The London Interbank Offered Rate dispute continues to elevate to a full-blown scandal, raising a number of vexing issues for bankers. Setting aside the obvious ones (What is the benchmark if Libor disintegrates? What about all those outstanding contracts referencing Libor?), let's take a step back and ask a simple question.
Why can't the banking industry — particularly large institutions with amazingly sophisticated risk management operations — ever see this kind of thing coming?
An interesting survey, released by risk management advisers Corven Consulting in July, argued that bank risk management was very immature and reactive compared with banks' counterparts in the aviation sector. In my opinion, this viewpoint might just have some merit.
As an investment banker focused on advising community banks, a licensed private pilot, and a former bank regulator, I see potential disparities between the regulatory processes of airlines and banks, particularly the megabanks. Airlines and their regulators look for root causes; bankers and their regulators generally focus on the issue du jour. The comparison is worth exploring and the potential lessons are worth thinking about. Here are three takeaways from the aviation sector that megabankers and financial regulators should consider.
First, question authority. Every member of the crew is on the hook for a safe flight. Commercial airline co-pilots, though second in command, have a duty to speak up when they determine that a given situation is unsafe or illegal. Captains are not dictators. They have an obligation to deal with concerns from the crew. A line mechanic can ground an aircraft full of paying passengers until he or she is satisfied the aircraft is ready for take-off. Further, there is a high degree of personal accountability, which serves to focus the mind. Screw up in the cockpit, find another career. Period.
While community bankers are often banned from the business when their banks fail, megabank executives often escape this plight as a result of "too big to fail" and inconsistent policy. Despite all we've been through, it appears the focus continues to be on profit rather than competency. I believe a "safety first" culture is needed at the megabanks. Additionally, an open airing of issues and immediate accountability might insure problems are identified on the trading floor rather than first revealed in The Wall Street Journal.
Second, encourage self-reporting. In the aviation sector, airlines and the government offer incentives for pilots to self-report near-misses, airspace breaches, altitude busts and the like. Self-reporters are required to lay the situation bare, discuss the buildup to the mistake, and offer ideas on how the system and training can be improved. These reports, scrubbed of identifying information, are available to other pilots and system personnel. This database is maintained by NASA, not the Federal Aviation Administration. In exchange for full disclosure of mistakes, a self-reporter receives immunity in most cases from FAA action against that individual's pilot's license. The theory is that the small breaches and near-misses may reveal something noteworthy about weaknesses in the broader system. Aviation regulators and practitioners alike mine this data to determine which issues warrant full regulatory attention and which are one-hit wonders.
In the financial sector, megabankers and regulators should similarly reward, not penalize, self-reporters. This would help defuse the adversarial nature of the relationship and improve the data on which systemic improvements are made. Internal analyses of emerging problems, inconsequential breaches and occasional failures of internal controls are rarely disclosed in a timely manner to regulators because bankers fear retribution and retaliation. A fair process, administered by a neutral entity, would improve the flow of information between the industry and the government — and improve the quality of the solutions as well.
Third, improve after-incident reporting. The National Transportation Safety Board prepares exhaustive reviews of aviation accidents and incidents. The agency also forwards recommendations to regulatory authorities. Through the years, hundreds of airline safety improvements have been implemented on the hard-won facts and circumstances of prior accidents. In the financial sector, we see some semblance of this in the material loss reviews performed by the regulators' inspectors general and the U.S. Government Accountability Office. But these reports ultimately have little utility because they focus primarily on regulatory failures rather than the problems at the banks themselves – suggesting solutions that are both patently obvious at that point and, in many cases, already implemented.
Pilots get frustrated at times with the NTSB's singular penchant for placing the blame squarely in the cockpit or the controller's station. But there is no question in anyone's mind that accountability lies with the professionals at the controls, not the FAA. Similarly, we need to turn the material loss review process away from the blame game and more toward an NTSB-like process of deconstructing the failures of management and banking practice — and learning lessons.
Flying airplanes and running megabanks are clearly very different enterprises. But they are both complex activities and involve significant risk. And, as we all know, both are prone to very public and embarrassing mishaps that undermine public confidence. Perhaps, given the wild ride of the past 10 years, banking can learn something from the industry that itself has posted an impressive and improving safety record during a similar span of time.
C.K. Lee is a managing director of Commerce Street Capital LLC in Dallas, a former bank regulator, and a licensed private pilot. The views expressed are his own.