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Home > Business Strategy Best Practice > An Approach to Understanding Reputation Risk in Financial Services

Business Strategy Best Practice

An Approach to Understanding Reputation Risk in Financial Services

by Philip Whittingham

This Chapter Covers

  • What we mean by reputational risk, why reputation risk is important in financial services, and how it is related to other risks faced by financial services businesses.

  • The regulatory drivers that are increasing the pressure on financial services firms to manage reputation risk.

  • Some practical suggestions on how reputation risk can be usefully incorporated in the risk management cycle and processes in a financial services business.

Introduction

The Oxford English Dictionary 2010 defines reputation as “the beliefs or opinions that are generally held about someone or something.” If we follow that definition, reputational risk must be the potential for loss or damage that occurs to an organization through an adverse impact on its reputation. In other words, something must happen that causes people to doubt previously held beliefs. We assume, of course, that these are “good” beliefs that are being damaged.

Why are these beliefs so important? Well, think about what happens when you move to a new area. Typically you will ask your neighbors if they can recommend a “good” doctor, or dentist, or place to eat, and so on. The same applies to financial services. Our buying decisions—such as our choice to take out an insurance policy or take a mortgage—are very influenced by a number of factors that include price and perception of quality or brand. Indeed, we might pay more for a product which we perceive to provide greater value (as car manufacturers established a lpong while ago). This is why television and media adverts for financial services products are typically geared at building a perception of trust and stability, rather than focusing on the purely financial benefits and product features. Firms invest a lot in building these public profiles and in establishing a reputation to support the profile through the appropriate customer service.

So, how does this link to reputational risk? Let us consider two possible scenarios.

  • A well known high-street bank is subject to rumors about its financial security. What happens? There is a sudden increase in customers transferring their accounts or business relationships elsewhere.

  • A well-known insurer receives publicity that it is disputing claims. What happens? It loses potential customers.

Are these realistic scenarios? Well, a little research will quickly show that they are indeed based in reality. What they both have in common, though, is that although there is loss, it is not a “typical” loss for the business. Retail banks typically are used to sustaining loss through the credit default of a customer, while insurers (particularly personal lines insurers) are used to losing customers primarily on price.1 However, in both scenarios a contributory driver or factor in the loss of client trust and declining business volume as a result is loss of reputation.

Case Study

Northern Rock

The story of Northern Rock sits at the heart of the financial crisis of 2007. At the start of the year, Northern Rock was one of the success stories of the UK finance sector. Its pretax profits had risen 27% on the previous year, and the 10 years of growth since conversion to a bank (previously it was a UK building society owned by its savers and borrowers) had seen a year-on-year asset growth of 20%. To do this, Northern Rock relied on wholesale markets rather than retail deposits to fund most of its lending. It bundled its loans together and sold them to investors. However, a reliance on wholesale funding also made the bank vulnerable.

Central bank action in response to a perceived housing bubble meant that interest rates were rising, and this was having an impact on Northern Rock. The initial effect was a fall in share price and a profit warning. The real crunch came in August 2007 with the global liquidity freeze, the timing of which was less than ideal for a cash-starved operation.

Shortly after, the liquidity markets dried up. Northern Rock told the regulator that it was in trouble and a message was passed to the Bank of England. The possibility that the Bank of England might need to act as lender of last resort was raised, but instead it was decided to find a buyer for the bank. A sale fell through on September 10, and it was agreed that emergency funding should be provided. However, news of this leaked out and a public statement had to be rushed out by the government on September 14.

Arguably, the financial community should have taken some comfort at this point. Customers took a different view, though, gaining their facts mainly from press coverage and leaked stories. Alerted to the trouble, the public began to withdraw its funds and a run on the bank commenced that only stopped on September 17, when the government had to announce an unprecedented guarantee for all existing deposits.

There are three key elements to the financial crisis more generally, as highlighted by this story, that are of interest to those learning about reputational risk management, and these are as follows.

  • In part the crisis was probably aggravated by banks not wanting to highlight their difficulties by going to the Bank of England. Reputational considerations would have been at the heart of this.

  • The regulator and the Bank of England had crisis management approaches that did not appear to be adequately coordinated and did not sufficiently address the reputational risk dimension of the case.

  • The public, clearly fearing the worst, participated in a run on the bank that, perhaps, could have been avoided if the messaging had been better.

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Further reading

Book:

Articles:

Reports:

  • Kaiser, Thomas. “Nowhere to hide: Reputational risk management.” Frontiers in Finance (December 2009): 18–21. Online at: www.frontiersinfinance.com/15108.htm
  • Micocci, Marco, Giovanni Masala, Giuseppina Cannas, and Giovanna Flore. “Reputational effects of operational risk events for financial institutions.” Paper presented to the 18th International AFIR Colloquium, Rome, October 2, 2008. Online at: tinyurl.com/3w2y6rx [PDF].

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