Managing Reputational Risk

Victor Hugo wrote that “Nothing is as powerful as an idea whose time has come,” a sentiment which could suitably be applied to the concept of reputational risk. It is now difficult to read any quality business publication, or browse online, without coming across the term – whether in relation to disgraced politicians, or failed business people or business models.

Reputational risk is a frontier risk or, as the Economist once termed it, the “risk of risks.” The crystallization of reputational risk can engulf and destroy a company, and often the careers of some of its top executives.

Think of companies like BP, Toyota and Sony. They’re still with us, but they have suffered reputational hits from which it will take years to recover.

Why is reputational risk so dangerous, and how can it be managed? Starting with the core concept, reputation is built on the sum total of stakeholders’ interactions with an organization, and the perception of how the organization will behave compared with those stakeholders’ expectations. When a company meets, even exceeds, stakeholders’ expectations, it builds up a store of reputational capital. When reputational risk crystallizes, the opposite happens – a negative event impacts stakeholders’ perception of that company, and destroys reputational equity. When a company fails to deliver against the expectations it has set, the outcome can be anything from mildly irritating to catastrophic.

It’s important to recognize that pure reputational risk does not exist – it is one of the outcomes of operational risk crystallizing. What really matters for a company is when operational risk and reputational risk combine to create a perfect storm. It works like this. Something goes wrong inside a company which is serious enough to threaten some significant aspect of its operations, and a material part of the related revenue generation which underpins the business model. Investors lose confidence – initially because they perceive a threat to the company’s potential for earnings growth, then more substantially when they see no quick fix to the company’s difficulties. These insecurities grow – and this is the important part – when other key stakeholders, whose support is needed to reestablish the equilibrium of the business model, also lose confidence, and leave in droves.

Repairing the damage to the company’s operations is one thing, restoring trust among stakeholders is another. The latter process may take years but, until it happens, the company will never return to full health. So Toyota may have fixed the brakes on its cars, and Sony may have resolved the technical issues that allowed its customer data to be hacked, but both face the reality of customers breaking sometimes life-long loyalty to the product, taking their business elsewhere, and causing irreparable damage to the companies’ revenue-generating capabilities. BP may have controlled the leak from its Deepwater Horizon rig, but it has suffered a severe hemorrhage of political support on Capitol Hill, fuelled by the incendiary anger of the Gulf communities, which continues to undermine its ability to secure long-term and profitable deep-sea exploration licenses off the U.S. coast.

And that is why legislators and regulators, all over the world, are increasingly requiring companies to protect their reputation. It is also why the insurance sector is finally grasping the nettle (or realizing the opportunity) in developing products focused on the challenges posed by reputational risk.

These developments come at a time when a growing body of academic research is now able to identify the value lost when reputational risk materializes. This dovetails with the work being conducted by Reputation Institute which demonstrates the correlation between, on the one hand, the relationship between a company’s reputation and the degree to which stakeholders subsequently support or distance themselves from that company and, on the other hand, the connection with increases or decreases in stock price and company value. This is an exciting area of work, with relevance – in practical and commercial terms – for those involved in the areas of governance, risk and insurance.

The simple fact, in conclusion, is that reputational risk is indeed an idea whose time has come. In a world of always-on, always-connected social media, there is no hiding place for companies, or individuals, who fail to deliver against expectations. All companies, without exception, should have reputational risk strategies in place. It is far cheaper, and more efficient, to prevent such risk from materializing than paying for the mop-up costs afterwards. Ask BP, Toyota or Sony – they know.

Topics Talent Risk Management