2.6.2011

By Tris Squires

Despite the amount of money that banks put into risk management, be it operational, investment, or political risk, there is one area that banks have traditionally only mentioned in passing, that of reputational risk.

Now that is not to say that banks haven’t acknowledged reputational risk. Indeed back in 2005, the Economist Intelligence Unit found that “52 per cent consider reputation risk as a risk by itself, while 48 per cent consider it as a consequence of other risks” like operational risk – people, process, systems and external events – compliance and financial.

And yet, pre-the credit crisis, around the world banks had been feted for their strategies, while countries such as Ireland and Iceland were being cited as models for other sovereigns to aspire to in terms of regulating financial services. So it was understandable that reputational risk tended to take a back seat.

The strange thing is that reputational risk isn’t new. From Barclays and its continued trading in Apartheid South Africa to Arthur Anderson and its role in the Enron saga, financial services should have kept an eye on this risk. Indeed, Andersen is a classic case of reputational risk management.

The year before Enron, the company changed its name to Andersen because there was “extraordinary power in our name because it stands for time-tested values, a unique one-firm global operating approach and recognized superior performance,” according to its managing partner and CEO Joseph Berardino.

So how has reputational risk affected banks and what have they done to counter this?

Reputation wilting
The effect of the US sub-prime mortgage market on the financial crisis is widely credited as exposing both the banking industry and financial system safety net players (central banks and regulators) in many countries to considerable level of distress and economic and reputational damage.

Bank distress research generally highlights several key factors for their problems: mismanagement and illiquidity or loss of capital. Legal and political factors were contended between respective stakeholders namely, shareholders, management, creditors, central banks, deposit insurance agencies, regulators and governments scrambling to protect their interests causing untold costs and reputational damage to the banking system.

These circumstances have heightened the need for policymakers to consider corrective policy options under the broad umbrella of bank resolution and restructuring techniques. The issue of bank resolution was at the forefront of recent changes made in a number of countries to deal with the problems. For example the bail-outs of Northern Rock, Bear & Sterns, Bradford & Bingley, AIG, Hypo Real Estate Bank, and RBS. It also saw the mergers of Bank of America and Merrill Lynch and Lloyd’s and HBOS and the collapse of Lehman and several structured investment vehicles. Additionally, the US financial crisis has brought to the fore the need for a possible new special resolution regime for financial conglomerates so authorities can effectively deal with the investment banks that may experience financial distress.

In the US, investment bank such as Citigate have seen reputational risk leading to negative publicity, loss of revenue, litigation, loss of clients and partners, exit of key employees, share price decline and difficulty in recruiting talent. The transformation of other institutions such as Goldman Sachs and Morgan Stanley to become traditional bank holding companies, helped maintain their reputation, appearing to bring an end an era of aggressive investment banking strategies on Wall Street.

Prior to the 2007 upheaval, many banks failed to recognise the reputational risk associated with their off-balance sheet instruments. Banks managed market, legal, operational, and liquidity risk using complex, numeric structures and discrete models. In the ensuing stressed conditions some firms went beyond their contractual obligations to support their sponsored securitisations. At the time, reputation risk, received little if any attention from most financial institutions.

Reputation risk refers to the damage of reputation of a bank and the negative impact this has on a bank’s earnings, liquidity and capital position.

This usually happens when a bank is incapable of delivering its service commitments. Reputational risks include being unable to sufficiently meet customer account needs or expectations, unreliable or inefficient delivery systems, delayed responses to customer inquiries, or violations on the privacy of their customers.

The risk of losses of a credit organisation due to the decrease in the number of customers as a result of negative public image about financial stability has an impact on the quality of provided services or the nature of business in general.

A study in reputation
Despite the number of studies dealing with reputation risk still in its infancy,
Barclays Global Investors research officer Jason Perry, examined the results of a large sample of financial companies in Europe and the US, run between 1994 and 2008 for his paper Measuring Reputational Risk: The Market Reaction to Operational Loss Announcements. It shows that “substantial reputational losses occur following announcements of ‘pure’ operational losses”.

Fraud is found to be the event type that generates the most reputational damage but Perry warns that the announced dollar amounts are likely understate the effect of operational losses on the financial sector.

“This is because in addition to inflicting direct financial losses upon a firm, operational loss events may have an indirect impact on a firm via reputational risk. Disclosure of fraudulent activity or improper business practices at a firm may damage the firm’s reputation, thereby driving away customers, shareholders, and counterparties,” he writes.

The relationship of reputational risk with the diminution of an organisation’s brand and product and therefore, shareholder value, has become even more marked in the last three years.

Fines or investment controls
Regulators are increasingly adopting a “name and shame” policy when it comes to errant financial houses. According to The impact of “naming and shaming” on business reputations An empirical study in the field of financial regulation by Judith van Erp at Erasmus University Rotterdam, public regulators embrace disclosure policies for reasons of transparency, consumer empowerment or market deterrence. She added that regulators “see great advantages of reputation sanctions in comparison to financial sanctions.

“Reputation sanctions are regarded as strong, powerful weapons, whose normative blows can both educate the market about right and wrong and deter potential offenders.”

The Financial Services Authority (FSA) have reported an upturn in the number of transaction reporting fines taking place but while the continued referral of British firms to enforcement suggests the risks are considered to be worth taking, the loss of trust for the whole industry is at stake.

Evidence suggests that whatever the actual cost of the fine and the accompanying redress, reputational damage cost firms even more. Regulatory Sanctions and Reputational Damage, a research paper from Oxford University’s faculty of law and the Saïd Business School and headed-up by John Armour, professor of law, found that: “Reputational sanctions are very real: their stock price impact is on average 10 times larger than the financial penalties imposed.”

The report cites an article from The Times newspaper of 7 July 2009, where the embarrassment factor for banks “no longer counts for much, alas”.

Yet the report’s authors says they interpreted “the fall in equity market value in excess of mandated payments as the firms’ reputational loss”.

Moreover, the report found that: “The reputational effect is proportionately greater for small firms; that it has increased in intensity since the financial crisis of mid-2007; that it is unrelated to the size of financial penalties levied; and that it spills over to the firm’s parent.”

More damaging than the risk to an individual bank’s reputation, however, was the overall effect on the banking industry. Armour writes that the UK banking industry was “fundamentally important” to the UK economy, and the more tarnished the industry’s reputation became with UK consumers and shareholders, the more likely it was that some of these businesses would disappear abroad.

Changes in corporate perception
According to research in May 2010 from PwC, companies are less likely in future to go to banks to fund growth and development. The corporate treasurers surveyed said they “felt that they had been let down by their banks during the crisis and therefore wanted to reduce their reliance on bank funding”.

This marks a massive behavioral shift, as short term borrowing was a fundamental source of corporate funding before the credit crunch. It therefore marks something quite dangerous to banks, which are generally still in recovery mode after the financial crisis.

Operational activity and measures
Banks have of course been working hard to prove to their corporate customers of their desire to be long-term financial partners. But the message from corporate purse holders is clear: prove it.

This has seen some banks, such as Lloyds invest substantial resources into advertising, with a campaign called ‘For the journey’, being a yardstick in commercial adverts. It has also stuck its neck out with a new Corporate Markets website.

The caveat of business as usual holds true many banks. Operations models remain largely unchanged as companies are intent on justifying themselves to shareholders first and foremost. Coupled with the greater scrutiny being faced from regulators, banks are less likely to find stringent changes as being the best course of action. Under an ever cautious environment banks are less worried about the future and resolved to get more capital reserves to pay governments back if they have been subsidised.

The issue of reward structures has also been debated and the lack of any real change on pay and remuneration levels is cited as the major issues damaging the banks reputation. Big pay is still out there, five per cent of RBS staff has big bonuses. In 2010/11 Barclays paid out £2.7 billion in bonuses to its staff, with the top five below board level earning £49million in total. Changes to pay structures where payments are now deferred and paid in shares, are likely to do little to curb public anxiety and perception of the banking elite.

PR perspective
Banks have morphed from exchanging and trading creatures into mechanisms which have very concerned about transparency, latency and risk issues. The crisis has taught banks to recognise the effectiveness of integrated communications strategies, where the right message, delivered by right people to right audiences via a mix of channels is critical.

PR has faced a war on semantics and a number of expressions that have been eroded through the last few years by negative perceptions of banking have emerged rebranded. As such, terms such as hedge fund which were seen as a necessary evil, has been reinvented to be known as Absolute Return Strategies. The same goes for Structured products which are now called Investments.

Rather than supporting new M&A or IPOs, a insider from a PR Consultancy who did not want to be named, now finds journalists generally spending their time chasing results announcements, doing ‘coverage depression’, ‘damage limitation’ and ‘being available on phone’. Banks have responded to the crisis by bringing a number of the dedicated PR functions such as crisis/ issues management and campaigning in house. This is marked by the large number of switches and transfers from PR companies to investment banks.

In house media offices at banks have come a long way in the last four years with some banks using the growth to their advantage. As the first publicly owned bank, RBS Nat West sees itself as suffering more pressure and ignominy at the hands of the general public than others. As well as changing the leadership it did, in PR terms, acknowledge its previous mistakes and malpractices.

A plan to rebuild the banks reputation as an organisation was set out, so as to re-establish reputation and give the public ‘incremental evidence of change, over time’.

Quarterly reporting, to include all disclosures, was a new component to help engender trust, and openness with customers, shareholders, stakeholders, and politicians.

A spokesperson for RBS sees the value in recognising the support base: “You will only rebuild reputation if you can serve your customers well.”
Despite this, there is still some way to go. The Fortune Most Admired Companies 2011, which surveys executives in all US industries, once again failed to include a “megabank” in the top 20. The closest was JP Morgan at 23 and Goldman Sachs was the only other entry.

One PR director commented: “Banks have to remember that reputation is the sum of all its parts be it performance, investment areas, business practice, media relations, brand management and the rest.”

The future
Obviously there are great lessons for banks on how to improve systems and controls, with risk and compliance people having greater checks over sales people. Banks need to understand that they can, and must, manage reputation risk in much the same way that they manage other types of risk-through sound strategies, modeling, business intelligence, and technology.

A bank should incorporate the expos-ures that could give rise to reputation risk into its assessments of whether the requirements under the securitisation framework have been met and the potential adverse impact of providing implicit support.

Industry observers have indicated that banks run by investment managers lack the relationship building skills and customers care services of retail banking colleagues and The Retail Distribution Review model introduced by the FSA in 2006 for the retail sector could be usefully adapted by investment banks. As well as having up-skilled staff and a positive effect on economies of scale, this will also drive down upfront fees.

Regaining faith
Financial institutions were once the first port of call for companies seeking funding. Now companies have lost faith in their financial support. In effect, the damaged reputation of the banks as corporate lenders is now leading to a major shift in behaviour by corporate borrowers.

A damaged reputation can cost an organisation in terms of decreased brand value; reduced share price; lost customers, partners, and strategic relationships; and difficulty in recruiting and keeping top notch employees.

After the crisis banks are now emerging with operations and systems put in place, covered by in house teams saying ‘we are covered from a risk perspective’. All this considered it will be a long wait before the country’s banks reach parity and as Warren Buffet said: “It takes twenty years to build a reputation and five minutes to destroy it.”