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04/04/2011

Reputational Risk


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The global financial crisis of 2007–2009 was associated with an unprecedented degree of financial and economic damage. For investors and financial intermediaries, the estimates seem to have risen to over $4 trillion or so worldwide by the time things began to stabilize, according to the International Monetary Fund (2009). Along with the financial damage has come substantial reputational damage for the financial services industry, for financial intermediaries and asset managers, and for individuals.

At the industry level, for example, Josef Ackermann, CEO of Deutsche Bank and chairman of the International Institute of Finance, noted in April 2008 that the industry was guilty of poor risk management with serious overreliance on flawed models, inadequate stress-testing of portfolios, recurring conflicts of interest, and lack of common sense, as well as irrational compensation practices not linked to long-term profitability—with a growing perception by the public of “clever crooks and greedy fools.” He concluded that the industry has a great deal of work to do to regain its reputation.1 Crisis-driven reputational damage at the firm level can be inferred from remarks by Peter Kurer, former supervisory board chairman of UBS AG, who noted at the bank’s annual general meeting in April 2008 that “We shouldn’t fool ourselves. We can’t pretend that there has been no reputational damage. Experience says it goes away after two or three years.”2

Perhaps it does, perhaps not, but the hemorrhage of private client withdrawals at the height of the crisis suggests severe reputational damage to the world’s largest private bank—to the point that it was surpassed in assets under management by Bank of America (after its acquisition of Merrill Lynch) in 2009. The number of financial firms—ranging from Santander in Spain to Citigroup in the United States and Union Bancaire Privée in Switzerland—that have reimbursed client losses from the sale of bankrupt Lehman bonds, collapsed auction-rate securities, and investments in Bernard Madoff’s fraudulent scheme suggests the importance of reputational capital and the lengths to which financial firms must go to maintain it. And at the individual level the world is full of disgraced bankers whose hard work, career ambitions, and future prospects lie in tatters.

Whether at the industry, firm, or individual level, the reputational costs of the financial crisis have been enormous. The first section of this chapter considers the special nature of financial services and traces the roots of the reputational risk that firms in the industry invariably encounter. The second section defines what reputational risk is and outlines the sources of reputational risk facing financial services firms. The third section considers the key sources of reputational risk in the presence of transactions costs and imperfect information.3 The fourth section surveys available empirical research on the impact of reputational losses imposed on financial intermediaries, including the separation of reputational losses from accounting losses. The chapter concludes with some governance and managerial implications.

THE SPECIAL CHARACTER OF FINANCIAL SERVICES

Financial services comprise an array of special businesses. They are special because they deal mainly with other people’s money, and because problems that arise in financial intermediation can trigger serious external costs. In recent years, the roles of various types of financial intermediaries have evolved dramatically. Capital markets and institutional asset managers have taken a greater portion of the intermediation function from banks. Insurance activities conducted in the capital markets—such as credit default swaps and weather derivatives—compete with classic reinsurance functions. Fiduciary activities for institutional and retail clients are conducted by banks, broker-dealers, life insurers, and independent fund management companies. Intermediaries in each cohort compete as vigorously with their traditional rivals as with players in other cohorts, and the competition has been intensified by deregulation and rapid innovation in financial products and processes. Market developments have periodically overtaken regulatory capabilities intended to promote stability and fairness as well as efficiency and innovation. The regulatory arbitrage that can result has a great deal to do with the dynamics of the financial crisis of 2007–2009, and is being addressed in many of the regulatory efforts that have been proposed.

It is unsurprising that these conditions would give rise to significant reputational risk exposure for all financial firms. For their part, investors in banks and other financial intermediaries are sensitive to the going-concern value of the firms they own, and hence to the governance processes that are supposed to work in their interests. Regulators, in turn, are sensitive to the safety, soundness, and integrity of the financial system and will, from time to time, recalibrate the rules of the game. Market discipline, operating through the governance process, interacts with the regulatory process in ways that involve both costs and benefits to market participants and are reflected in the value of their business franchises.

WHAT IS REPUTATIONAL RISK?

There are substantial difficulties in defining the value of a financial firm’s reputation, the extent of damage to that reputation, the origins of that damage, and, therefore, the sources of reputational risk. Reputation itself may be defined as the opinion (more technically, a social evaluation) of the public toward a person, a group of people, or an organization. It is an important factor in many fields, such as education, business, online communities, and social status. In a business context, reputation helps drive the excess value of a business firm and such metrics as the market-to-book ratio. However, both a precise definition and data are found to be lacking. Arguably many deficiencies in both definition and data can be attributed to the fact that theory development related to corporate reputation has itself been deficient. Such problems notwithstanding, common sense suggests some sources of gain/loss in reputational capital: 

  • The cumulative reputation of the firm, including its self-promoted ethical image.
  • Economic performance—market share, profitability, and growth.
  • Stakeholder interface—shareholders, employees, clients, and suppliers.
  • Legal interface—civil and criminal litigation and enforcement actions. 

Consequently, proximate symptoms of sources of loss in reputational capital include:

  • Client flight and loss of market share.
  • Investor flight and increase in the cost of capital.
  • Talent flight.

Increase in contracting costs. For practical purposes, reputational risk in the financial services sector is therefore associated with the possibility of loss in the going-concern value of the financial intermediary, which is to say the risk-adjusted value of expected future earnings. Reputational losses may be reflected in reduced operating revenues as clients and trading counterparties shift to competitors; increased compliance and other costs required to deal with the reputational problem, including opportunity costs; and an increased firm-specific risk perceived by the market. Reputational risk is often linked to operational risk, although there are important distinctions between the two. According to Basel II, operational risks are associated with people (internal fraud, clients, products, business practices, employment practices, and workplace safety), internal processes and systems, and external events (external fraud, damage or loss of assets, and force majeure). Operational risk is specifically not considered to include strategic and business risk, credit risk, market risk or systemic risk, or reputational risk.4

If reputational risk is bracketed out of operational risk from a regulatory perspective, then what is it? A possible working definition is as follows: Reputational risk comprises the risk of loss in the value of a firm’s business franchise that extends beyond event-related accounting losses and is reflected in a decline in its share performance metrics. Reputation-related losses reflect reduced expected revenues and/or higher financing and contracting costs. Reputational risk, in turn, is related to the strategic positioning and execution of the firm, conflicts of interest exploitation, individual professional conduct, compliance and incentive systems, leadership, and the prevailing corporate culture. Reputational risk can frequently be rooted in conflicts of interest—between the firm and its clients, between clients, or within the financial firm itself.5 Reputational risk is usually the consequence of management processes rather than discrete events, and, therefore, requires risk control approaches that differ materially from operational risk.


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According to this definition, a reputation-sensitive event might trigger an identifiable monetary decline in the market value of the firm. After subtracting from this market capitalization loss the present value of direct and allocated costs, such as fines and penalties and settlements under civil litigation, the balance can be ascribed to the impact on the firm’s reputation. Firms that promote themselves as reputational standard-setters will, accordingly, tend to suffer larger reputational losses than firms that have taken a lower profile—that is, reputational losses associated with identical events according to this definition may be highly idiosyncratic to the individual firm.

In terms of the overall hierarchy of risks faced by financial intermediaries, reputational risk is perhaps the most intractable. In terms of Exhibit 6.1, market risk is usually considered the most tractable, with adequate time-series and cross-sectional data availability, appropriate metrics to assess volatility and correlations, and the ability to apply techniques such as value at risk (VaR) and risk-adjusted return on capital (RAROC). Credit risk is arguably less tractable, given that many credits are on the books of financial intermediaries at historical values. The analysis of credit events in a portfolio context is less tractable than market risk in terms of the available metrics, although many types of credits have over the years become marketized through securitization structures such as asset-backed securities (ABSs) and collateralized loan obligations (CLOs), as well as derivatives such as credit default swaps (CDSs). These financial instruments are priced in both primary and secondary markets, and transfer some of the granularity and tractability found in market risk to the credit domain. Liquidity risk, by contrast, has both pluses and minuses in terms of tractability. In continuous markets, liquidity risk can be calibrated in terms of bid-offer spreads, although in times of severe market stress and flights to quality, liquidity can disappear.

Exhibit 6.1: A Hierarchy of Risks Confronting Financial Intermediaries

A Hierarchy of Risk Confronting Financial Intermediaries

If the top three risk domains in Exhibit 6.1 show a relatively high degree of manageability, the bottom three are frequently less manageable. Operational risk is a composite of highly manageable risks with a robust basis for suitable risk metrics together with risks that represent catastrophes and extreme values—tail events that are difficult to model and, in some cases, have never actually been observed. Here management is forced to rely on either simulations or external data to try to assess the probabilities and potential losses. Meanwhile, sovereign risk assessment basically involves applied political economy and relies on imprecise techniques, such as stylized facts analysis, so that the track record of even the most sophisticated analytical approaches is not particularly strong—especially under conditions of macro-stress and contagion. As in the case of credit risk, sovereign risk can be calibrated when sovereign foreign-currency bonds and sovereign default swaps (stripped of nonsovereign attributes like external guarantees and collateral) are traded in the market. This leaves reputational risk as perhaps the least tractable of all—with poor data, limited usable metrics, and strong fat-tail characteristics.

The other point brought out in Exhibit 6.1 relates to the linkages between the various risk domains. Even the most straightforward of these—such as the linkage between market risk and credit risk—are not easy to model or to value, particularly in a bidirectional form. There are 36 such linkages, exhibiting a broad range of tractability. It can be argued that the linkages that relate to reputational risk are among the most difficult to assess and to manage.

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NOTES

1. For the ensuing report, see http://www.iasplus.com/crunch/0804iifbestpractices.pdf.

2. See http://careers.hereisthecity.com/front office/corporate and investment banking/ press releases/124.cntns.

3. Earlier studies focusing on reputation include Chemmanur and Fulghieri (1994), Smith (1992), Walter and De Long (1995), and Smith and Walter (1997).

4. Basel II at http://www.bis.org/publ/bcbs107.htm.

5. See for example Attorney General (2003), Demsky (2003), Herman (1975), Krozner & Strahan (1999), Saunders (1985), Schotland (1980), and Walter (2004).

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Comments

Dear Professor Walter: I found your article on Reputational risk very interesting and informative.
My question or query refers to whether any central bank in the world has defined a methodology for a financial instituion to arrive at a "cost of capital" for reputational risk? How would a financial institution go about, in a simple manner, to calculate this risk? Thank you for any suggestion/reference on this issue.

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