Thoughts on Reputational Risk in Banking
Prof Dr Ingo Walter, Leonard N. Stern School of Business
The epic financial crisis of a few years ago left behind massive damage to the process of financial intermediation, the fabric of the real economy, and the reputation of banks and bankers. Even today, some five years later, little has happened to restore financial firms to their former glory near the top of the reputational food-chain in most countries. For reasons of their own, many boards and managers in the banking industry have little good to say about the taxpayer bailouts and inevitable regulatory tightening – while acceptance of responsibility has been almost non-existent - in their haste to get back to business as usual. Indeed, they have inflicted a drumbeat of new reputational damage upon their industry.
There have been some notable exceptions, to be sure. In the middle of the crisis Josef Ackermann, former CEO of Deutsche Bank and Chairman of the International Institute of Finance (the preeminent lobbying organization for the world’s largest banks), noted in 2008 that the industry as a whole was guilty of poor risk management, with serious overreliance on flawed models, inadequate stress-testing of portfolios, recurring conflicts of interest, and lack of common sense, as well as irrational compensation practices not linked to long-term profitability – with a growing perception by the public that it was the playground of “clever crooks and greedy fools.” Ackermann concluded that the banking industry had a great deal of work to do to regain its reputation, and hoped that this could pre-empt damaging regulation. Too late.
Crisis-driven reputational damage at the firm level can also be inferred from remarks by Peter Kurer, former Supervisory Board Chairman of UBS AG, who noted at the bank’s annual general meeting in April 2008 that “We shouldn’t fool ourselves. We can’t pretend that there has been no reputational damage. Experience says it goes away after two or three years.” Perhaps it does, perhaps not. But the haemorrhage of UBS private client withdrawals at the height of the crisis and immediately thereafter suggests severe reputational damage to what was then the world’s largest private bank.
The number of financial firms -- ranging from Santander in Spain to Citigroup in the US and Union Bancaire Privée in Switzerland -- that have reimbursed client losses from the sale of bankrupt Lehman bonds, collapsed auction-rate securities, and investments in Bernard Madoff’s Ponzi scheme suggests the importance of reputational capital and the lengths to which financial firms must go to try to restore it. And at the personal level the world is full of disgraced and side-lined bankers whose hard work, career ambitions and future prospects lie in tatters.
Whether at the industry, firm or personal level, the reputational costs of the financial crisis five years ago was enormous. All the more curious, therefore, that banks have more recently run into an even greater firestorm of reputational losses. Consider the following questions:
- Is it acceptable to mis-sell worthless payment protection insurance to retail mortgage and credit card customers?
- Push in-house products to investor clients against superior (better-performing or cheaper) third-party products?
- Invade segregated customer accounts and borrow the money for your own operations?
- Facilitate clients’ evasion of taxes legally payable in their countries of residence?
- Launder money for drug dealers and arms traffickers and facilitate violations of bilateral and multilateral trade and financial sanctions?
- Sell securities to institutional clients which you know will collapse in value – and then use your proprietary trading platform to speculate against them?
- Use an investment advisory relationship to earn kickbacks from product vendors?
- Design off-balance-sheet structures for clients solely for purposes of financial misrepresentation?
- Exceed your internal or regulatory risk exposure limits and cover your tracks?
- Submit false Libor numbers and trade against them – and work in cahoots with other banks and money brokers to implement the scheme?
- Redefine a bank’s central exposure hedging platform into a profit center and circumvent established risk controls to generate earnings?
Each of these activities has the name of a major bank attached to it, sometimes several banks. Most of them seem to intentionally violate established regulations and legal statutes - or just defy common-sense definitions of what is fair, appropriate and ethical.
Banks and bankers, some would argue, have somehow lost their way in carrying out their key role as efficient allocators of capital and creators of better social welfare. They seem more like wealth-redistributors, from their clients to bank employees and shareholders, all the while privatizing returns and socializing risks on the back of taxpayers when things go badly wrong. Fair assessment or not, it’s no wonder the industry as a whole and individual banks have seen their reputational capital erode.
What might explain this? After all, some of the best educated, most highly talented and morally upright people in the world work for banks and do their best to serve clients, owners and other stakeholders well.
It could be that the changed competitive market structure in global banking, in which more intense competitive pressure and heavily commoditized markets have made it increasingly difficult to deliver ambitious promised returns to shareholders and attractive bonus pools to employees. This creates incentives to migrate banking activities to less open and transparent markets where transaction costs and profit margins are higher. These are markets that have become increasingly problematic as a result of greater product complexity and erosion of transparency, with efforts to reform them often resisted furiously by banks and their advocates.
It could also be that, in such an environment, the definition of “fiduciary obligation” - the duty of care and loyalty that has traditionally been the benchmark of trust between banker and client - has morphed into redefining the client as a “trading counterparty,” to whom the bank owes nothing more than an acceptable disclosure of price, quantity and product description. A deal is a deal, and what happens thereafter is only of limited concern in a world where the “long term” is after lunch.
Compounding the effects of market dynamics is the changing nature of the banks themselves, which might be considered both a cause and a consequence of crisis-related and subsequent reputational issues. If bank size, institutional complexity, imbedded conflicts of interest and the ability to manage and govern themselves were contributory factors leading to the recent crisis, these issues are even more problematic today, as a result of still bigger and broader financial conglomerates emerging from governments’ efforts to stabilize the system. In the resulting restructuring process some important things can easily get lost, with thousands of people from competing institutions newly on the team. Whatever affirmative culture once existed can get washed-away in the merger integration. Such factors are sometimes complemented by banks’ underinvestment in risk management and compliance (the “defense”) and its perennial disadvantage in questions of judgment and engagement against revenue- and earnings-generation (the “offense”). Usually this “tilt” is compounded by levels and systems of compensation designed to emphasize bonus against malus. Reputational capital is lost be people, acting individually and collectively, so what drives them is of critical importance.
Nor can boards of directors be let off the hook. They are supposed to set the tone that dominates everything a bank does, and how that is projected into the marketplace. In some cases factors like poor industry knowledge of directors, dominant of “imperial” chairmen, and a boardroom sociology that puts a premium on “teamwork” can be at fault. And who is supposed to control boards? Presumably it’s individual investors and fiduciaries, which control shareholder voting rights. Perhaps most important are institutional investors who fail to use the power of the proxy to challenge errant boardroom behavior – possibly because they themselves face conflicts of interest and do business with the same banks in which they hold voting shares.
And not least, banking regulators have plenty of problems understanding and approving conventional risk indicators and management in large, complex banks. Understanding the specific reputation-sensitivity of practices in the banks they regulate at the business-line level just may be too much to ask. Frederick the Great of Prussia has often been quoted as having said “Banking is a very special business that should be the province of very special people.” By “special” he presumably meant people who were honest and trustworthy to a fault, with a keen eye to their fiduciary obligations in handling other people’s money, and to do so in confidence.
Maybe banking today attracts some rather un-special people who liberally use terms like “share of wallet,” “guaranteed bonus,” “caveat emptor” and “Muppets” in connection with the work they do every day. Arguably, businesses where these characteristics are highly valued have become increasingly important in banks over the years. So the bacterium gradually infests larger parts of the organization, and the consequent reputational erosion becomes viewed as a natural consequence of the new world of banking. Meantime, educational institutions enthusiastically churn out more of the same. Unfair? Certainly. But it doesn’t take too many bad apples.
Anyway, who cares? Reputational losses occur from time to time in any business, no matter what the industry. They eventually go away. And they are usually much less problematic when pretty much all of the players are doing the same thing. One would like to believe that market discipline - through stock price erosion that reflects the impact of reputation-effects on the franchise value of banks - can be a powerful deterrent. But this depends critically on the efficiency and effectiveness of corporate governance. Banks continue to encounter serious instances of reputation loss due to misconduct despite the effects on the value of their business.
Alternatives include civil litigation and external regulation aimed at avoiding or remedying damage created by unacceptable financial practices. Yet civil litigation seems ineffective in changing bank behavior despite “deferred prosecution” agreements not to repeat offenses. This again suggests continued material lapses in the governance and management process.
Dealing with reputational risk can be an expensive business, with compliance systems that are costly to set up and maintain, and various types of walls between business units and functions that impose opportunity costs on banks due to inefficient use of information within the organization. And some kinds of reputational risk exposure in banks subject to conflicts of interest may defy sustainable control and possibly require structural remediation involving withdrawal from certain activities. These are not popular topics among bankers. Nonetheless, it can be argued that operational, compliance and reputational issues contribute to market valuations among the world’s major financial conglomerates that fall well below valuations of simpler, more specialized financial services businesses.
As demonstrated by the kinds reputation-sensitive “accidents” that seem to occur repeatedly in the financial services industry, neither good corporate governance or stakeholder legal recourse or more intrusive regulation seems to be particularly effective in stanching reputational losses in banking. Are the just “a cost of doing business” in this industry. One would hope not. The same argument in the pharmaceutical, petroleum or food industries would be considered appalling by most people.
Bottom line: Managements and boards of financial intermediaries must be convinced that a good defense is as important as a good offense in determining sustainable competitive performance. Admittedly this is extraordinarily difficult to put into practice in a highly competitive environment for both financial services firms and for the highly skilled professionals that comprise the industry. A good defense requires an unusual degree of senior management attention and commitment. Internally, there have to be mechanisms that reinforce the loyalty and professional conduct of employees. Externally, there has to be careful and sustained attention to reputation and competition as disciplinary mechanisms.
In the end, it is probably leadership more than anything else that separates winners from losers over the long term – the notion that appropriate professional behavior reinforced by a sense of belonging to a quality franchise constitutes a decisive comparative advantage.