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Reputational Risk and Corporate Governance

By IB Insights | December 19, 2013

Though more is being written about reputational risk there is still surprisingly little that is research/evidence-based. Too often what appears is more polemic than perspective and lacks sufficient context. Though reputational risk is different to other risks companies are not taking adequate steps in addressing it. This is partly because it is not seen clearly enough as a boardroom issue. There are clear advantages in implementing a proper reputational risk management strategy and in recognising the value and benefits of a reputational risk approach.

An increasing number of respected independent research studies, most recently that of the Conference Board in 2009 and a 2010 study involving leading investors, company secretaries and directors have found that reputational risk is a major concern for boards and directors. When reputational risk materialises, it can affect income streams, endanger earnings growth and affect investor confidence.

Reputational risk is different to other risks. It is difficult to define, measure and therefore manage – a task made more complicated by uncertainty over who ‘owns’ the issue inside companies. However it can be seen as the comparison that key stakeholders make between how a company or its employees are expected to behave and how they actually behave; it can be positive as well as negative. Practical measures and action strategies aim at performance management as well as perception management. As the financial crisis gathered pace in 2008 the dangers posed by reputational risk crystallising have become apparent. A number of high-profile scandals, have shattered trust in companies and institutions previously perceived to be safe and secure.

Despite its importance, evidence suggests that boards and top management teams are not doing enough – in terms of specific policies and implemented practices – to manage exposure to reputational risk. Stakeholders whose support is critical to the long-term sustainability of the business – including investors, regulators, customers, suppliers, staff and opinion-formers – are however increasingly demanding evidence that companies are taking the issue seriously. Reputational risk impacts are real, and managing and mitigating them is a priority.

Although there is an increasing amount of evidence that some companies are treating reputational risk with the importance it deserves, the majority of companies are probably still doing very little of substance in this area. There seem to be two dominant reasons. The first is that the issue is still seen as a frontier concept, and some companies have not worked out a process for addressing it – caught in the headlights, they do not move the agenda forward. The second comes from companies who argue that no special measures are necessary, since all reputational risk is ultimately the outcome of operational risk materialising. Since, these companies argue, operational risk is already being managed then, ergo, they have reputational risk covered.

Neither stance is persuasive, and certainly neither is defensible from the point of view of directors’ fiduciary duties to shareholders to protect (and grow) the assets of the company (not to mention other duties increasingly being introduced to take account of other stakeholders’ agendas). Inaction by directors could eventually land them in hot water in terms of personal liability, but we should not see the reputational risk agenda as one simply of threat and downside. There are many positive reasons for taking steps to master this difficult challenge.

It is certainly true that reputational risk is generated as a result of other types of risk – not just of an operational nature – materialising. But devising an approach to managing reputational impacts with this perspective alone represents an inadequate management response. Reputational risk permeates, and pervades, all aspects of a company’s operations, and so reputational risk should be marbled throughout a company’s risk register. This means not treating reputational risk as a discrete risk category or classification, but understanding its presence in everything that goes on inside a company.

The main justification – or business case – why reputational risk should be addressed is because the underlying effect and impact of damaged stakeholder relationships can be more pervasive and longer-lasting than the immediate losses resulting from the crystallisation of the original (operational) risk. Companies which have suffered reputational hits have often taken years to recover, and the transaction costs associated with restoring damaged stakeholder relationships, and re-establishing business continuity, have to be factored in addition to the operational losses.

There are clear advantages in implementing a proper reputational risk management strategy. By its nature, such a programme increases the capability of the company to prevent the risk from materialising in the first place. This comes about not least as the result of greater alignment between the different communities in the company – particularly the corporate affairs/communications, and risk management functions – which need to spend more time working with each other if the reputational risk strategy is to work to full effect.

This is where the ultimate payback materialises. A properly-initiated strategy helps to protect the value of the company – the deployment of reputational capital to protect the existing revenue streams and future earnings growth so highly prized by investors. Developing a deeper understanding of intangible stakeholder sentiments to deliver hard-edged business benefit.

Part of the challenge in addressing reputational risk is many companies still view reputation management as primarily a communication initiative. This is further compounded when, as is too often the case, reputation risk is not incorporated into risk management. There are additional challenges for senior management and Boards in crafting a response. While media monitoring has become more sophisticated, social media are rapidly gaining influence. Companies need to respond by anticipating downside losses while exploiting upside gains.

In Islamic Financial Institutions (IFIs) reputational Risk arises out of any uncertainty on Shariah compliance. IFIs’ reputation is highly dependent on the perception of customers with respect to Shariah Compliance and issues surrounding investor’s protection given the traditional reliance on the deposit products etc. Success of an Islamic financial system is based on stakeholders believing that the system is Shariah Compliant. This single factor intensifies the role of good corporate governance to ensure that the faith of stakeholders is not compromised and the system sustains and grows smoothly. The reputational risk factor i.e. loss of faith has to be managed right from the inception of an IFI and the Shariah advisor/board are assigned to perform their duties. Reputational risk is significant for all public-interest entities with banks being no exception. However in Islamic banking, this risk emanates with higher magnitude and increased intensity.

Behaviour is more important than structures. Given that the reputation of an institution is directly linked to the ‘expected behaviour’ of an institution in relation to its stakeholders, such expected behaviour can be best understood in the light of Islam’s principles on contracts, property rights, trust and the principles of governance. These principles will determine the true character of an institution and any deviation from these principles will expose the institution to reputational risk.

Ethical and social risk is a sub-set of reputational risk, not the other way round. Economic durability (from positive customer, employee and shareholder relationships) and environmental sustainability (and social responsibility) together provide the bedrocks for future viability. That is also a reality in which all the actors in any company’s immediate crisis also have a shared stake whether they know it or not.

 

By Arif Zaman

This article was originally published in the Muslim Council of Britain’s publication entitled ‘Nurturing the Future in Islamic Finance and Thought Leadership’ as part of an international delegation to the 6th World Islamic Economic Forum in Kuala Lumpur, Malaysia May 2010. The article is reproduced on this website with the kind permission of the Muslim Council of Britain and the full brochure can be accessed here: http://www.mcb.org.uk/wief/Documents/6WIEF%20Brochure.pdf

 


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