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n Sept. 13, 2007, the British Broadcasting Corporation'€™s (BBC) business editor Robert Peston broke the news that British bank Northern Rock, one of the top-five mortgage lenders in the United Kingdom, had requested emergency support from the Bank of England.

On the following day, a Friday, there was a run on the bank. Thousands of people lined up for hours to withdraw their funds.

It was the first run on a British bank in 150 years. Some customers held their funds in '€œInternet only'€ accounts, which they were unable to access due to the large number of customers trying to log on.

On Monday, Sept. 17, worried savers continued to withdraw their funds. An estimated £2 billion sterling was withdrawn between Sept. 12 and Sept. 17.

The Northern Rock story illustrates just how quickly liquidity problems can lead to a bank spiraling downward.

It is important to distinguish solvency from liquidity. Solvency refers to a bank having more assets than liabilities, so that the value of its equity is positive. Liquidity refers to the ability of a bank to make payments as they become due.

Banks that are solvent can '€” and sometimes do '€” fail because of liquidity problems. It is clearly important for banks to manage liquidity carefully.

Another story of liquidity risk is provided by hedge fund management firm Long-Term Capital Management (LTCM). In the summer of 1998, LTCM took a huge loss because a default by Russia on its debt caused a flight to quality. The LTCM story reinforces the importance of carrying out scenario analyses and stress testing to look at what can happen in extreme scenarios. It is important to consider not only immediate losses but also losses created by knock-on effects.

Liquidity risk is the risk of a bank'€™s inability to meet its maturing obligations, including the obligation to fund an asset in a sustainable manner.

Liquidity risk arises because there is a tendency for banks to finance long-term needs with short-term funding. It is related to endogenous liquidity (nature of liquidity assets) and exogenous liquidity (funding liquidity). Exogenous liquidity is very important when banks cannot sell assets quickly or have a '€˜mismatch'€™ between the funding structure of assets and liabilities.

There are two methodologies that have been used by banks to measure liquidity risk, which are the nominal stock-based method and a flow-based method. Liquidity risk measurements based on nominal stock-based methods use various financial ratios as an indicator of the level of a bank'€™s liquidity risk, whereas measurements based on flow-based liquidity risk use the liquidity-gap analysis.

Liquidity gap is the difference between the amount of bank'€™s assets and bank'€™s liabilities maturing in a certain period. In the event of a negative liquidity gap, it can pose a risk to the bank so that it requires a strategy to mitigate the liquidity risk.

Liquidity needs are uncertain and have become more difficult to predict, so banks must assess a worst-case liquidity scenario by either converting assets into or borrowing funds externally. Once stress-testing results have been produced, they should become inputs to the bank'€™s strategic decision making. All too often, particularly when times are good, the results of stress testing are ignored. This happened at a number of banks and other financial institutions prior to July 2007.

The New Basel III Requirements are designed to ensure that banks do this. Basel III has introduced requirements involving two liquidity ratios, which are designed to ensure that banks can survive liquidity pressures.

The liquidity ratios are the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The LCR focuses on a bank'€™s ability to survive a 30-day period of liquidity disruptions. Basel III regulations require the LCR to be greater than 100 percent so that a bank'€™s liquid assets are sufficient to survive these pressures.

The NSFR focuses on liquidity management over a period of one year and the NSFR being greater than 100 percent so that the calculated amount of stable funding is greater than the calculated required amount of stable funding.

The amount of stable funding is calculated by multiplying each category of funding (capital, wholesale deposits, retail deposits, etc.) by an available stable funding factor (ASF), reflecting their stability, while the required amount of stable funding is calculated from the assets and off-balance sheet items requiring funding (RSF) factor to reflect the performance of the funding required.

The above new rules are tough and have the potential to dramatically change bank balance sheets. However, there is a transition period planned, during which the effect of the rules will be monitored. It is possible that the rules will be eased somewhat before they are finally implemented. The LCR requirement is scheduled to be implemented on Jan. 1, 2015. The NSFR requirement is scheduled to be implemented on Jan. 1, 2018.

Exactly how Basel III will be implemented is still uncertain and this uncertainty is one of the major risks that banks face. How successful will the measures be once they have been implemented? We will not know this for some time.

One problem facing regulators is what is referred to as unintended consequences. Basel I had the unintended consequence of discouraging loans to high-quality corporations because of the 100 percent risk weight that would be assigned.

The 1996 Amendment and the development of the credit derivatives market that came after it encouraged banks to find ways of moving credit risks from the banking book to the trading book in order to reduce capital requirements.

Hopefully, the benefits of the new measures will outweigh any harm to the banking system arising from unintended consequences.

It is also important for bank risk managers to continually '€œthink outside the box'€ about what could
go wrong so that as many potential adverse events as possible are identified.