Reputational Risk in a Post Dodd Frank world

Agenda

• 1) Reputational Risk and Shareholder Value• 2) Sources of Reputational Risk• 3)Reputational Risk and Conflicts of Interest• 4)Valuing Reputational Risk

The Complexity of Integrated Risk Control

• Risk• Sovereign • Risk• Liquidity• Risk• Operational • Risk• Credit Risk• Market Risk• = Reputational Risk!!!

Operational Risk vs. Reputational Risk- BIS

• People– Internal fraud– Clients, products and business practices– Employment practices and workplace safety

• Processes• Systems• External events– External fraud– Damage or loss of assets, force majeure

• Reputational risk is driven by:• A) Firm strategy• B) Market and credit risk exposures• C) The quality of corporate governance• D) Regulatory compliance issues• E) All of the above• F) None of the above

Performance Gaps, Competition and Conflict

• SOCIETY‟S GENERALLY ACCEPTED VALUES– “Immoral Conduct”

• PEOPLE‟S EXPECTATIONS– “Irresponsible Conduct”

• LEGISLATION– “Illegal Conduct”

• ENFORCEMENT INFRASTRUCTURE– “External Compliance Failure”

• FIRM CONDUCT– Reputational Benchmarks– Competitive Benchmarks

• MARKET-BASED COMPETITIVE PERFORMANCE

Decomposing Reputational Events in a Going-concern Valuation Framework

Conflict of Interest

• Wholesale Domain Type-1 - Firm-client conflicts. • Principal transactions. – Abusive tying. – Fiduciary violations. – Self-dealing. – Front-running.

• Type-2 - Inter-client conflicts. • Misuse of information. – Client interest incompatibility

Conflict of Interest - Retail

Retail Domain Type-1 - Firm-client conflicts. • Biased client advice. – Involuntary cross-selling. – Churning. – Inappropriate margin lending. – Failure to execute. – Misleading disclosure and reporting. – Misuse of personal information.

Conflict of Interest - HybridDomain-TransitionType-1 -Firm-client conflicts.• Suitability. • Stuffing.• Conflicted research.• Proxy voting.• Spinning.• Laddering (ramping).• Bankruptcy risk-shifting.• Late trading.• Market timing.

Conflict of Interest- A.G.N.Y.

ML’s Mission StatementsCLIENT DEDICATIONOur clients’ interest come first. By serving them well, we will alsosucceed.SUITABLE RECOMMENDATIONSOur financial recommendations are consistent with our clients’ long-term goals, financial circumstances and risk tolerance.FULL DISCLOSUREWe inform our clients of the costs and benefits of doing business with

Merrill Lynch.THE INTEGRITY OF MERRILL LYNCHOur principles, financial strength, service quality and market

leadership provide comfort and security to our clients through good times and bad.

Citi & WorldCom, 2002

Example: GS & NYSE

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Conflicts of interest are:A) More serious in finance than in other

industriesB) Can be exploited even with under perfect

informationC) Can be exploited even with zero transaction

costsD) Are more prevalent in the retail than in the

wholesale sector of industries

SSBs Near-death Experience, 1991

JP Morgan and Banco Español de Crédito, 1993

SocGen 2008

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The shareholder costs associated with reputation-sensitive events are:

A) ImmaterialB) Simply a cost of doing businessC) Disappear quickly from share valuationsD) Are easy to measureE) Represent matters of serious concern to

boards

Optics

• “Image is reality. It is the result of your actions.

• If the image is false and our performance is good, it‟s our fault for being bad communicators. If the image is true and reflects our bad performance, it‟s our fault for being bad managers.

• Unless we know our image we can neither communicate nor manage.”

Mervyn King Bank of England

Too many in financial services have thought “if it’s possible to make money out of gullible or unsuspecting customers, particularly institutional customers, that is perfectly acceptable”

Good businesses “keep a clear vision of who their customers are, and are run by people who don’t think they should simply maximise profits next week.”

In the past 25 years banks have increasingly “taken bets with other people’s money”

“They didn’t understand the nature of the risks they were taking”