Reputational risk in banks nibm lecture 220213

K. Ram Mohan,
General Manager(Chief Operations Officer)
Punjab National Bank, Head Office: New
Delhi

The fragility of reputation
“ It takes 20 years to build a
reputation and five minutes to
ruin it. If you think about that,
you’ll do things differently “
 “Ourassets are ourpeople, capital and reputation. If any
of these are everdiminished, the last is the most difficult
to restore.” (Goldman Sachs Business Principles)

Reputational Risk in Banks: Agenda
1. Reputation, Its Attributes , Importance &Value to
firm
2. Reputational Risk: Definitions, Reputational Risk
Capital, Case Studies, Examples &Surveys
3. Reputational Risk Measurement: Broad
Qualitative &Quantitative Measures
4. Reputational Risk Assessment framework of PNB
5. Assessment/Evaluation (Off-site & On-site) of
Reputational Risk by Regulator: Important Points
to consider
6. Reputational Risk Management
7. Case Study of a Better managed Reputational

“The beliefs or opinions that are
generally held about someone or
something
A widespread belief that someone
or something has a particular
characteristic”
Compact Oxford English Dictionary
Reputation

 It is:
 an intangibleasset
 not abrand
 thesum total of all stakeholders’ experience
 public information regarding an organization’s
trustworthiness
 It also assures:
 premium value growth opportunities to shareholders (value
growth resulting from managerial experience, innovation,
intellectual property)
 continued comparativeadvantage
What is Reputation

• Customers
• Suppliers
• Investors
• Advocacy groups
• Regulators
• Policymakers
• General public
Reputation = judgments and perceptions of others
Reputation is “owned” by
stakeholders

Stakeholders’ perceptions develop via three
channels
• Direct experience with the company
• What others say about the company (online and off)
• What the company says about itself (marketing, PR,
exec comments, etc.)

Importance of Reputation to Stakeholders
 Employees: Are more loyal to a company with good
reputation.
 Investors and business partners: Will take risk in a
company that they can thrust based upon its
reputation. (More than 90% think about reputation in
investment decisions: 40% care about reputation, 50%
care partially).
 Lawmakers and regulators: Reputation can help
lessen the legal burden on a company.
 Public at large: Preserve ―social license to operate
 Customers and Depositors: Support loyalty to company
 Competition: Barrier to entry

 Information asymmetry
 Outsiders don’t know as much about a company as
insiders, so a good reputation alleviates and allows
customers to make a choice
 Important for all companies but crucial and vital to
banks as our relationship is solely built on
faith/trust.
 More important in a period of rapid changes,
globalization, internet blogs, activism, mass media.
Importance of Reputation and Trust

Positive reputation yields measurable value
- Strong brand loyalty
- Returning high value customers
- Lower employee turnover
- Easier recruitment of high-caliber employees
- Higher investor confidence
- Positive regulatory environment
- Lower costs of capital
A company highly regarded by its stakeholders is
more likely to enjoy:

The risk: Negative reputation exacts a measurable
penalty
- Increased customer churn
- Elevated customer acquisition costs
- Higher employee training costs
- Regulatory constraints
- Increased cost of capital
- Lower investor confidence
- Increased vulnerability to competitors
A company viewed with distrust and outrage by its
stakeholders is more likely to suffer:

Reputation: Penalty orAdvantage?
BP Stock Price vs. DJIA: 2007-2012

Reputation: Penalty orAdvantage?
Apple Stock Price vs. DJIA: 2007-2012

 Banks may encounter various issues that could
significantly harm or even destroy their brand name in a
short period of time.
 Some of the important factors which may lead to same:
 Adverse regulatory reports and sanctions
 Continued decline in share price
 Consistent unfavorable ratings
 Increased incidences of fraud
 Sudden change of management; no succession planning
 Public perception of organization’s standards drop
 Actions that result in stakeholders lose of trust and
confidence
How can Reputation be Tarnished?

Reputational Risk
 While building and maintaining a solid reputation is
important for all types of organizations, it is especially
important for financial institutions / Banks.
 It could be argued that protecting reputation is the most
significant risk management challenges that boards of
directors face today.
 As for ladies in Victorian times, the reputation of a bank is
both its most important asset and the asset that is most
difficult to recover once it is lost.
 While expectations of women’s virtues have nowadays
relaxed a bit, those of the virtues of financial institutions
have hardened to the point where the value of a bank’s
reputation is practically impossible to underestimate.

Reputational Risk: Regulatory Definitions
 FSA(UK): The risk that the firm may be exposed to
negative publicity -Trust - about its business practices
or internal controls – Actions -, which could have an
impact on the liquidity or capital of the firm or cause a
changein itscredit rating. -Affecting itsstakeholders-.
 US Federal Reserve(2004): “Reputation risk is the
potential loss that negative publicity regarding an
institution’s business practices, whether true or not,
will cause a decline in the customer base, costly
litigation, or revenuereductions(financial loss).

 HKMA: “Reputational risk” means the risk that an
Institution’sreputation is damaged by oneor more than
one reputation event, as reflected from negative
publicity about the Institution’s business practices,
conduct or financial condition.
 Such negative publicity, whether true or not, may
impair public confidence in the Institution, result in
costly litigation, or lead to a decline in its customer
base, businessor revenue.
Reputational Risk: Regulatory Definitions

Basel Definitions
 The Basel Committee on Banking Supervision (BCBS
(2001)) defines reputational risk as “the potential that
adverse publicity regarding a bank’s business practices and
associations, whether accurate or not, will cause a loss of
confidencein theintegrity of theinstitution.”
 In a more recent document, the Committee (BCBS
(2009)) defines it as the “risk arising from negative
perception on the part of customers, counterparties,
shareholders, investors, debt-holders, market analysts, other
relevant parties or regulators that can adversely affect a bank’s
ability to maintain existing, or establish new, business
relationshipsand continued accessto sourcesof funding.

It is, perhaps, an indication of thedifficulty of providing a
rigorous assessment framework for reputational risk
that the Basel II Accord, arguably the most important
regulatory document on risk of the last decade,
expressly takes reputational risk out of operational risk
and does not mention it anywhere else in its 300+ page
document.
Basel Definitions

Relationship between Reputational Capital and
Risk
 The fluctuating value of the company’s reputation has
been termed reputational capital and calculated as the
market value of the company in excess of its liquidation
valueand itsintellectual capital.
 It constitutes the residual value of the company’s
intangible assets over and above its stock of patents and
know how.
 While “Reputational risk is defined as the range of
possible gains and losses in reputational capital for a
given firm.
 So urce: The Reputatio n Institute

Reputational Capital
 Provides a platform from which other investment
opportunitiesmay arisesimilar to R&D in thisrespect:
 Upside example: sound corporate citizenship improves
relations with constituency groups and provides a holistic
approach to implementing strategy
 Constituency groups are Community, Regulators, Customers,
Partners, Employees, Investors, Activists, and Media
 Difficult to quantify thesegainsbut they exist
 Downside example: Loss of reputational capital comes from
these same 8 constituency groups; threats include rogue
behavior by employees, defection by partners, and the threat
of legal action by regulators

Reputational Risk- Opinions /Surveys
 Reputational risk is regarded as the greatest threat to a
company's market value, according to a study by
PricewaterhouseCoopers and the Economist
IntelligenceUnit.
 Reputational risk also overtook credit risk the most
pressing issue facing bank audit committees, according
to an annual survey released on February 27, 2007, by
Ernst & Young.

Reputational risk a top concern for boards
• 63% of directors see reputational risk as top concern…
and concerns are growing
• Primary concerns cover product quality, liability,
customer satisfaction
• Secondary concerns: integrity, fraud, ethics
• Three-fourths of directors seek broad-based risk
assessment… and they want to know more
Third Annual Board of Directors Survey 2012 - Concerns
About Risks Confronting Boards – EisnerAmp

Reputational Risk
(52)
Regulatory Risk
(40)
Human Capital Risk
(40)
IT RISK
(35)
Financial, Market, Credit and Insurance Risk
(30)
Crime, security, political, natural hazard, FX, Terrorism, Country Risk
(20)
Source: Economist Intelligence
Unit, 2005
Max Scale: 100

 According to Economist Intelligence Unit(2005) survey,
―52% consider reputation risk as a risk by itself, while
48% consider it as a consequence of other risks like
operational risk - people, process, systems and
external events - compliance and financial.
 Appears that if first risks are more quantitatively
analyzed - market, credit, operational … -
Reputational risk appears as a second tier risk -
mostly within financial institutions - while it appears as
a risk of its own in the corporate world - like Hilton,
Cruise companies where emphasis is on their
products/services -.
Reputational Risk: A Risk by itself ora
Consequence (Second tier)of OtherRisks

Impact of Reputational Risk – Case Study
 In the midst of the global credit crisis partly caused by the
U.S. subprime mortgage meltdown, Northern Rock,
Britain's fifth largest mortgage lender, had to be bailed out
by theBritish central bank, theBank of England.
 The institution began as a small local lender in early 2001,
but grew excessively in 2005 and through early 2007,
primarily by relying on wholesale markets rather than retail
deposits.
 Northern Rock bundled its loans together and packaged
them into bonds that it sold to investors around the world;
however, as liquidity dried up this past summer in the U.S.
and acrosstheglobe, it spelled disaster for Northern Rock.

 When news leaked out that Northern Rock had approached
the Bank of England to obtain emergency funding,
customersreportedly withdrew Â£2 billion in oneday.
 Britain's first bank run in 140 years occurred despite the
bank's solvency, the nation's strong economy, low interest
rates, and low inflation.
 Northern Rock becameavictim of reputational risk.
Impact of Reputational Risk – Case Study

 Scandals/Fraud:
 Arthur Andersen co. fell almost entirely due to its
damage to its reputation after Enron’s scandal in
2002.
 Interesting case in the field of reputation. Similar to
Barings in the field of operational risk.
 One year earlier in 2001, the Chief Executive was
saying: ―There is extraordinary power in our name
because it stands for time-tested values, a unique
one-firm global operating approach and recognized
superior performance.‖
OtherExamples – Financial Sectors

Fraud: KPMG paid 456 million dollars but escaped indictment
that could have crippled the firm.
Market Timing/Fraud in 2003/2004 at Putnam Investments
 Paid 4 million in fines.
 Fired top management of international funds.
 Lost 14 billion of assets under management in a week (5%).
 Assets under management from 272 billion (03) to 192 (07).
Never recovered from institutional clients.
 Putnam sold to Great-West Life in Feb. 07 ending a history
dating back to 1937.
©Enterprise Risk Advisory, LLC 28
OtherExamples – Financial Sectors

 Safety Issue: Union Carbide chemical leak in Bhopal in 1984.
 Environmental issue: Home Depot promising to stop selling wood
from protected forests after Rainforest Group Action intervention,
Exxon Valdez
 Catastrophe: Concorde crash and impact on both Air France (less
impact ) and British Airways (larger impact due to slow response).
 Product Recall:
 Tylenol tampering scare in 1982 due to cyanide. Limited
impact due to Johnson and Johnson quick responses in the
end. In fact, Johnson and Johnson has been rated top in
reputation by Harris Interactive.
 Perrier suffered longer from toluene traces found in its waters
due to lack of crisis management.
Examples – Non Financial Sectors

 The Basel Committee is of the view that existence of assessment
framework may help Board & senior management to better
understand threats to reputation and to develop proactive
reputation risk management plansin response.
 Although thecausesof reputational risk and itsindicatorsappear
to be quite straightforward, their assessments are not
quantitatively possibleas:-
 The Indications of reputational risk cannot be always linked to the
factorsenumerated above, and
 Most of the indicators and the causal factors listed above cannot
becaptured objectively and hencequantification isquitedifficult.
 Some of the broad factors (both qualitative as well as
quantitative) arelisted in thenext slides:
Reputational Risk Assessment /Measurement

 Complaints by all stakeholders act as an early warning system:
Monitor and analyze trends.
 Identify and monitor your company’s HOT SPOTS in relation to all
your stakeholders’ interests, particularly in periods of rapid
change. Ex. Organizational changes, new products/services.
 Compliance/Audit functions. Are they proactively identifying and
following-up on issues?
 Assess flows of risk information in the institution.
 Assess the link between compensation programs and desired
behaviours.
 Is reputation risk part of the new product approval process?
 Is there a Code of Ethics? Reward ethical behavior? Penalize
misbehavior?
 Evaluation of media coverage of companies
 Monitor internet blogs
20
Reputational Risk – Qualitative Measures

 Measured as the market value impact of an event which is above
the direct value of the event itself, the excess is qualified as the
reputational impact.
 Ex. Federal Reserve Bank of Boston measured Reputational
impacts of operational events:
 Internal Fraud: The market value impact was more than 6
times the value of the internal fraud itself, which is due to lack
of control by the company and lack of confidence in actual
management.
 Externally caused events: No reputational impact.
 Thus, seems to confirm the initial definition of reputation as
being based on ACTIONS by company.
 Fines account for less than 10% of total market value loss.
Reputational Risk – Quantitative Measures

 Failures by companies that have a reputational impact have a
lasting financial effect on the market value of companies:
 1/3 of financial analysts say that their evaluation of a company
will take into account the impact of a failure in reputation up to
3 years after the event. (Hill/Knowlton 2006 survey)
 Companies take up to 3 years to recover from a crisis that
affected their reputation. (Burson/Marstelle Market research)
 Model developed by UK-Based OxFord Metrica called
ValueReaction Model: Analyze impact of reputation crisis on
company stock price. Will company recover from a crisis? If
management handles crisis badly, investors conclude that
management cannot handle unexpected events.
 Set up Loss Data Base of operational events and their
reputational impacts.
 Scenarios modeling of major threats using expert judgment
23
Reputational Risk – Quantitative Measures

Reputation Risk: Model Quantitative Financial
and non Financial Impacts of Damage: Factors
 Stock Price decline
 Run on the bank
 Decrease in business, decline in market share
 Ratings downgrade
 Regulatory investigations, Penalties, fines
 Shareholders’ litigations
 Negative media coverage
 Pressure groups and public opinion
 Employees and contractors resignations / withdrawals.

Reputational Risk Assessment Framework of
PNB
 Assessing reputational risk is not an objective process, rather it
is a subjective assessment that could reflect a number of
different factors.
 The bank has attempted to create an Reputational Risk index
which will provide the insight into the bank’s reputation risk
status.
 The bank’s reputational risk framework consists of 17 risk
parameters selected after prolonged discussion by a group
of risk experts
 Each parameter has been categorized into different
attributes depending on the severity of the occurrence of an
event within theparameter.

PNB
 After finalization of weights, simulation techniques have
been used to generate distribution of all the possible scores.
 In the absence of adequate data set, a methodology has
been developed for generating total number of possible
scenarioswith thegiven parametersand their attributes.
 Methodology developed to capture most representative
distribution depicting all thescenario.
 The distribution has been generated by assigning different
probabilitiesto different attributes.

PNB
 Graphically representation of the framework:

Score Bands of Risk Index
 The distribution matches with intuition that distribution of
the reputational risk shall be skewed as majority of the
events will cause negligible or low risk but some events
may lead to sudden increasein reputational risk
 Based on this distribution total score has been divided into
different scorebands.
 Based on this distribution total score has been divided into
different scorebandsand different ratings.

Reporting &Action Points
 The Bank tracks the Reputational Risk Index on regular
basisand put up to thetop management.
 The increase or decrease in the overall scores is further
analyzed granularly.
 Score of each of the parameters are analyzed in detail and
the concerned user divisions are advised to take corrective
actions for improvement.

Assessment /Evaluation of Reputational Risk by
Regulator
 Oneof themost difficult tasksfor regulatorsisto determine
how to assessafinancial institution'sreputational risk.
 Regulators may complete a risk matrix when conducting
full-scopeexaminations.
 To arriveat acompositerisk rating for oneof therisk areas,
thefollowing criteriamay beused when assessing risk:
 Level of inherent risk - High, Moderate, or Low
 Adequacy of risk management - Strong, Acceptable, or
Weak
 Trend or direction of risk - Decreasing, Stable, or Increasing

Off-site examination by Regulator
 Regulators may review corporate press releases, letters
to shareholders, stock message boards, and stock
analyst comments to gain an initial indication of
reputational risk.
 They may also consider: :
 whether an institution respondsto thecustomer concerns;
 Whether the stock analyst recommends buying or
selling and why; and
 what the shareholders, employees, or general public are
saying about theinstitution.

Off-site examination by Regulator
 Further, they may also
 analyzethefinancial statements,
 review marketing plans& advertising campaigns,
 consider whether the institution is growing excessively
and what types of risky products and services it is
providing, if any.
 They may also consider whether the institution is
expanding outside its normal geographical area and is
supportiveof thecommunity.

On-site examination by Regulator
 Whileon-site, Regulatorsmay:
 talk to both bank employees and management to get a
sensefor itemslikecorporateethics,
 talk to Human Resources to determine whether a
consistent message on the importance of ethics is being
conveyed throughout theorganization, and
 consider whether the institution's risk management
practices are strong and commensurate with the size and
complexity of theinstitution.
 assess whether an institution's expertise is adequate and
controls are in place to oversee growth if the institution
should engage in riskier products or enter into new
businesslines.

 In addition, Regulators may determine whether there
areviolationsof consumer law. For example,
 Is the institution involved in unfair or deceptive
practices, such ascharging excessiveinterest rates, or
 Are there situations where the institution is
overcharging its customers for accrued interest on
loans?
 Reimbursing consumers for these charges could be
embarrassing and tarnish an institution'sreputation.
 Excessive violations could result in class action suits, civil
money penalties, or other regulatory actions.

 In the information technology area, where reputational risk
and operational risk go hand in hand, examiners may also
measure board and management oversight from the top
down. E.g.
 Isoversight adequate?
 Are policies and procedures tailored to the institution, rather
than boiler-plate?
 Arethereadequateinternal controls?
 Lax oversight and controls leave an institution open to security
breaches and employee theft, which again could result in
unfavorable media attention and may damage the institution's
brand name and reduce the public's confidence in the institution.

 It is the current and prospective impact on earnings and
capital arising from negativepublic opinion
 It measuresthechangein perception of acompany
 It is linked with customer expectations regarding an
organization’s ability to conduct business securely and
responsibly
Reputational Risk Management

Key Goals of Management of Reputational
Risk
 Identify and minimize factors that could damage reputation
(threats) and identify and exploit factors
that could boost reputation (opportunities)
 Identify gaps between stakeholder experience and
expectation and bridgethem by:
 improving business strategy/performance/behaviour
and/or
 influencing stakeholder beliefs and expectations so they
are more closely aligned with reality and what
thebusinesscan realistically deliver
 Ensure processes are in place to enable the business to
respond and ride out the storm if an unforeseen
crisishits(crisismanagement contingency plan)

MajorGaps in Management of Reputational
Risk
Reputation literacy
not on risk agenda
Reputation literacy
not on risk agenda
Risk literacy
not on reputation
agenda
Risk literacy
not on reputation
agenda

A dual approach to managing risk to reputation
As reputation is based on perception, not
necessarily reality, risks to both reality
and perception must be actively managed
Reputation must
be built both:
„inside-out‟
Reputationand „outside-in‟

Spotting major „mismatches‟
Strategy vs expectations
 Performance vs objectives
 True intentions vs „spin
‟Real vs published risk exposures
 Compliance „in letter vs „spirit‟ ‟
 Minimal disclosure vs transparency
Product reality vs marketing claims
 „Easy-win incentives vs stretching targets‟
 Executive directors
 Non-executive directors
 Management
 Public relations
 Internal auditors
 Risk and insurance
managers
 All other employees
 Business partners
…All must play their part
in moulding and upholding
corporate reputation
Make reputation risk management everybody’s
business

Enterprise wide competence aligns
organizational action

Management of Reputational Risk Internally
 Maintaining timely and efficient communications among
shareholders, customers, boards of directors, and
employees
 Establishing strong enterprise risk management policies
and procedures throughout the organization, including an
effectiveanti-fraud program
 Reinforcing a risk management culture by creating
awarenessat all staff levels
 Instilling ethics throughout the organization by enforcing a
codeof conduct for theboard, management, and staff

Management of Reputational Risk Internally
 Developing a comprehensive system of internal controls
and practices, including those related to computer systems
and transactional websites
 Complying with current laws and regulations and enforcing
existing policiesand procedures
 Responding promptly and accurately to bank regulators,
oversight professionals (such as internal and external
auditors), and law enforcement
 Establishing a crisis management team in the event there is
a significant action that may trigger a negative impact on
theorganization

 In 2004, SunTrust Banks, a $180 billion financial
institution headquartered in Atlanta, disclosed that due
to an accounting oversight, it had to restate its
corporateearnings.
 Because of accounting errors, the bank had overbooked
the allowance for loan and lease losses, and therefore
underreported earnings, for the first two quarters of
2004 by approximately $22 million.
 This led to a delay in the release of its third-quarter
earningsstatement.
Case Study of A BetterManaged Reputational
Risk

 Within hours, SunTrust issued a press release
announcing the accounting irregularities.
 The release stated that its audit committee, with
the assistance of an independent law firm, would
begin a review and initiate lines of
communication with independent auditors about
the errors.
 In short, the institution addressed the issue
immediately, communicating openly with the
public and its customers.
Risk

 Within a month of the press release, the audit
committee panel determined that the errors in the loan-
loss data related to the auto loan portfolio were higher
by approximately $25 million.
 Loan loss calculation errors and false draft meeting
minuteswerealso uncovered.
 As a result, three credit administration division
members, including the top credit officer, were fired,
and acontroller wasassigned to another division.
Risk

 Within a month of the press release, the audit committee
panel determined that theerrorsin theloan-lossdatarelated
to theauto loan portfolio werehigher by approximately $25
million.
 Loan losscalculation errors and false draft meeting minutes
werealso uncovered.
 As a result, three credit administration division members,
including the top credit officer, were fired, and a controller
wasassigned to another division.
 Less than two months later, the SEC launched a formal
probeof SunTrust'saccounting deficiencies.
Risk

Risk
 Though this newsworthy event cast a negative light on
SunTrust's reputation, overall it did not hurt the
organization'sfranchisevalue.
 Initially, the market and public perception were critical of
the accounting issue, and SunTrust's shares fell 1.12% (less
than $1 dollar to $69 per share);
 however, because the organization's board and senior
management were proactive in addressing the issue
quickly, the stock price loss (and financial statement gain,
in this case) was manageable, and reputational risk was
controlled.

“The way to gain a good
reputation is to
endeavour to be what
you desire to appear “
Socrates, 469-399 BC
The concept isn’t new

“The way to gain a good
reputation is to
Socrates, 469-399 BC
Any Questions
If No Questions, then……

Reputational risk in banks nibm lecture 220213

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