Reputational Risk- A risk which is often ignored

Reported by: |Updated: July 11, 2016

Dr. R. C. Lodha

‘It takes 20 years to build a reputation and five minutes to ruin it, if you think about that, you’ll do things differently”

-Warren Buffet

R. C. Lodha is executive director at Central Bank of India
(R. C. Lodha is executive director at Central Bank of India)

Reputational Risk is unique in its kind. Unlike the other forms of identified risks such as credit risk, market risk or Interest Rate Risk in Banking Book (IRRBB), where the total loss on occurrence of adverse impact may be quantified based on certain percentages (Default probabilities), Value at Risk models or through other complex statistical tools, identifying the impact on a firm due to loss of reputation becomes a very tricky business.

Ingo Walter, a professor at Stern School of Business has defined reputational risk as:

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.

The ‘after-effect’ of an incident causing loss to reputation will be reflected in lower operating revenues, flight of deposits, increase in staff attrition and loss of talent.

Therefore, it is clear from the above definition that reputational risk first affects the market value of the firm leading to erosion of market capitalization. As an after effect of the loss due to reputational damage, accounting losses occur. Reputational risk, when viewed as a separate cohort is not an accounting loss.

Laws and regulations governing the market are not created in a vacuum. They are deeply rooted in the values and ethics expected from an individual. The same is applied to an institution. Social opinions on issues like lying, cheating and stealing also apply to an institution. These are ultimate benchmarks against which society will judge the institution and punish them for the same if not complied with. Therefore, social values are the primary origins/sources of reputation..

But fundamental values in society may or may not be reflected in people’s expectations as to how a firm’s conduct is assessed. There will always be a conflict of interest between market performance and corporate governance benchmarks. But it is the duty of the management to work towards optimizing both sets of benchmarks as the stakeholders are different in each case.

The regulator will lay more emphasis on corporate governance issues, highest standards of compliance, ethics and market discipline and in ensuring a level playing field to promote healthy competition.

The shareholders of the bank will focus more on profitability, stability and market share.

If the bank strays too far in the direction to meet the demands of social and regulatory pressures, it runs the risk of poor performance in the market, increases in NPA assets, loss of revenue and loss of talent which will reflect in the bottom-line. Shareholders often punish the management for poor performance which may even lead to a change in corporate control.

If the bank leans towards concentrating on market performance by adopting such strategies which breed unhealthy monopolistic competition thereby questioning the very conduct of business, the regulator will step in to ensure control. Striking the right balance between the two ensures the right reputation in the market.

It is also important to note that values and expectations from institutions are never static in time. It also differs across cultures. The influence of media and politics is also high in forming public opinion. Small instances with a potential to cause damage to reputation may go unnoticed. But with the confluence of media highlighting those instances, the system and the public will start reacting and start screaming foul. A new set of legislations may come in place from the regulator to curb such practices or the institution may be put through a litigation process. This will definitely affect the reputation of the bank and the effect will be felt instantaneously on the market value of the firm.

Ups and downs are common in the business and the stakeholders may forgive the bank for incurring temporary business losses. However, banks should learn from such mistakes, ensure systems in place to detect losses early and religiously follow the exposure limits. Repetition of mistakes will go against in favor of the bank.

The ultimate loser due to events leading to reputational damage is the bank and its shareholders.

Assessing reputation risk

In order to test the impact on reputation due to adverse incidents, we frame a null hypothesis that there is no presence of a reduction in the market value of the firm due to a particular event. Alternatively, if there is a presence of loss in the market value due to the loss of reputation, the null hypothesis is rejected and hence proved of its existence.

We create a sample prediction of returns based on the stock prices of the banks and compare the predicted returns with actual returns on the bank’s shares after the occurrence of the event. The cumulative positive difference, if any, is considered as the excess return lost by the shareholder.

In order to create this prediction, we regress the daily return on the bank stock with the daily return on the Bankex index and market index. We use data from 300 days to 50 days prior to the announcement date of the event. The resulting coefficients are then multiplied by the returns on the industry and market indices from 50 days prior to 50 days after the date of announcement, in order to obtain an estimation of the daily stock return during this period. Now, the excess return is calculated as predicted return minus the actual bank stock returns during the period of turmoil, and the cumulative excess return is calculated. In order to translate these results into the monetary effect on the bank stock, the cumulative excess return is multiplied by the total market value of equity (outstanding equity shares times the price per share) 50 days prior to the date of announcement of the event.

So, this amount represents the return which the shareholders would have received had they sold their shares on the market 50 days prior to the announcement and the cumulative loss for each day will be the loss which the shareholders incur for holding on to the shares for each day.

Using the above methodology, it was found that the liquidity crisis faced by a private sector bank resulted in monetary loss impact on the market value by Rs. 16410 crores. The corruption scandal in a prominent public sector bank resulted in monetary loss impact by Rs. 1526 crores.

Unique situation in public sector banks

State-run public sector banks are unique due to the high stake of government holding. This generates high levels of trust among depositors and assures them of safety due to government backing. While this was missing in the case of the private sector bank where depositors flocked to remove their deposits due to an announcement of a small default in Lehmann brothers, there was no such incident reported where depositors in any PSBs created a run on the deposits due to announcements of adverse events.

However, public sector banks must ask themselves this question. In the absence of government support, would they still enjoy the same reputation and trust with depositors? This question is very relevant in today’s scenario as the government is considering the possibilities to reduce stake in public sector banks.

Public sector banks require additional Basel III capital to the tune of 4.25 lakh crores by FY 2019. The share of stress assets in the loan book of PSBs is also high. Under these circumstances, any event which may cause reputational damage will be severe.

Way forward

Since assessing reputation risk is a complicated business and does not initially amount to an accounting loss, the prudent way to manage the same would be to ‘learn from other mistakes’.

The policy and governance framework in the bank must be strengthened to ensure there is no occurrence of such untoward incidents in their banks. The source of reputation risk is the conduct of business operations. The magnitude of reputation risk faced by the bank will depend on the extent to which the event is publicized by the media. Therefore, there is a need for efficient public relations management in every bank.

The speed of mitigation also plays a very important role in reputation risk management. By ensuring limited spokespersons to make official statements, it will help the bank in quashing rumors which may cause panic although if not completely.

In light of the above events, it is clear that there is a presence of reputation risk in the normal conduct of business. Ignoring reputational risk could be fatal to any organization and steps must be initiated to frame a systematic process to mitigate any reputational damage which may occur.. The overall objective of any organization is maximizing shareholders value and at no circumstances must a bank compromise in this aspect.

As the old adage goes, “if money is lost nothing is lost, if health is lost something is lost and if character is lost, everything is lost. In banking parlance, if banks make losses, nothing is lost. If the structural health of the organization is lost, something is lost and if reputation is lost, everything is lost.”