BBK3253 Risk Management Prepared by Dr Khairul Anuar L3 Reputation Risk
What is Reputation: General Definition A corporate reputation is a collective representation of a firm s past actions and results that describe the firms ability to deliver outcomes to multiple stakeholders. It gauges a firms relative standing both internally and externally. (Fombrun/Foss: Developing a Reputation Quotient, 2000) 2
Comparison of Reputation and Image Reputation: Corporate Actions and Conduct that Create Trust As Experienced by different Stakeholders. Serves as a reservoir of goodwill in time of crises. Image Belief and personal evaluation of a firm Tied to the firm directly, not to actions by the firm. If image is positive, reputation will improve However, reputation evolves more slowly than image because it is tied to actions. 3
Comparison of Reputation and Brand Reputation: Cannot be enhanced by just a name change. Larger concept as it includes other elements as we will see. Often referred as Emotional Capital of the firm Thus, if capital, it is subject to risk. Brand: What differentiates the company from the competition Marketing of the company including advertising and publicity Refers to logos and names of companies 4
Value of Corporate Reputation: Drivers Client Service, New Products, New Services, Pricing Long-term Financial Performance & investment value Corporate Governance & leadership External factors Social/Environ mental Responsibilities Pressure Groups Reputation Human Capital/Talent, Culture, Corporate Ethical Values Communication Disclosures, Crisis Management 5
Value of Reputation to the Firm A good reputation encourages consumers to buy products and services. Suppliers are willing to do business with you, thus expanding opportunities. Top notch employees want to join and stay with your organization, thus enhancing its innovation capabilities and value. Favorable outlook from regulators and rating agencies, thus decreasing financing cost and increasing value. Investors want to hold shares, thus increasing value. Positive feedback from media and pressure groups increase value. In a crisis mode, investors give the company the benefit of the doubt, thus easing short-term decrease in value. 6
Value of Reputation: Quantitative Measures An Intangible asset which doesn t show up in the balance sheet. It is sometimes referred as Emotional Capital. It has a current value and influences future value of the firm. Best approach is by the Court of Financial Opinion: Stock Market! Estimated value of reputation = Market Value of Company- Balance Sheet Value - Intellectual Property Brands( Cos like Brandz, Core Brand) Copyrights - other Intangible Assets. 7
Value of Reputation: Quantitative Measures Usually, reputation is the largest component of intangible assets. Reputation reflects the rise of the non-physical economy, especially in the developed world. Some surveys have shown ratios of market value to balance sheet value between 10 and 100. 8
Reputation Risk: Qualitative Measures 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. Eg. 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 behaviors. 9
Reputation Risk: Qualitative Measures 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 10
Reputation risk: Indicators Rate your organization: Low if Management anticipates well changes in market and regulatory nature Franchise value minimally exposed Moderate if Management adequately responds to changes in market Franchise value is controlled High if Management doesn t anticipate reputation risk Weaknesses are present Franchise value substantially exposed to in litigation, consumer complaints. 11
Reputation Risk: Quantitative 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. 12
Reputation 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 13
Quantitative Financial and non Financial Impacts of Damage Stock decline Run on the bank Spike in policy surrenders (for insurance companies) Outflow of assets under management Drop in sales, decline in market share Ratings downgrade (for bonds) Regulatory investigations, license withdrawal, fines Shareholders litigations and class-actions Political fall-out, discontent in communities Negative media coverage Pressure groups and public opinion Employees and contractors withdrawal 14
Importance of Reputation and Trust Information asymmetry there is always a gap what insiders and outsiders know about a company. Since outsiders don t know as much about a company as insiders, a good reputation alleviates and allow customers to make a choice. More important in a period of rapid changes, globalization, internet blogs, activism, mass media. 15
Importance of Reputation to Stakeholders Employees: Are more loyal to a company with good reputation. Help with recruiting 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 suppliers: Support loyalty to company Competition: Barrier to entry 16
Reputation Risk: Number 1 Risk for CROs Reputation 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 17
Why Reputational Risk is Increasingly Important Source: Economist Intelligence Unit, 2005 Max scale : 100 18
Reputation and Financial Impact Hill & Knowlton/MORI: Return on Reputation, March 2006. 19
Aon Risk Survey - Brand and Image Risk Ranking Source: Aon s 2009/10 Risk Management Benchmarking Survey 20
Recoverers & Non-recoverers Abnormal Returns Source: The impact of Catastrophes on Shareholder Value Pretty & Knight, 1994 21
The Importance of Corporate Reputation Market value is heavily determined by corporate reputation 70-80% of a company s assets are not on the balance sheet Intangibles are increasingly important Reputation affects current performance Better employees More loyal customers Better terms and service by vendors Higher-margin products and services 22
The Importance of Corporate Reputation Reputation affects expected future performance Belief that current performance will continue and improve Less uncertainty about future cash flows A good reputation leads to lower perceived risk Lower cost of capital Higher stock price 23
The Three Main Determinants of Reputational Risk 1. Reality gap Reputation exceeds the company s ability to meet expectations Difficult for executives to admit that a reality gap exists Tend to be optimists Are focused on the upside part of risk-taking for creating value 2. Changing external beliefs and expectations Behavior considered acceptable or even laudatory no longer is so Putting friends on the board Managing earnings Beliefs and expectations of all stakeholders have to be considered These changes can emerge over time Can be crystallized by a single event 3. Poor internal coordination Failure to consider reputational risk on other units Failure to consider interaction effects of decisions in different units 24
Value of Reputation: National Corporate Survey Microsoft: 1st place Johnson and Johnson: 2nd Google: 4th Berkshire Hathaway Inc. 21st American Express Company: 34th Wells Fargo & Company: 36th State Farm Insurance: 42nd Allstate: 51st (Consult Fortune s annual survey of America s Most Admired Companies.) 25
Examples of Damage to Reputation: Non-Financial Catastrophe: Three Mile Island (partial nuclear partial nuclear meltdown which occurred in one of the two Three Mile Island in Pennsylvania in 1979) 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 26
Examples of Damage to Reputation: Non-Financial 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 27
Examples of Damage to Reputation: Financial 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. Fraud: KPMG paid 456 million dollars but escaped indictment that could have crippled the firm. 28
Management of Reputation Risk Develop Corporate Social Responsibility programs: Build goodwill vis-à-vis stakeholders. Enhance internal ethical programs. (61%). Establish Code of Conduct by employees. AXA established a Sustainable Development Department in 2001 to coordinate a variety of environmental, community, educational and charitable programs. Integrate environmental impact studies in investment decisions and publicize. Monitor external perceptions of company by all stakeholders (61%) 29
Management of Reputation Risk Proactively monitor external threats. Eg. Sales practices, bid rigging, failure of insurers, regulatory investigations, market timing on competitors and determine our possible reactions to them. Reactive or proactive and how to face the issue Establish an internal whistle blowing approach. A crisis or an attack on reputation never come at a surprise. Someone knew something within the organization. 30
Management of Reputation Risk Integrate communications strategies: right message, delivered by right people to right audiences via a mix of channels is critical. Economic capital: Integrate reputation impacts into the calculations of other risks, in particular operational risks. In financial industry, 30% feel that they can t quantify while 66% feel that they can quantify in the energy sector 31
Management of Reputation Risk Is reputation risk part of the overall risk policy? Traditional Approach : CEO is in charge (84%) Reflects focus on crisis management only, reactive Reputation is focused only on organization's own operations. Dedicated personnel or dedicated task force CRO, head of business units, communications manager (42%). Reputation risk management is more than PR. External parties expect dedicated resources like for the other risks. 32