Risk and Reward of Culture and Reputation

Hans-Kristian Bryn and Carl Sjostrom

Responding to external and uncontrollable events like natural disasters, pandemic and unpredictable political decisions has become a constant feature of running businesses. But calamities can just as well be home made. In a number of articles, we have considered how different risk and reward considerations can help to inform the choices facing decision makers. We now turn to the importance of “centring” the business by bringing culture and reputation more fully into the structure of the decision-making process.

Culture

Culture can be a nebulous concept and is a word that raises a red flag for many. It is therefore important to clarify how we define “culture” and to establish that we address it without trying to define what is good or bad. Culture should therefore in our context be taken to be the shared beliefs and accepted behaviours of the organisation – basically “what kind of place this is.”?

The concern that many have is that culture is an intangible issue, but the beliefs and behaviours that make up culture are, as we have discussed previously, expressions of the purpose, ownership and origins of the organisation, which in turn have a direct impact on strategy, actions and performance. Companies therefore need to understand how culture impacts risk parameters and what needs to be encouraged and discouraged in order to try to align the culture with the commercial intentions. This is important since it is reflected in the evaluation of how realistic the execution of the strategy is, which in turn is reflected in the valuation of the company.

The importance of culture has historically not been seen as a key component of risk management frameworks and improvement initiatives.?More recently, culture has become more central to how organisations think about risk, often due to failings that have root causes in people and their beliefs and behaviours.?For example, in financial services, conduct risk has been a key focus area for firms as well as regulators[1].?From a governance perspective, alignment of culture with purpose and strategy has become a key responsibility of the Board[2]. There is also increasing focus on how companies can measure and assess culture. As a consequence, the culture and how the assessment is made, has now also become a key risk topic for many Boards in non-financial services firms.??

From a reward perspective, organisations typically look at culture either from the risk minimisation angle, encouraging or countering cultural aspects with incentives, or by promoting desired cultural traits. Such promotions can, for example, be through benefits that reinforce green credentials or family friendly values, or financial rewards for team work or innovation.

The links created between culture and reward tend to be the result of initiatives where the company wishes to take a stance, which is a valid use of such structures since reward is most powerful as a signalling tool. However, if companies look beyond promoting positive attributes to reflecting on how all beliefs and behaviours held collectively work in favour or against the strategic direction chosen, reward can be used to more surgically address points of mis-match.

Since culture reflects who we are, organisations typically don’t want it to change. But when the company changes through growth or significant capital events, like a merger, altering the culture often becomes imperative for the transformed entity to survive. Companies therefore need to ensure that the strategy implementation is in line with a culture that make the results sustainable. The table below illustrates how what is measured for ongoing success can be complemented with measures that nudge such cultural alignment.

It is easy to say that cultural problems may occur but most organisations struggle to identify them from within, as shared beliefs and accepted behaviours evolve slowly over time. This means that the first warning for many is that the new strategy has unintended reputational consequences.

Reputation

If culture is about “what kind of place this is” then reputation is about “what kind of place do they think this is.”?In the context of this article, we look at reputation as the external decoding of the observed actions and behaviours of the company. The reputation may either support or contradict the image the organisation wants to project, but our key concern here is the accuracy of that perception in terms of how it matches reality. Reputation is a function of what organisations do, how it is explained through communications and in what way the signals are received, in particular how stakeholders interpret and trust these.?

If observers perceive something different then there is a distortion that can be expensive since the consequences of gaining a reputation that is either more positive or negative than what is deserved will tend to be more costly over the long-term than a more “accurate” perception. Given this classic coding-transmission-decoding chain, much of this so-called accuracy of perception relies on the clarity with which the company codes and transmits, whether through what they sell, how they manage the company or how they ?market themselves.

The reward debate usually focuses on the negative impact that compensation levels can have on the reputation of a company. Unless there is strong communication from the business that explains why the outcomes of salary setting, incentive design and pension policies should be accepted as fair in the eyes of different stakeholders, the reputational impact can be brutal. The length of today’s published remuneration policies and reports bear witness to how contentious this has become for shareholders, employees and lawmakers alike.

However, if we regard reputation as the external interpretation of a company’s culture, the ability of reward to help the alignment with strategy is also translatable here. The organisation may have an ambition or a reality of being a certain type of company but if it is perceived as something different, or if there is a possibility that this perception changes, the company should consider how reward can send a signal to executives and employees to counter this. Such signalling, which to some extent is also relevant for external stakeholders, should clarify what beliefs the organisation stands for, how actions and behaviours are expected to promote them and address anything that runs counter to this.?

Historically, risk management was focused on measuring the financial consequences of losses occurring due to causes of reputational failure, be that in terms of direct losses, remediation, fines, compensation claims etc.?However, with an increasing recognition of the importance of reputation as an intangible asset, more focus has been given to understanding reputational risk at an increasingly granular level. In the UK, the Financial Reporting Council (FRC) has incorporated reputation into its definition of Principal Risks as “A risk or combination of risks that can seriously affect the performance, future prospects or reputation of the entity. These should include those risks that would threaten its business model, future performance, solvency or liquidity.”?As a consequence, management and the Board need to consider both financial and reputational impact as part of their respective executive and oversight responsibilities.?

There is clearly a different set of impacts that we are seeking to capture when we consider reputational risk compared to financial risk.?Firstly, companies are considering less the immediate loss (say over a one-year time horizon) and more the longer-term impact, often crystallised as a drop in the share price, and/or demand, from which the business may not recover.?Secondly, the risk to the intangible asset of reputation can crystalise from how the reputational profile and external perception of the company changes. This is increasingly measured in terms of the traditional and social media trending. We therefore see more companies using AI based monitoring tools to capture media and social media mentions that are translated into changes to stakeholder priorities and reputational impact.?

Thirdly, capital allocation is a key determinant of corporate performance both in the short and longer term to ensure that funds are distributed to the opportunities that are most likely to generate the greatest value, having taken risk into account. Since reputation has consequences for the cost of capital as well as the effectiveness of capital allocation, reputational risk needs to be an integral part of this process as well.

In the capital allocation process, the value of any proposed business case should be assessed once a balanced view has been taken of the opportunity, the risks and of how to implement the decision to go ahead. As we have set out previously, many business cases are underweight in terms of the consideration of reputational impact.?This can be due to a combination of factors, chief among which are:

• Reputational impact is seen as more difficult to assess
• Reputational risk requires business case owners to liaise with multiple internal stakeholders and functions, such as Corporate Affairs, HR and Risk Management
• The available data (both sources and quality) is often perceived as being more qualitative, hence the temptation can be to ignore rather than incorporate the reputational risk in the analysis
• The culture of many organisations is closely linked to being successful in obtaining capex.?Hence, if a business case is border-line positive, having taken into account the key financial impacts, overlaying the reputational impacts can easily make the business case a no-go decision

A well-articulated risk appetite statement, which is illustrated below, is a decision-making tool, guide rails for management and a monitoring mechanism for the Board.?It is not however, a straitjacket designed to prevent management from running the business.?The risk appetite statement supports both Board and management in making better capital allocation decisions based on business cases that reflect both financial and reputational risks.?It is also an effective mechanism both from an oversight and decision-making perspective as set out in the diagram below.

?In our experience, the risk appetite statement is often focused on the preference (appetite) for taking financial risk individually or in aggregate irrespective of whether the organisation is risk averse, neutral or tolerant for the risk in question.?We see fewer examples of organisations using the framework above to articulate explicitly their risk appetite in relation to reputational risk – even for those risks where the reputational impact is more significant than the financial impact.?Outside financial services, there are therefore few organisations that are explicit about the types and amount of reputational risk they are willing to accept.?In addition, many organisations appear to have a ‘cultural blind spot’ in terms of recognising how they are encouraging and rewarding success in obtaining capex.???

Conclusion

We have in this article made the case that culture and reputation are not adequately reflected in many organisations’ planning and decision-making.?If a company and its strategy are changing then it is likely that culture will have to as well. This will have a significant impact on the success of the strategy implementation, reputation and company valuation - and therefore the sustainability of long-term performance.

However, with a dispassionate view of culture and reputation, an organisation can drive actions and behaviours in support of its strategy by bringing these cultural variables into the decision-making process.

By supporting that process with a reputational risk appetite and consideration of cultural risk, the company can achieve better insight on both risks and opportunities. This can then be underpinned by encouraging the desired actions and behaviours through a reward approach that aligns to the evolving strategy and the desire to strengthen the culture and reputational capital.?

This article was published in the March 2023 issue (343) of Governance (www.governance.co.uk). Published with permission.

[1] e.g. Financial Conduct Authority, ‘Five conduct questions programme’, 13 February 2023, FCA.gov.uk.

[2] e.g. The Culture Report, ′Corporate culture and the role of boards’,?July 2016, Financial Reporting Council; and Financial Reporting Council, ‘Creating positive culture: opportunities and challenges’, December 2021, Financial Reporting Council.