what happened was the following.

US mortgage lenders lent too much to high risk borrowers.

Because the lenders had "on-sold" these high risk loans to others - including a Swiss bank - when the latter found out that they had under-estimated the risk of the instruments they had bought and their profit margins were thus greatly squeezed, central banks in a number of countries had no choice but to boost liquidity, so that there would not be too sharp a fall in new lending.

Fears of a sharp US economic slowdown then followed, forcing the US Federal Reserve to cut US official interest rates to help prevent a greater US and global credit crisis.

The whole incident was thus a welcome reminder that even the sharpest banker, financier or investment advisor never possesses anything like the perfect knowledge of markets finance textbooks assume they possess.

Indeed, it was the lack of such knowledge which de-stabilised global financial markets and market players are still wondering what other rodents there are to be exposed.

The accompanying diagram, from the latest IMF Global Financial Stability Report, provides an excellent snapshot of how the incident impacted on the global risk profile.

But the good news is that a number of key risks were highlighted by these events.

The first was that it is now much harder to identify and foresee systemic risks in the global financial system.

Until the recent troubles, it was widely believed that the increased complexity of the global financial system, in itself, provided significant protection to the system from de-stabilising shocks.

Instead, the troubles provided a sharp wake-up call that with the increased complexity came a whole set of new uncertainties and unknowns.

In particular, the complex composition of some derivative instruments - and the lack of transparency regarding some holders' balance sheets - make it harder to assess the risk exposure of individual entities, including some regulated institutions.

Hence, when the weaknesses in such assets became recognised, financial shock waves were sent around the world.

The second problem highlighted by the recent troubles is the impact of such risk exposure is a
lot wider and broader than previously realised, encompassing more than an individual country or even a region.
For example, over the last couple of years, U.S. sub-prime and other mortgage-backed assets have been a key ingredient of structured credit products that have been sold to a broad set of investors outside the United States.

Hence, the US problems were quickly exported to other economies and to shareholders and financial institutions across the globe - ranging from shareholders in European banks, investors in hedge funds, to even non-bank housing lenders in Australia.

The third problem highlighted is that the mere exposure of unexpected risks can have severe effects on market and financial liquidity, which can then force radical central bank actions.
These, in turn, can have serious effects on share markets and economies in general.

For example, although the Australian share market recovered quickly from the August downturn, the RBA has warned that further global financial problems could again impact on our markets and on the Bank's interest-rate setting decision-making,

In short, the events exposed global financial market weaknesses which need to be addressed by both the markets themselves and by greater scrutiny of them by international bodies, such as the IMF and Bank for International Settlements.

Knowledge is certainly power.

The problem is even the smartest banker, financier or investment advisor cannot have anything like perfect knowledge of what is happening

Indeed, given the ever-growing complexity of the global financial system we are likely to see further exposure of rodents - and white ants - in its basements and even attics.

Like it or not, such exposures will then produce further incidents of financial market and equity market instability and uncertainty over the months and years ahead.

IMF Global Financial Stability Report, October 2007.

Dr David Clark taught Business Economics at the University of NSW for 35 years, was an AFR and Personal Investor columnist for over a decade, and is now an investor educator. The views expressed are those of David Clark's, not necessarily those of Vanguard's.