First of two parts.

This past fall, large global banks found themselves in far more trouble than their “worst case” stress tests contemplated. Sound familiar? The funding crisis sparked by European sovereign debt fears is all too similar to nightmares only a few years behind us.

The Great Meltdown of 2007-2008 revealed more than a few management and regulatory failures. Warren Buffett famously said that “you only find out who is swimming naked when the tide goes out.” Individual risk professionals, banks, consultants, advisors, industry organizations, rating agencies and banking regulators were swimming naked.

We had fallen in love with models and rigorous mathematical explanations for market and balance sheet liquidity. The models’ logic and math were not wrong.  Events showed, however, that we did not understand the limits of our rocket science. Nor did we always apply it correctly.

On the human side, we drew the wrong conclusions from years of only insignificant losses resulting from poor liquidity risk management. Instead of remembering the history of long periods of good times punctuated by panics, we became comfortable with what looked like superior management and regulation.

In the early months of the Great Meltdown, bank supervisors from five of the hardest hit countries studied the problems at eleven banks and issued a timely report. Writing more than six months before Lehman Brothers’ failure and the nationalization of AIG, the supervisors noted that at some firms, it was a particular challenge to get senior managers to accept the results of extreme stress tests – particularly when they were based on hypothetical, forward-looking scenarios.

“Some firms found it challenging before the recent turmoil to persuade senior management and business line management to help develop and pay sufficient attention to the results of forward-looking stress scenarios,” the Senior Supervisors Group report said. “The larger the shock imposed, the less plausible the stress tests or scenarios in the eyes of business area and senior management.”

One reason for management’s nonchalance may have been indifference. “Monitoring and reporting functions were performed routinely, by-the-numbers, without going beneath the surface to sniff out potential problems. As long as the dashboard glowed green, everything was thought to be just fine. As a result, many institutions failed to spot – or worse, ignored – warning signs that a systemic crisis was lurking and were under- prepared when it hit.”

A second reason is that managers confused stress tests forecasts with predictions. Worst-case stress is, by definition, highly improbable. Instead of understanding stress tests as tools for revealing vulnerabilities, managers who regarded them as implausible predictions felt confident that they did not need to pay attention.

A third contributing factor has been described as the “Cassandra Effect.” In the words of one risk management professional, who spoke to The Economist on condition of anonymity: “The more you warn your colleagues about the tail risks — the rare but devastating events that can bring the bank down — the more they roll their eyes, give a yawn and change the subject.  This eventually leads to self-censorship.  The system filters out the thoughtful and replaces them with the faithful.”

With the benefit of hindsight, we can clearly see that some firms underinvested in liquidity risk management. According to the Senior Supervisors Group’s March 2008 report, “Firms that experienced material unexpected losses … typically appeared to have been under pressure over the short term either to expand the business aggressively, to a point beyond the capacity of the relevant control infrastructure, or to defend a market leadership position. In some cases, concerns about the firm’s reputation in the marketplace may have motivated aggressive managerial decisions."

At firms with outsized losses, the top brass “tended to champion the expansion of risk without commensurate focus on controls across the organization or at the business-line level. At these firms, senior management’s drive to generate earnings was not accompanied by clear guidance on the tolerance for expanding exposures to risk,” the supervisors’ report said. "For example, balance sheet limits may have been freely exceeded rather than serving as a constraint to business lines. The focus on growth without an appropriate focus on controls resulted in a substantial accumulation of assets and contingent liquidity risk that was not well recognized.”

At least one global bank compounded the problem by treating risk management as a compliance requirement instead of as an essential business control. According to The Economist, at Citigroup Inc., the head of risk reported not to then-Chief Executive Charles Prince, nor to the board, “but to a newly hired executive with a background in corporate governance law, not cutting edge finance.”

Next: A closer look at liquidity risk measurement failures.

Leonard Matz is an independent liquidity risk consultant. This article is adapted from his book, “Liquidity Risk Measurement and Management: Basel III And Beyond” (Xlibris Corporation, 2011).