(Photo credit: Wikipedia)
Stepping nimbly around the grand piano, the banker fixes a conciliatory smile. "I'm sorry, Mr. Liberace, but we've polled music critics, and they don't put a high value on your reputation."
Liberace frowns in this imaginary encounter. "Look here! I've made over $10 million from my TV show, my gig in Vegas nets $300,000 every week, and I earn millions every time I tour. Just listen to this.”
But the banker cuts him off. “Doesn't matter. We’re concerned about reputation risk.”
Incredulous, Liberace faces the banker, ”You won't do business with me because some people don't like me? I’ll bet you that most of them watch my television specials anyway!"
This confusion between the marketing notion of reputation risk as a potential loss of affinity, and the financial notion of reputation risk as a potential loss of liquidity, is creating regulatory pressure on banks to challenge legitimate transactions with qualified clients. It gets worse. Misunderstanding the meaning of reputation and watching the wrong indicators will make hash out of liquidity-management strategies that have to secure an estimated $800 billion in contingent capital under Basel III.
More broadly, this misunderstanding encourages companies beyond the banking sector to misdirect resources from operational controls to communications expenses, thereby botching the risk management process entirely.
I call it the Liberace Effect.
The governor of the Federal Reserve outlined her misunderstanding of reputation in the banking sector earlier this year: to her, it's the product of perceptions, much like the "brand equity" that's measured in online comments or the absence of a better explanation of the variable spread between companies' book value and stock price. The Fed believes that banks must do more to assess risks to their enterprise value from such opinions, and one outcome is that some of them are shying away from doing business with payday lenders, online gambling sites, dating services, and other companies that throw off reasonably reliable cash-flow. I guess the thinking is that those less savory reputations could put opinions about banks at risk.
I'm all for guaranteeing full employment to lawyers hired to decipher this blather, but regulatory reliance on imaginary metrics in lieu of real ones makes it harder for banks to fulfill their fiduciary responsibilities (i.e. it's riskier policy). It just doesn’t make sense.
Consider this illustration: The Reputation Institute, a respected polling organization, reported in its survey on reputations of 150 leading US companies in 2013 that Disney ranks #1, and Goldman Sachs ranks #145. Yet, where the reputational impact of stakeholder impressions really counts from a liquidity perspective, Goldman Sachs’ operating margin of 37% beats Disney’s 21%, and the former’s profit margin of 22% beats the latter’s 14%. Yes, Disney benefits from a price to sales ratio of 2.62 versus Goldman’s 2.1, but that measure isn’t terribly illustrative of relative performance across industry sectors. And Goldman’s stock has increased 58% over the past year while Disney is up “only” 32% (the S&P500 is up 18%).
So fans approve of Disney’s piano playing, but they pay more (and more often) for Goldman’s performances.
This Liberace Effect also distorts another area of financial regulation: The reputation risks disclosed (or not) by the vast majority of S&P500 constituent companies in section 1A of the annual 10K reports.
My firm, in cooperation with the reputational value insurer Steel City Re, recently studied the risk disclosure of 491 of the S&P500 companies over the past 12 months , and found that apart from a slight performance advantage for businesses that disclosed risk in one way, shape, or form, there was no material difference in their stock price performance. A number of the best-known companies that arguably rely on great reputations for their valuation were among the non-disclosers, including
In other words, they're really not telling us anything at all, with one exception: They’re doing it wrong. Firms that are consumer-facing disclosed reputation risk with a statistically-significant higher frequency than the average, while firms in the energy and utilities sector went the other way. By focusing on reputation as branding, they’re all failing to appreciate that reputation risk impacts employee costs, credit costs, supplier costs and, wait for it, even regulatory costs.
The Economist nailed the problem in an article last year:
"...the industry depends on a naive view of the power of reputation: that companies with positive reputations will find it easier to attract customers and survive crises. It is not hard to think of counter-examples. Tobacco companies make vast profits despite their awful reputations. Everybody bashes Ryanair for its dismal service and theDaily Mailfor its mean-spirited journalism. But both firms are highly successful. The biggest problem with the reputation industry, however, is its central conceit: that the way to deal with potential threats to your reputation is to work harder at managing your reputation. The opposite is more likely: the best strategy may be to think less about managing your reputation and concentrate more on producing the best products and services you can."
What if we chose to define reputation as the understanding of stakeholders that a company delivers satisfactory results, and their expectations that it will keep to its forecasts while operating within both the law and their particular definitions of appropriate behavior?
Doing so would be the opposite of theLiberace Effect.
Agood reputation wouldn't be one that people said they liked in a poll, but rather one that got higher valuations in decision markets, and reported better financial statement metrics because it performed more efficiently, profitably, and consistently over time than its competitors.We would focus on operational controls as the engines of reputation, and their management over time as the mechanism for sustaining it.
Reputation risk would be the possibility that said operational qualities would falter or otherwise be disrupted and, as a consequence, generate negative news. But the measurement would be based on the integrity and authority of those operations, as evidenced by the day-to-day vetting and valuation of stakeholders through their financial decisions, and not viewed dimly in the mirror of opinions.
It would make risk disclosures from S&P500 companies more meaningful, and allow for apples-to-apples comparisons within and between industry sectors. Perhaps more companies would be inspired to disclose reputation risk because it would be a real business KPI, and not a modified version of brand equity.
Liberace wasn't my taste as an artist, but I imagine his reputation as a bank client was stellar. Isn't it time we stopped letting the Liberace Effect bias our understanding of reputation?
