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Chapter 6 Reputational Risk.docx

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FIN 800
Lorne Zeiler

FIN800 Ethics in Finance CHAPTER 6 Reputational Risk  April 2008: industry 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 growing perception by public of “clever crooks and greedy fools” THE SPECIAL CHARACTER OF FINANCIAL SERVICES  Financial services comprise an array of special businesses because they deal mainly with other people’s money, and because problems that arise in FI can trigger serious external costs  Competition between FIs have intensified by deregulation and rapid innovation in financial products and processes WHAT IS REPUTATIONAL RISK?  Reputation: opinion (social evaluation) of public toward a person, a group of people, or an organization o In business context, reputation helps drive excess value of business firm and metrics as the market-to-book ratio  Sources of gain/loss in reputational capital: o Cumulative reputation of the firm, including its self-promoted ethical image o Economic performance – market share, profitability, and growth o Stakeholder interface – shareholders, employees, clients, and suppliers o Legal interface – civil and criminal litigation and enforcement actions  Proximate symptoms of sources of loss in reputation capital include o Client flight and loss of market share o Investor flight and increase in the cost of capital o Talent flight o Increases in contracting costs  Reputational risk: risk of loss in value of firm’s business franchise that extends beyond event-related accounting losses and is reflected in decline in share performance metrics o Reputation-related losses reflect reduced expected revenues and/or higher financing and contracting costs o Related to strategic positioning and execution of the firm, conflicts of interest exploitation, individual professional conduct, compliance and incentive systems, leadership, and the prevailing corporate culture o Usually the consequence of management processes rather than discrete events; therefore requires risk control approaches that differ materially from operational risk  Firms that promote themselves as reputational standard-setters will tend to suffer larger reputational losses than firms that have taken a lower profile SOURCES OF REPUTATIONAL RISK  Origin may emanate from intersection between financial firm and competitive environment, on the one hand, and from direct and indirect network of controls and behavi
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