operational risk and reputation in the financial industry

Operational Risk and Reputation in the Financial

IndustryRoland Gillet (Sorbonne, Solvay)Georges Hübner (ULg, UM and LSF)

Séverine Plunus (HEC-ULg)

AGENDA Basel II : Operational risk and reputational risk Litterature Review Sample : construction and descriptive

statistics Methodology Results Evidence from other data Conclusion

Operational risk Basel II:

“The risk of losses resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic risk and reputational risk.”

(BIS, 2005, p140, n°644)

Reputational risk

• Basel II:“the risk of significant negative public opinion that results in a critical loss of funding or customers”

(BIS, 1998, p7). • More generally, reputational losses are all events

that, once known by the market, negatively affect the cash-flows of the company, either due to losses in the client base, lack of confidence of external parties materializing in increased discount rate, funding rates, or decreased cash-flows.

But do the markets really dissociate reputational risk from operational risk?

Literature Review (1)

• Murphy et al. (2004)– Their contribution builds on a previous line of results

showing significant negative price impacts of firms accused of fraudulent activities (Skantz et al., 1990; Karpoff and Lott, 1993; Reichert et al., 1996).

– Results:• significant declines in reported earnings, increased stock return

volatility, and declines in analyst’s estimates. • larger firms experience smaller negative impacts since losses

behave as fixed costs. • A strong brand name mitigates the impacts and is interpreted as

a protection against reputational damage.

Literature Review (2) Only two papers examine the reputation

impact on market returns of operational events affecting financial institutions. Cummings, Lewis and Wei (2004)

Results: Banks experience smaller negative impact than insurance companies. Both types of companies however experience significant negative price

reactions market value drops exceeding the amount of the operational losses

de Fontnouvelle and Perry (2005) Results

the announcement date only has a significant, negative impact on the price

negative price impacts are larger when the operational loss is due to internal fraud

Our study Stock market reaction after the announcement of

operational losses in listed financial companies.

154 financial companies listed on major Stock Exchanges

Three events per firm: First press release, Explicit recognition by the company, and, Settlement date.

Reputational risk: difference between the market value loss and the announced loss amount of the firm.

Sample construction OpVantage First, provided by the Fitch Group.

criteria to filter this data collection: company group incorporated either in United States or in

Europe; companies of the financial industry; operational losses higher than 10 millions US dollars; loss settled no sooner than January 1994. companies publicly listed “September 11th” events removed.

final sample: 103 largest losses having occurred in American companies 51 largest losses in European companies.

The sample – descriptive statistics (1)

Nb

Market Returns

betaValue

(in Mio $)Mean min Max SD

Europe 51 47184 0,02% -0,46% 0,54% 2,14% 1,09

USA 103 59264 0,05% -0,19% 0,37% 2,03% 1,20

Total 154 55370 0,04% -0,46% 0,54% 2,07% 1,17

The sample – First press release

Panel A - Full sample

Nb

Market Loss size (in Mio) Average Returns (t=0 to 10)

betaSharpe

ratio

Value

(in Mio)Mean Min Max Mean min Max SD

Europe 51 38138 277 11 3000 0.04% -1.83% 2.79% 1.82% 1,10 -0,51

USA 103 60462 196 10 2650 -0.13% -4.47% 1.44% 1.96% 1,26 -0,49

Total 154 53053 222 10 3000 -0.07% -4.47% 2.79% 1.91% 1,21 -0,49

Panel B - Known losses

Europe 28 45447 239 11 2923 -0.04% -1.83% 2.79% 1.90% 1,19 -0,60

USA 62 60873 165 10 2650 -0.01% -1.42% 1.44% 1.75% 1,22 -0,52

Total 90 55847 188 10 2923 -0.02% -1.83% 2.79% 1.80% 1,21 -0,55

Panel C - Unknown losses

Europe 23 27539 309 11 3000 0.13% -1.21% 1.12% 1.71% 0,99 -0,39

USA 41 62558 222 10 2160 -0.30% -4.47% 0.81% 2.27% 1,32 -0,43

Total 64 46646 254 10 3000 -0.14% -4.47% 1.12% 2.07% 1,20 -0,41

The sample – Recognition by the companyPanel A - Full sample

Nb

Market Loss size (in Mio) Returns

betaSharpe

ratio

Value


Europe 17 24601 596 35 3000 -0.49% -2.87% 0.44% 2.63% 1.0 -0,28

USA 28 61591 517 8 4371 -0.04% -3.27% 1.96% 2.24% 1.3 -0,38

Total 45 47299 368 8 4371 -0.21% -3.27% 1.96% 2.39% 1.1 -0,35

Panel B - Known before and unchanged losses

Europe 3 51781 1301 440 2923 -1.04% -2.54% 0.14% 2.74% 0.9 -0.31

USA 4 82849 201 73 372 0.70% 0.27% 1.96% 3.08% 1.3 -0.47

Total 7 69534 673 73 2923 -0.45% -3.27% 1.96% 2.93% 1.2 -0.42

Panel C – Learned or changed losses

Europe 9 22063 492 25 3000 -0.12% -1.18% 0.44% 1.91% 0.7 -0.35

USA 18 58870 657 8 4371 -0.17% -3.27% 1.10% 2.10% 1.2 -0.51

Total 27 46534 488 8 4371 -0.15% -3.27% 1.10% 2.04% 1.0 -0.46

Panel D - Unknown losses

Europe 5 12863 252 100 452 -0.84% -2.87% 0.35% 3.84% 1.4 -0.07

USA 6 49919 215 90 455 -0.16% -2.54% 1.12% 2.09% 1.2 -0.07

Total 11 33075 232 90 455 -0.47% -2.87% 1.12% 2.89% 1.3 -0.07

The sample – Settlement

Panel A - Full sample

Nb

Market Loss size (in Mio) Returns

betaSharpe

ratio

Value


Europe 23 27415 346 11 2923 -0.07% -0.73% 0.78% 1.33% 0.96 -0.33

USA 42 65114 322 10 2650 -0.05% -0.98% 0.85% 1.59% 1.10 -0.48

Total 65 54064 330 10 2923 -0.06% -0.98% 0.85% 1.50% 1.03 -0.43

Panel B - Known before and unchanged losses

Europe 2 25244 1508 92 2923 0.07% -0.30% 0.44% 1.40% 0.82 0.02

USA 6 59555 511 15 2650 -0.11% -0.98% 0.28% 1.46% 1.27 -0.62

Total 8 50977 760 15 2923 -0.06% -0.98% 0.44% 1.44% 1.14 -0.46

Panel C – Learned or changed losses

Europe 21 28301 207 11 691 -0.05% -0.73% 0.78% 1.32% 0.32 -0.36

USA 36 64926 284 10 2160 -0.04% -0.97% 0.85% 1.61% 1.04 -0.46

Total 57 51433 256 10 2160 -0.04% -0.97% 0.85% 1.51% 0.84 -0.43

Methodology Abnormal return for firm i:

ARit = Rit – αi – βi Rmt for t= -20 to 20

Abnormal return due to reputational effect:

Average and cumulative average abnormal return:

and

ARi0 (Rep) =Ri0 – αi – βi Rm0 + loss / Market Cap

N

iitt AR

NAR

1

1

20

20t

tARCAR

Results

CAR around the three event dates.

-8,00%

-7,00%

-6,00%

-5,00%

-4,00%

-3,00%

-2,00%

-1,00%

0,00%

1,00%

2,00%

3,00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

First press release CAR(Rep) First press release

Recognition Settlement

1st press release Recog. Settlemt

T CARCAR(rep) CAR CAR

-15 to 1 -5.28*** -1.82** -0.64 1.71**

-8 to 8 -4.35*** -1.57* -1.14 0.79

-5 to 10 -4.44*** -0.57 -0.88 0.78

0 to 13 -2.37*** 1.45* -0.80 0.53

CAR for American loss eventsUSA

-10,00%

-8,00%

-6,00%

-4,00%

-2,00%

0,00%

2,00%

4,00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

days

CA

Rt

First press release (Rep) First press releaseRecognition Settlement

CAR for European loss eventsEurope

-6,00%

-5,00%

-4,00%

-3,00%

-2,00%

-1,00%

0,00%

1,00%

2,00%

3,00%

4,00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

days

CA

R

First press release (Rep) First press release Recognition Settlement

Test statistics for US and European loss events

First press release Recognition Settlement

USA CAR CAR(rep) CAR CAR

T = -15 to 1 -5.09*** -3.55*** -0.53 1.87**

T = -8 to 8 -4.21*** -3.38*** -0.61 0.26

T = -5 to 10 -4.23*** -2.64*** -0.80 0.08

T = 0 to 13 -3.73*** -2.03** -1.17 -0.53

Europe

T = -15 to 1 -1.95** 1.87** -0.36 0.34

T = -8 to 8 -1.58* 2.07** -1.06 0.99

T = -5 to 10 -1.19 2.75*** -0.41 1.23

T = 0 to 13 1.18 5.39*** 0.21 1.65**

First press release

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

Days

CA

Rt

Known losses (90) Unknown losses (64)Known losses (rep) Unknown losses (rep)

Sub-sample analysis according to the knowledge of the losses – First press release

Known losses Unknown losses

T CAR CAR(rep) CAR CAR(rep)

-15 to +1 -3.46*** -0.73 -4.90*** -1.95**

-10 to +5 -2.71*** 0.45 -6.30*** -3.30***

-8 to +8 -2.60*** 0.53 -4.98*** -2.05**

-5 to +10 -1.94** 0.85 -4.39*** -1.89**

0 to +15 -0.17 2.33*** -2.87*** -0.82

Recognition by the Co

-8,00%

-6,00%

-4,00%

-2,00%

0,00%

2,00%

4,00%

6,00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

Days

CA

Rt

Known before losses (7) Changed or learned losses (27)Unknown losses (11) Série5Série6

Sub-sample analysis according to the knowledge of the losses – Recognition by the company

Known

before Learned or changed Unknown losses

T CAR CAR(rep) CAR CAR(rep)

-15 to +1 -2.97*** 0.32 1.23 0.44 2.09**

-10 to +5 -2.20** -0.04 0.64 0.61 2.01**

-8 to +8 -2.40*** -0.85 -0.21 -1.28* 2.51***

-5 to +10 -2.00** -0.22 0.59 -0.37 1.33*

0 to +15 -1.22 0.03 1.33* -0.54 1.16

Settlement date

-0,50%

0,00%

0,50%

1,00%

1,50%

2,00%

2,50%

3,00%

3,50%

4,00%

4,50%

-25 -20 -15 -10 -5 0 5 10 15 20 25

Days

CA

Rt

Known before (8) Learned or changed (57)Série4

Sub-sample analysis according to the knowledge of the losses – Settlement

Known before Learned or changed

T CAR CAR CAR(rep)

-15 to +1 -0.27 1.66 3.50***

-10 to +5 0.39 0.37 2.33***

-8 to +8 0.78 0.26 2.23**

-5 to +10 0.46 0.22 2.29**

0 to +15 0.05 -0.74 1.31*

First press release

-9.00%

-8.00%

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

CA

R

Internal and External Fraud (27) Clients Products and Business Practices (111)Série2 Série3

fey

Sub-samples according to the event typeFirst press release

CAR(Rep) First press release

T Frauds Clients…

-15 to +1 -4.22*** -1.94**

-10 to +5 -4.47*** -1.48*

-8 to +8 -3.66*** -0.47

-5 to +10 -4.66*** 2.22**

0 to +15 -4.22*** -1.94**

Recognition by the company

-12.00%

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

CA

R


Sub-samples according to the event typeRecognition by the company

CAR(Rep) Recognition

T Frauds Clients…

-10 to +5 -3.37*** 2.17***

-8 to +8 -3.74*** 1.07

-5 to +10 -3.10*** 0.08

0 to +15 0.49 -0.48

Settlement

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

-25 -20 -15 -10 -5 0 5 10 15 20 25

CA

R


Sub-samples according to the event typeSettlement

CAR(Rep) Settlement

T Frauds Clients…

-10 to +5 2.39*** 1.14

-8 to +8 1.53* 2.07**

-5 to +10 1.39* 2.11**

0 to +15 -1.11 1.82**

Evidence from other data

Evidence from other data Volumes

average volume for each companies on a 250 days basis,

daily variation of the volume -20 + 20 days around the three announcement

date. Garch

Student test : H0: the average conditional volatility during the 10 days

following the announcement is the same than the average conditional volatility of the estimation period.

H1: conditional volatilities are different.

tttt

ttt xR

2

12

12

Evidence from other data (2) Cusum of squares

The CUSUM of squares test (Brown, Durbin, and Evans, 1975) aims at assessing the constancy of the parameters of a model and is based on the test statistic:

where w is the recursive residual defined as:

The expected value of S under the hypothesis of parameter constancy is :

VolumesVolume variation (USA + EUR)

-50%

0%

50%

100%

150%

200%

250%

300%

350%

-25 -20 -15 -10 -5 0 5 10 15 20 25

Press Recognition Settlement

Garch effects

0 to +10d

Average

(estimation

period)

1st press release Recognition Settlement

p-value p-value p-value

USA 0.0009% 0.12% 0.02 0.07% 0.15 0.01% 0.00

EUR 0.0011% 2.64% 0.11 0.03% 0.00 0.01% 0.07

Total 0.0010% 0.96% 0.05 0.06% 0.10 0.01% 0.02

2t 2

t 2t

Cusum of squares - USA

-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40

CUSUM of Squares 5% Significance

-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


Cusum of squares - Europe

-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


-0.4

0.0

0.4

0.8

1.2

1.6

5 10 15 20 25 30 35 40


CONCLUSION

Conclusion CAR < 0 around the first press release and the

recognition by the company date. As far as reputational risk is concerned, it is

significantly negative before the first press release, and significantly positive after.

CAR significantly positive around the settlement date The investors overreact when they do not know about

the loss size. automatic correction of the stock returns 10 days after the recognition by the company date.

if the loss is due to frauds: market reaction significantly worse and negative effect on the reputation of the company.

Conclusion Volumes variations: significant peak in trades

whenever the company recognizes the loss event, which corresponded to changes in market alphas and betas confirmed by a cusum of squares test.

anticipation before the first disclosure happens, correction of the settlement returns for the initial effect.

The timing of the resolution of uncertainty also matters to a very large extent, especially when one has to assess at what moment the market perceives a shift in the risk profile of the financial institution that has suffered from a large operational loss.