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