A solid reputation is an intangible that is rarely noticed until it is gone. But the financial services industry is becoming increasingly aware of the value of reputation, not just as a differentiator among firms but also as the foundation of investor confidence in the capital markets system.

Earlier this summer, a high-level group of Wall Street executives, known as the “counterparty risk management policy group,” issued a report detailing best practices for firms to follow to promote the stability of the financial system. It laid out how to reduce the risks of systemic financial shocks and limit the damage if such shocks occur.

As well as the more conventional systemic risks — market risk, credit risk, counterparty risk and operational risk — the report warned of reputational risk issues that could, in themselves, undermine the system.

Among the concerns, it cited such seemingly mundane issues as suitability and disclosure in the sale of complex financial products to retail investors, the potential conflicts of interest inherent in financial intermediaries and the fiduciary responsibilities of institutional investors.

What is striking is that the group seems primarily concerned about the reputational damage that is lurking in everyday business practices. It’s not worried about high-level corruption or exposure to financial crimes such as money laundering. Rather, it appears to fear that standard business practices could rebound and damage reputations.

The warning has been heard in Canada, as well. In a speech late last year, Superintendent of Financial Institutions Nick Le Pan said firms should anticipate and deal with reputational risks before problems arise. He also singled out ordinary business practices, saying: “That includes being aware of how remuneration structures can bias incentives.”

It’s not just a fear that basic business practices could come to be viewed as coercive that has financial firms fretting. They also seem to be worried about potential reputational risk, even when they are operating without conflicts of interest. Earlier this year, TD Bank Financial Group president and CEO Ed Clark warned that transactions that seem acceptable now could come back to harm financial firms, even if they are otherwise perfectly proper.

Banks have done such a good job of transferring away their own risks through derivative use, he said, that they risk taking the heat should those trades ever blow up in the face of the institutions on the other side of the transactions — chiefly pension funds, insurance firms and, by proxy, individual investors that own the risks through hedge funds. “The whole reputational risk around this kind of industry is something that the banks, as a whole, sit and worry about collectively, as opposed to compete on it,” he told an industry conference.

The tricky part for firms is that avoiding all possible reputational risk would probably damage their businesses immediately. For example, a dealer could eliminate the risk of giving its reps inherently biased sales incentives by equalizing compensation for all its products and services or by putting its advisors on straight salary. But sales would surely suffer and revenue decline.

And while the financial services industry appears to be fretting about future reputational risk, they are having to atone for some past offences.

Companies have long talked about the importance of trust and reputation within the financial services industry, yet a succession of scandals has done little to deter clients or crimp profits. For instance, the revelation of firms’ involvement in improper market-timing trading in mutual funds has hardly dented net sales. As well, a succession of other ugly incidents has passed with little apparent impact on firms’ businesses.

Investment dealers have underwritten and sold their clients some egregious stock promotions, with no apparent impact on the firms’ profits. Securities dealers and insurance firms employ compensation schemes that can skew client advice. The industry also takes advantage of clients in all sorts of little ways, from inflated administrative fees to excessive spreads in foreign-exchange transactions or even wildly expensive bond market trades. Mistakes are also made, such as accidentally releasing confidential client information or bungling systems upgrades that leave clients unable to access their money.

Yet clients keep coming back, and the profits continue to pile up — even at the firms that have tarnished their reputations the most. While various outrages, both small and large, may send the odd client packing, it’s hard to see that any have done much to hurt the financial services businesses.

@page_break@If there’s any area in which financial firms may be constrained by their reputations, it’s bank mergers. The federal government is said to fear the political fallout that could follow mergers if they lead to branch closings, service reductions and diminished competition. Yet, for the most part, people need credit; they need to save and invest, and such needs soon outweigh both innocent stumbles and more serious sins.

Nevertheless, it appears that the industry increasingly views reputational issues as potentially crippling. “This emphasis on operational and reputational risks reflects the hard reality that these elements of risk are critically important ingredients to sustaining public confidence in the financial system,” the CRMPG report notes. “As such they are highly relevant to the goal of financial stability.”

Regulators, too, are looking more closely at reputational risk. During its 2004 round of supervisory reviews, the Office of the Superintendent of Financial Institutions scrutinized reputation risk-management practices at several firms under its jurisdiction, focusing specifically on structured transactions, trading in mutual and segregated funds, due diligence on the funding of brokered mortgages and financial reinsurance.

In a report released in June, OSFI notes: “While it is evident that many [financial institutions] have taken significant steps to enhance their reputation risk-management practices, there are still areas that would benefit from further development.” Other regulators and the public, it adds, are also focusing more than in the past on corporate ethics and integrity in the wake of recent corporate scandals. “This is a key issue for an industry that relies on the confidence of consumers, creditors and the general marketplace,” the report says.

Reputational risk is often a consequence of inadequate management of other business risks, such as market, credit and operational risks, OSFI says. In addition to the financial impact from the misstep itself, the reputational impact may be devilishly difficult to quantify.

Although reputational risk is often a derivative of more concrete risks, how firms respond when they run into problems is where reputation risk management comes in. Typically, the response must come from the top.

For example, once it was revealed that reps from a Manulife Financial Corp. subsidiary had referred many clients to the now-defunct structured product firm Portus Alternative Asset Management Inc., Manulife CEO Dominic D’Alessandro stepped up and guaranteed clients’ investments. Soon afterward, a voluntary initiative among many independent dealers that had also sent clients Portus’s way aimed to collect their fees from Portus referrals for possible distribution to clients.

Similarly, TD’s Clark took the unusual step of apologizing after the bank announced that it would take a charge against earnings to cover a legal settlement and increase reserves as a result of lawsuits concerning the bankruptcy of Enron Corp. TD denies that it did anything wrong but, Clark says, he regrets that the case has had an economic cost to the bank.

Although such examples suggest the industry is becoming increasingly active in managing reputational risk, OSFI’s review found disparities among firms’ efforts. Some firms are handling reputational risk as part of their overall management of more conventional risks, while others have distinct initiatives in place. OSFI stresses that improving the effectiveness of such practices should be a priority for all firms, and notes that it will continue to pay increasing attention to how firms manage the risk as part of its supervisory reviews. “All institutions must recognize that their reputation is a strategically important asset and should endeavour to strengthen their reputation risk-management practices,” it says. However, it’s not yet prepared to set standards in the area.

Indeed, it’s hard to carve out rules when the asset is ephemeral, and the tactics required to defend it are necessarily nebulous. OSFI notes that senior management and boards should be actively involved in setting the appropriate “tone,” including a strong commitment to a code of ethics and a conflict-of-interest policy, and “appropriate consequences” for material breaches of internal policies that put a firm’s reputation at risk. OSFI suggests that future reviews may focus on issues such as whether senior management and the board had communicated a strong commitment to protecting reputation, and whether they had properly assigned responsibilities for risk management.

OSFI also notes that some firms have focused reputation risk management on particular products or business lines; it recommends expanding that to all businesses. It also recommends better use of monitoring tools and establishing measurement criteria, and improving the comprehensiveness and timeliness of reporting to senior management and the board. Such practices may be subject to future supervisory reviews.

Finally, OSFI has observed significant variation in the scope and quality of ongoing training for employees in managing reputation risk. It particularly notes weaknesses in areas of staff awareness of codes of conduct or conflict-of-interest policies.

If codes of conduct and increased executive attention manage reputational risk, it shouldn’t be too burdensome. But if firms have to toss out traditional business practices in favour of more client-friendly ones to ensure the stability of the financial system, then that is an infinitely bigger challenge. IE