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)

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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

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Value of Corporate Reputation: Drivers

5

Long-term

Financial

Performance

& investment

value

Human

Capital/Talent,

Culture,

Corporate

Ethical Values

Client Service,

New Products,

New Services,

Pricing

Reputation

Corporate

Governance

& leadership

Communication

Disclosures,

Crisis

Management

External factors

Social/Environ

mental

Responsibilities

Pressure Groups

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.

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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.

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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.

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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.

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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

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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.

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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.

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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

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Reputation Risk: Number 1 Risk for CROs

Source: Economist Intelligence Unit, 2005

Max scale : 100 17

Crime, security, political, Natural hazard, FX, Terrorism, Country Risk

(20)

IT Risk

(35)

Financial Market, Credit and Insurance Risk

(30)

Human capital Risk

(40)

Regulatory Risk

(40)

Reputation Risk

(52)

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

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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

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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

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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.)

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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

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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

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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.

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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%)

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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.

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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

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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.

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