In my remarks today, I want to consider various aspects of how reputational harm manifests itself in banks and begin a dialogue with you about how we might refresh our thinking about this category of risk. I will start with a description of some factors that can affect a bank's reputation, especially in the wake of the financial crisis. Next, I will talk about ways in which reputation matters, including how supervisors can use their unique ability to see inside the institutions that they examine to uncover some early indicators of reputational problems. I will then turn to other reasons why policymakers may want to think about reputation. One reason involves possible consequences regarding financial inclusion; that is, a customer's ability to have a relationship with his or her bank that puts them in the position to save, access credit in a sustainable way, and understand the nature of the financial transactions in which they participate. Reputation also may help or hinder a bank's ability to innovate, so I will introduce this topic next. Finally, I want to frame a discussion around the recent cybersecurity threats that banks are facing and place them in the context of reputational risk so that they too can be discussed constructively.
Of course, I preface these remarks with the admonition that these views are my own and may not be representative of those of the Federal Reserve Board.
The Financial Crisis and the Reputation of Financial Institutions
It has been more than five years since this country began experiencing a financial crisis that reverberated well beyond Wall Street. This crisis was unique, and many of its marks on individuals and communities remain. It was a crisis in which significant numbers of both subprime and prime mortgage defaults quickly spread across whole cities and regions until the impact was felt throughout the country. The devastation was magnified by waves of foreclosures, significant drops in house values, job losses, and, ultimately, significant reductions in household wealth, which have been responsible, in part, for the slow recovery we confront today.
The causes of the crisis and the subsequent devastation are myriad, but to large swaths of the American public who have experienced the devastation, the causes rest squarely on the shoulders of financial institutions, especially the largest institutions. Further, many Americans direct their anger at not only banks, but policymakers as well. Because the economy pulled back from the brink of depression only through a massive and unprecedented infusion of public dollars, American taxpayers feel that they were forced into a position of accepting that the government had to put a lot on the line to save the financial system from ruin. And many of those taxpayers are still unhappy about such a massive government intervention that seemed to aid banks that were not held to account, while distressed households were left to pay the price.2
Unfortunately, in the public's view, little has happened to restore their trust and confidence in financial institutions. Since the crisis, the public's views of banks have been informed — for better or worse — by their experiences and those of their families and neighbors, who may have lost their homes, their jobs, or their household wealth. Many attempted unsuccessfully to modify their underwater mortgages, even when they were current on their payments. Against this backdrop, the public's lack of trust and confidence has been magnified by, among other things, the Occupy Wall Street movement, payday loans, overdraft fees, rate-rigging settlements in London Interbank Offered Rate (LIBOR) cases, executive compensation and bonuses that seem to bear no relationship to performance or risk, failures in the foreclosure process, and a drumbeat of civil litigation.
In the Internet age, the impact of consumer distrust is amplified: anyone can easily, cheaply, and anonymously create, organize, and participate in a protest. Participants do not have to gather physically to make their action felt. A recent survey found that
- 60 percent of American adults use social media, such as Facebook or Twitter, and
- 66 percent of those social media users (39 percent of all American adults) have used social media to engage on civic and political issues, including by encouraging other people to take action on a political or social issue.3
Take, for example, the impact of the consumer backlash that erupted in late 2011 when one of the nation's largest banks attempted to charge a $5 monthly fee for its debit card. A California woman, frustrated with the bank's decision to impose the fee, created a Facebook event, dubbed "Bank Transfer Day," and invited her friends to join her in transferring their money from large banks to credit unions on that day. In the five weeks leading up to Bank Transfer Day, this Facebook event received extensive press coverage and resulted in billions of dollars in deposits reportedly shifting out of large banks. The bank targeted by the Facebook protest ultimately reversed itself and declined to assess the monthly fee.
How Reputational Risk May Be Relevant
Financial institutions of all sizes have shared in the fall-out — fairly or unfairly — from a general decline in their industry's reputation among the public. Moreover, the steady stream of litigation against financial institutions since the crisis has further harmed the reputations of specific firms among their customers.
Consider that in today's financial institution sector, a substantial portion of a bank's enterprise value comes from intangible assets such as brand recognition and customer loyalty that may not appear on the balance sheet but are nevertheless critical to the bank's success. Also consider that at the end of 2012, deposits at commercial banks reached a record $10 trillion. At the same time, the share of each deposit dollar that banks lent out hit a post-financial crisis low in the third quarter, which means that banks' net interest margins have fallen sharply. Across the industry, loan-to-deposit ratios are going down. In 2007, banks' aggregate loan-to-deposit ratio was 91 percent. This ratio currently stands at 70 percent. In such a context, achieving higher earnings is a challenge.
If bank profitability is going to improve in a context of low interest rates and higher compliance costs, lending income may remain low. Profits will need to come from elsewhere. One source of profits would be products that are not interest-rate dependent, but fee-dependent.
In other words, compressed net interest margins mean that many banks may look to new fee-generating products and trading activity to enhance profits. The pressure to generate enhanced profits through high fees is palpable, and banks may choose to move aggressively down these paths. But when a bank already suffers from a poor reputation — either deservedly or as a knock-on effect of broader discontent with the financial industry — it likely will face difficulties in introducing new fee-generating products or activities without inviting further criticism and damage to its reputation. So an evaluation of the effects of the new product or activity on the bank's reputation prior to launch is arguably necessary.
Reputational Risk and Supervision
The effects of the financial crisis, combined with the power of the Internet to broadly and quickly publicize information — whether factually accurate or not — should alert banks to how they are managing their reputations. And supervisors have a duty to see that all risks are fully understood, even those risks that, like reputational risk, are unquantifiable or have not fully emerged. I believe this is an area where supervision can add value. To the extent possible, supervision can unveil hidden loss exposures that may be building up through the accumulation of reputational risk elements. If we were better able to identify and monitor such free-floating risk, and in so doing, to push bank boards of directors and senior management to pay more attention to reputational risk, we could help reduce the underpricing of these risks.
Many have argued, and I think it's a compelling argument, that ineffective supervision and enforcement of existing laws and regulations contributed to the financial crisis. By tolerating reduced transparency of risk in balance sheets and in complex institutional portfolios, as well as arbitrage around capital requirements and other prudential measures, supervision may have encouraged the underpricing of risk. And the sudden correction of this underpricing of risk,4 in turn, accelerated the crisis. The crisis punished investors who accepted more risk than they thought they had taken on, it punished consumers who overleveraged themselves, it punished Americans who lost their jobs and homes, and it contributed to the decline of once-vibrant neighborhoods and towns.
To mitigate the chances of such a crisis occurring again, supervisors need to redouble their efforts toward promoting greater transparency of risks and early confrontation of potential loss exposures. We should view these efforts as a set of responsibilities for both banks and regulators that are aligned to assure the public and markets that risks can be fully understood and accurately estimated and priced.
In some ways, this perspective is not new territory for bank regulators. The Federal Reserve, for example, issued supervisory guidance in 1995 that identified the six primary risks that remain the focus of its supervisory program, and reputational risk is among them.5 Having said that, it is still a risk that both banks and supervisors should learn how to identify ex ante rather than ex post.6
More Articles
- Antony Blinken, Secretary of State: Building A More Resilient Information Environment
- Encountering the News From the British Library's Breaking the News Exhibition: Unsettling, But Exciting
- GAO, COVID-19: State [Department] Carried Out Historic Repatriation Effort but Should Strengthen Its Preparedness for Future Crises
- Brennan Center: One in Three Election Officials Report Feeling Unsafe Because of Their Job
- From Medicare: Protect Yourself - If Someone Contacts You to Buy or Sell a Vaccination Card, It's a Scam; Key Things to Know From the CDC
- The US Economy: Small Business Pulse Survey Updates by the US Census
- Even Though the Room Is Full, They Are “The Only One in the Room”; Eight Women Across 3 Centuries in Smithsonian Exhibit
- "Fed Listens", How Does Monetary Policy Affect Your Community? "Our goal is to keep inflation around 2 percent over time"
- MFA Boston Exhibition Explores Relationship Between Fashion and Gender Tracing a Century of Style That Dares to Break the Rules
- US Federal Trade Commission: Romance Scams Rank First On Total Reported Losses