The Conundrum of Reputational Risk

The lawsuit filed against Ernst & Young for their auditing of Lehman Brothers and their acceptance of the now notorious “Repo 105” manoeuvre that Lehman used to hide their leverage in their quarterly filing and thereby mislead investors as to the true state of their finances has revealed that some of  E&Y’s auditors were concerned and brought up the issue of “reputational risk”.

Reputational risk is growing more fashionable as a concept among strategy thinkers but rarely has much traction among the board or within the C-Suite where a fight between quick profit and long term reputation is usually a round one knockout to profit. Reputational risk is a function that considers the risk of reputation damage as one of the criteria in decision making. The question goes: “what will people think about us or our products if we make this decision, it might be profitable but long term will we lose out as our reputation suffers for being dishonest, etc.”

Strategists tend to worry about the long term rather than the immediate and of the long terms pattern to discern, reputation is one of the most important. Repo 105 was the method used by Lehman Bros to avert the short term reputational risk of seeming too leveraged (ie having too much debt) which might have led to confidence problems in the market. Whilst Ernst and Young  felt that the practice did not breach GAAP rules, it was interesting that no US law firm agreed with them and in the end of the day, Lehman had to find a UK based law firm to sanction the practice.

Financial services companies do worry a lot about reputation but they tend to do so over the short term and within their financial constituency. Despite the crash of 2008, it is still clear that reputational risk still plays a small part in their decision matrix. Witness the witlessness of the foreclosure process which they saw as mechanical and did not consider the potential for reputation fallout. Goldman Sachs likewise have moved their reputation from being highly client-centric to being highly Goldman orientated. As one author put it succinctly, their clients are no more than counter-parties in the deal.

The problem with reputation managers is that they rarely can put their money where their mouth is. The deal is here and the reputation fallout is a long way away; certainly beyond the next bonus round. Investors put a lot more store by reputation as it is a good measure of future prospects and is a true measure of what the market thinks. The share prices of companies like Google and Apple relfect the high reputation of those companies. By a similar measure the fall of Yahoo’s stock price reflects a reputation worry in the market. A worry that asks where are they going, what do they stand for and why should I invest?