Risk Management

Tarnished Reputations Could Hit Banks Hard

With cash-stuffed corporate clients, lower profit margins, and new competition from outside the industry, banks’ survival hinges on winning back tr...
Caroline McDonaldJuly 26, 2012

Disgraced by scandals, banks may find it harder to win back trust. But with flush corporate clients, lower profit margins, and new competition from outside the industry, their survival may depend on it, experts contend.

In addition to the JP Morgan and London interbank offered rate (LIBOR) debacles, banks are facing new competition globally. “Other industries, such as grocers, are recognizing the trust issues and are moving into the banking sector,” Steve Culp, a managing director at Accenture Risk Management based in London, says, noting this trend in the United Kingdom. “They are getting licenses and leveraging their brand to attract customers.”

On top of this, Culp adds that banking profits are not what they once were. “Our analysis of the industry says that from 2000 to 2008, the profitability levels were 25% to 26%,” he explains. “If you go to the current, they have dropped significantly. Institutions are now chasing a 12%–14% target: a big degradation of profitability.” As a result, banks cannot afford “customer churn” in the same way they could when making significantly greater levels of profitability, he says.

Those organizations operating at lower profits and “not getting the customer churn numbers right are going to increasingly suffer,” says Culp. “From what I can see, the industry understands it. This will be the key area banks need to win if they’re going to remain profitable and survive.”

Cash Provides Choices
Bruce Lynn, managing partner with the Financial Executives Consulting Group, sees another threat from a lack of trust. “Banks run the risk that companies flush with cash may use their own funds for purchases such as mergers and acquisitions, rather than rely on their banks,” he says.

Lynn explains that corporations are “sitting on trillions of dollars of cash.” They will be deciding whether to make a purchase with 90% debt or 50% debt “and make up the difference because they have the cash on the balance sheet.”

If corporations fund their acquisitions with their own cash because of a lack of trust in the banks, “banks will suffer.” The net effect of badly managed reputational risk is that “people don’t want to do business with you,” he says.

In the past, relationships were important, but that appears to have been forgotten as transactions took precedence over relationships, says Lynn. “We’re entering a phase now where relationships are starting to count more. The trouble is that there aren’t any.”

Lynn adds that fines levied and nonprosecutorial agreements have not changed the behavior of the financial industry. “And with UBS as an example, they have sworn several times over the last few years they’ll never do it again,” he says. (Two top UBS officials resigned last fall in the wake of a $2.3 billion scandal involving unauthorized trades. Now the bank is one of a dozen being investigated for manipulating interest rates.)

While the government has been criticized for its soft approach to corporate crime, Lynn observes, “Where the next shoe could drop is if a bank is convicted of a crime. Some of its customers will not want to do business — why would you want to do business with a known criminal?” This would also leave fewer banks for corporations to do business with, he says.

Nevertheless, there could be some criminal indictments, “and criminal indictments are very serious to a bank. They will pay fines, they’ll do anything to avoid them, because they will no longer be able to play and the corporates will go somewhere else,” says Lynn.

“This is why up until this point the Justice Department didn’t want to convict a bank of a crime. It creates a problem for a publicly traded corporation to be known as doing business with somebody convicted of a crime,” he adds.

One possible outcome of the LIBOR scandal is that the rate itself may be changed. In that case, the question is what will replace it, says Lynn. “Will it be higher or lower than the current LIBOR? Will it be more volatile?” Whatever happens, he notes, most likely the cost for borrowing will go up — which will also affect banks.

And the outcome of it all? “Tens of millions in fines and legal fees and a huge settlement,” he says. Lawsuits will run the gamut from shareholders to companies banks do business with. And lawsuits mean damaged reputations.

Learning the “Three Cs”
Culp observes that building up trust again will involve communication, consistency, and commitment over extended periods of time.

Banks need to communicate externally that they are proactive lenders in a difficult economic time, he says. Internally, they need to communicate what is rewarded and ultimately the business strategy of the institution.

“That leads to consistency,” says Culp. “Because your communications say you want to drive sustainable profitability, you don’t want to reward reckless behavior. Yet your compensation or reward structures are not in alignment with that.” If the bank is inconsistent in this area, he says, its employees’ behavior will align with how they’re measured and how they’re rewarded.

John Alan James, executive director of the Pace Global Center for Governance, Reporting & Regulation, notes that “the mess that we see at HSBC, JPMorgan Chase, Facebook, even LIBOR, are perfect examples as to how boards, chief executive officers, and even business-unit managers [in banks and nonbanks] have not recognized that it is the compliance arena that many, if not most, of the newly discovered risk areas are coming from.”

He points out that with risk management, compliance, and internal audit, “the basis for success is sound policies and procedures, as well as a highly efficient monitor-and-test culture.” This combination is effective, he says, because of the checks and balances. Compliance monitors and tests the business units, internal audit monitors and tests both, “and the chief risk officer is apprised daily on what the testing is saying about the effectiveness of the policies and procedures.”

To effectively deal with compliance issues, James says, the Association of International Bank Auditors and Pace University’s Lubin School of Business now offer a six-month program leading to a new Certified Compliance and Regulatory Professional certificate. The program,” he says, “is designed to help hedge funds, asset managers, brokers, and dealers understand the more than 100 new regulations emanating from Dodd-Frank.”

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