Why Reputational Risk is excluded from Operational Risk scope?

Basel committee defined operational risk – in Basel 2 & Basel III (Finalizing post-crisis reforms) – as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. The definition includes legal risk but excludes strategic and reputational risks”.

A summarized elaboration of the definition, operational risk is about losses, which take place due the following:

• Poor implementation of process: For example, a process that is lack of supervisory review and staff may commit internal frauds incidents easily.
• People: For instance, Due to miscommunication/misunderstanding client’s request, a staff duplicates a transfer.
• System: For example, the system does not calculate the credited interest rate – if clients are subscribed to certified of deposits – correctly due to software failure (i.e. bugs, etc.)
• Or external events: For instance, nature disasters, terrorism, etc..

On the other hand, Basel defined reputational risk as “the risk arising from negative perception on the part of customers, counterparties, shareholders, investors, debt-holders, market analysts, other relevant parties or regulators that can adversely affect a bank’s ability to maintain existing, or establish new, business relationships and continued access to sources of funding (e.g. through the interbank or securitization markets”

According to Operational Risk Manager (ORM) handbook, which is published by Professional Risk Manager International Association (PRMIA) indicated the following:

• Initially, the main aim of defining operational risk is to set boundaries and to differentiate operational risk capital from other risks capital charges (i.e. Market risk, Credit Risk, etc.), as it is necessary to avoid double counting/allocation of capital.
• Since, the definition is capital oriented, According to PRMIA, Basel could not quantify reputational risk and could not find a standardized measurement to calculate capital for reputational risk. Therefore, Basel excluded reputational risk from operational risk scope.

Do you agree with underlined statement ???

According to a study (author: Andrea Spaltro, 2018) which was conducted to identify how to assess reputational risk. The study indicated that there are several approaches to measure reputation risk:

Qualitative approach:

• Survey-based methods (i.e. market research, etc..)
• Or there are some agencies which evaluate reputational risk. (they are similar to credit rating.) i.e. , Rep Track, Reputation Quotient & Reputation Index).
• However, the main shortcoming of such agencies that they use subjective measurements, which are not reliable.

Quantitative approach:

o??To measure the reputational risk from different aspects:

• Organizational approach: to consider reputation as intangible asset.
• Accounting approach: to check the differences between market value of company’s shares and its booking value.
• Financial approach: to evaluate equity securities.
• & Marketing approach: to measure company’s brand value

Still weakness points, which are defined, for four dimensions above can be summarized as follows:

• Subjectivity of the used measurement. (For first 3 approaches).
• There are some aspects cannot be measured. How we would measure customer satisfaction, customer loyalty, customer relationship management, etc.

Conclusion:

According to the presented information above, Basel excluded reputational risk from operational risk scope due to the following:

• There are no standardized measures to calculate reputational risk capital charge.
• Even if there are tools to measure it, they are subjective.
• Also, it is difficult to assess reputation risk, as each company, organization and/or financial institution manage it differently.

Furthermore, reputational risk must not be disregarded by companies and financial institution. Indeed, it should be included in company’s strategy, business model and daily operation scope.

Also, companies and financial institution should mitigate reputational risk by allocating sufficient capital. Although there is “no one size fits all” method to calculate reputational risk, but it is essential.

Board of directors & Senior management should consider reputational risk in their agendas and to be considered in the following:

• Value, Mission statement, strategy, objective, and business model of companies and banks.
• In corporate & risk governances.
• Risk capacity, Risk appetite, corporate & risk culture.
• To be discussed in different committees and/or to create a specified committee that is related to reputational risk only.
• To be included in 3 Line of defense plans.
• To be a central issue which should be concentrated by all stakeholders in the company.

So, what do you think? I would like to see your contribution, to input your comments and to conduct fruitful discussion ??.