Faculty of Business Management Globalisation BBK 3253 Risk

Faculty of Business Management & Globalisation BBK 3253 Risk Management L 5 – Reputation Risk

Citations by Warren Buffet & Goldman Sachs • It takes twenty years to build a reputation and five minutes to destroy it. (W. Buffet) • If you lose dollars for the firm, I will be understanding. If you lose reputation, I will be ruthless. (W. Buffet) • Our assets are our people, capital and reputation. If any of these are ever diminished, the last is the most difficult to restore. (Goldman Sachs Business Principles) 2

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. 3

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 4

Press Coverage of Corporate Reputation and Reputational Risk 5

Reputation Risk: Number 1 Risk for CROs Source: Economist Intelligence Unit, 2005 Max scale : 100 6

Why Reputational Risk is Increasingly Important Source: Economist Intelligence Unit, 2005 Max scale : 100 7

Reputation and Financial Impact • Hill & Knowlton/MORI: Return on Reputation, March 2006. 8

The Importance of Corporate Reputation • Market value is heavily determined by corporate reputation Ø 70 -80% of a company’s assets are not on the balance sheet Ø Intangibles are increasingly important • Reputation affects current performance Ø Better employees Ø More loyal customers Ø Better terms and service by vendors Ø Higher-margin products and services • Reputation affects expected future performance Ø Belief that current performance will continue and improve Ø Less uncertainty about future cash flows • A good reputation leads to lower perceived risk Ø Lower cost of capital Ø Higher stock price 9

The Importance of Corporate Reputation • Market value is heavily determined by corporate reputation Ø 70 -80% of a company’s assets are not on the balance sheet Ø Intangibles are increasingly important • Reputation affects current performance Ø Better employees Ø More loyal customers Ø Better terms and service by vendors Ø Higher-margin products and services • Reputation affects expected future performance Ø Belief that current performance will continue and improve Ø Less uncertainty about future cash flows • A good reputation leads to lower perceived risk Ø Lower cost of capital Ø Higher stock price 10

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 ü Tend to be optimists ü 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 ü Putting friends on the board ü 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 11

Value of Reputation: National Corporate Survey • Microsoft: 1 st place • Johnson and Johnson: 2 nd • Google: 4 th • Berkshire Hathaway Inc. 21 st • American Express Company: 34 th • Wells Fargo & Company: 36 th • State Farm Insurance: 42 nd • Allstate: 51 st (Consult Fortune’s annual survey of America’s Most Admired Companies. ) 12

What is Reputation: General Definitions • 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) • Reputation is public information regarding a players’ trustworthiness. A players’ reputation reflects the information that third parties have on how trustworthy his behavior has been in the past. (Ripperger 1998) 13

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. 14

Comparison of Reputation and Brand: • What differentiates us from the competition • Marketing of the company including advertising and publicity • Refers to logos and names of companies 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. 15

Value of Corporate Reputation: Drivers 16

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. 17

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 • Estimated value of reputation = Market Value of Company - Balance Sheet Value - Intellectual Property – Brands( Cos like Brandz, Core Brand) – Copyrights - other Intangible Assets. • 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. Opinion: Stock Market! 18

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. • 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 19

Reputation risk: Indicators • Rate your organization: Ø Low if ü Management anticipates well changes in market and regulatory nature ü Franchise value minimally exposed Ø Moderate if ü Management adequately responds to changes in market ü Franchise value is controlled Ø High if ü Management doesn’t anticipate reputation risk ü Weaknesses are present ü Franchise value substantially exposed to in litigation, consumer complaints. 20

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: Ø Ø 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. 21

Reputation Risk: Quantitative Measures • Failures by companies that have a reputational impact have a lasting financial effect on the market value of companies: Ø 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) Ø Companies take up to 3 years to recover from a crisis that affected their reputation. (Burson/Marstelle Market research) • Model developed by UK-Based Ox. Ford Metrica called Value. Reaction 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 22

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 23

Examples of Damage to Reputation: Non-Financial • Catastrophe: Three Mile Island • 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: Ø 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. Ø Perrier suffered longer from toluene traces found in its waters due to lack of crisis management 24

Examples of Damage to Reputation: Financial • Scandals/Fraud: Ø Arthur Andersen co. fell almost entirely due to its damage to its reputation after Enron’s scandal in 2002. Ø Interesting case in the field of reputation. Similar to Barings in the field of operational risk. Ø 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. Ø Fraud: KPMG paid 456 million dollars but escaped indictment that could have crippled the firm. • External events: SARS had huge impact on tourism both in Toronto and China 25

Management of Reputation Risk • Develop Corporate Social Responsibility programs: Ø Build ―goodwill‖ vis-à-vis stakeholders. Ø Enhance internal ethical programs. (61%). Ø Establish Code of Conduct by employees. Ø AXA established a Sustainable Development Department in Ø 2001 to coordinate a variety of environmental, community, Ø educational and charitable programs. Ø Integrate environmental impact studies in investment decisions Ø and publicize. • Monitor external perceptions of company by all stakeholders (61%) • Proactively monitor external threats. (56%). Ex. 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 26

Management of Reputation Risk • Establish an internal whistle blowing approach. A crisis or an attack on reputation never come at a surprise. Someone knew something within the organization. • 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 27