Sarah Bloom Raskin: Reflections on reputation and its consequences
Speech by Ms Sarah Bloom Raskin, Member of the Board of Governors of the Federal
Reserve System, at the 2013 Banking Outlook Conference, Federal Reserve Bank of
Atlanta, Atlanta, Georgia, 28 February 2013.
* * *
Good afternoon. I want to thank the Federal Reserve Bank of Atlanta for inviting me to join
you for today's 2013 banking outlook discussion. There are a number of interesting and very
relevant topics on your agenda, most of which are rightly focused on the financial and
regulatory environment. I would like to share some thoughts this afternoon on a broader
topic, however, that may be due for a refreshed look: the relevance of a bank's reputation.
Let's start in an elementary way in constructing a concept of reputation: We know that
reputation is not entirely a moral trait. We understand that there is a distinction between
character and reputation. When we say that someone shows good character, we are usually
referring to something at the core of their being or personality. On the other hand, when we
refer to a person's reputation, we recognize that reputation is our perception of the person,
that it is externally derived and not necessarily intrinsic to that individual. In other words, we
understand that a person may not have complete control over the perception that has been
created. Reputation, through no fault of one's own, can be tarnished. In the same way, one's
reputation can be golden, even though nothing was done to earn it. But like the notion of
character, reputation can be earned and it can be a type of stored value for when challenges
to one's own reputation come later.
Now let's bring this distinction into the context of banks: Many bankers have a sterling
character, and they operate financial institutions with sterling reputations that reflect that
basic character. At the same time, there are bankers who, regardless of their personal
character, manage financial institutions with reputations that have been tarnished. Their
banks' reputations could have been tarnished by almost anything, but likely most tarnish is
attributable to the subprime mortgage meltdown and the ensuing financial crisis that cost the
economy trillions of dollars; left millions of Americans bankrupted, jobless, underemployed,
or homeless; triggered massive litigation; and shook the confidence of our nation to the core.
Many of the darkest manifestations of the financial crisis have finally begun to diminish: the
boarded-up homes with overgrown lawns, the half-built skyscrapers, the "We Buy Houses
Cheap" signs planted at exit ramps, the eviction notices nailed to front doors. But even as the
economy comes back to life, our memory of these events is still sharp and the reputational
damage suffered by U.S. financial institutions during the crisis endures. To be blunt, a lot of
people have negative feelings about banks, which they distrust and blame for the huge
infusions of taxpayer money into the financial system that were deemed necessary during
the crisis.
These reputational consequences - whether justified or not - are to be expected.
Sociologists and economists have long remarked upon the central role that social trust plays
in healthy markets. Market transactions depend on a whole series of assumptions that
people must be able to rely on, including the soundness of money, the enforceability of
contracts, the good will of their partners, the integrity of the legal system, and the common
meanings of language. Social trust is the glue that holds markets and societies together. In
the context of banking, social trust and reputation are related concepts.
Banks themselves - in crisis or not - are particularly vulnerable to reputational
consequences because of their public role. The principal social value of financial institutions
is their ability to facilitate the efficient deployment of funds held by investors (and entities that
pool these funds) to productive uses.1 This value is maximized when the cost to the entity
putting capital to work is close to the price demanded by the entity that seeks a return on its
investment. In traditional banking, this means that financial intermediation occurs most
effectively when the interest rate charged for use of funds in lending is close to the interest
rate paid for deposits. As the difference between the two grows (which would be attributable
to amounts extracted by intermediaries as compensation for essential intermediation), the
costs of borrowing for the purposes of creating productive projects become higher than they
should be, with arguably negative reputational consequences.
Given these particular reputational dimensions associated with financial institutions, might
financial regulators have an interest in considering reputational harms analytically? Could
there be benefits to understanding the ways that an individual financial institution's reputation
- or that of the financial industry as a whole - might have particular effects on, for example,
safety and soundness, financial inclusion, or financial innovation?
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,
raterigging 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
So, while reputational risk is not a new concept by any means, it is an area that is ripe for
additional work. For example, the enterprise risk management framework of the Committee
of Sponsoring Organizations of the Treadway Commission - the so-called "COSO standard"
- does not address reputational risk. Likewise, the Basel capital frameworks exclude
reputational risks from regulatory capital requirements.7
Accordingly, the current approach to managing reputational risk is largely reactive rather than
proactive. Banks and examiners tend to focus their energies on handling the threats to their
reputations that have already surfaced. This is not risk management; it is crisis management
- a reactive approach aimed at limiting the damage. Instead, we should think about a
supervisory approach that incentivizes bank managers to sufficiently contemplate, quantify if
necessary, and control the factors that affect the level of such risks before they fully emerge
in an unmitigated form.
The way that the Federal Reserve supervises banking organizations may help identify risks
sooner. For all banking organizations, the supervisory program here does not simply rely on
an annual onsite examination. The Federal Reserve supplements its regular examination
activities with a program of continuous monitoring between examinations. One of the key
objectives of this program is to identify emerging risks and communicate with other
regulators and the banks an updated risk assessment and supervisory strategy based on
these risks.
When we contemplate a supervisory approach that illuminates reputational risk, we might be
able to more fully uncover the interconnection of risks that certain activities could impose on
investors, creditors, counterparties, and taxpayers. In this approach, we would first and
foremost need to encourage banks to assess the potential riskiness of particular operations,
investments, products, and decisions to their reputations and, ultimately, to their enterprise
value. As supervisors, one objective as we work with financial institutions to extract such
information would be to try to develop ways of measuring the value of the risks that banks
shift onto the financial safety net.
Reputation and financial inclusion
There is also a relationship between reputation and financial inclusion, by which I mean the
extent to which consumers can participate in a financial marketplace that consists of
competitive providers of credit, savings vehicles, and sources of enabling financial
information. As policymakers, we must address the perceived trustworthiness of those
financial institutions that interact with the public and move the millions of Americans lingering
in the margins of the financial marketplace into relationships that provide them with
sustainable access to banking and credit, an understanding of how mortgages and credit
work, and an understanding of how to create savings.
Data from the Federal Reserve's Survey of Consumer Finances and the Federal Deposit
Insurance Corporation's survey of the unbanked and underbanked show that the percentage
of families earning $15,000 per year or less who reported that they have no bank account
has been increasing steadily for the past five years, resulting in more than 28 percent of
these families being unbanked as of 2011.8 Families slightly further up the income distribution
scale, earning between $15,000 and $30,000 per year, are also financially marginalized:
12 percent reported being unbanked and almost 26 percent reported being underbanked in
2011.9
There are several potential reasons for these impediments to inclusion. When we examine
barriers that individual consumers face in becoming financially included, we uncover
trustworthiness and reputation. A Federal Reserve analysis of the most recent Survey of
Consumer Finances suggests that the primary reason individuals do not have a transaction
account is a simple dislike of dealing with financial institutions.10 If that dislike emanates from
the reputation of the particular bank, or the reputation of the banking industry as a whole,
policymakers and financial institutions will not be able to enhance financial inclusion without
addressing the reputational context.
Reputation and innovation
I'd like to imagine how the public's sense of well-being might be enhanced by their
interactions with financial institutions. If we paid attention to the experiences of consumers as
they interact with various segments of the financial marketplace, what could we learn? If we
see rigidities or imperfections in that interactive experience, what innovation might we
imagine that would not only reduce reputational risk but create something new and
potentially advantageous?
Technological innovation was the subject of a recent award ceremony in San Francisco. The
winners were companies with names like SoundCloud, GitHub, MakerBot, Techmeme, and
Snapchat, all of which presumably do amazing things, although I don't understand exactly
what.11 But, evidently, the real buzz at the ceremony was over something much more
mundane that I for one have no problem understanding. That buzz was around a pedestrian
item - a new and improved coffee cup lid.12 This lid, called FoamAroma, reportedly provides
exactly the right set of openings to maximize aroma and recyclability, while minimizing the
effects of coffee spurting out too fast. The point here is that the innovator noticed something
simple that others had not: many coffee shop employees don't drink their coffee from cups
with plastic lids like their customers do, so there was a market need that had not been
recognized and then addressed.
Here I am not just talking about the mixed miracle of mobile banking and mobile payments or
being able to take a picture of a check with a smart phone and it appearing in my checking
account. That's a topic that is amazing in its own right and worthy of a separate speech. I am
talking about encouraging banks to pay attention to the banking experiences of their
customers and finding process improvements or service elements that may lead to
something seemingly mundane but valuable nonetheless.
Some innovators see reputation itself as not just something to be managed, but as a product
in and of itself. With buyers and sellers repeatedly and constantly interacting on the Internet,
there are "reputation trails" that are being created that, when compiled, give an alternative
set of markers about how trustworthy a particular buyer or seller may be. These reputation
trails - gathered when you evaluate a product you've bought online or when you deliver the
product that you've promised - create a picture of trust that some have argued has value that
can be shaped.13
Reputational risks and cybersecurity
Perhaps reputation will one day transform commerce. But in the meantime, I would like to
mention one set of reputational issues that the banking industry is confronting as we speak.
As is the case for reputation trails, it too involves the Internet, but this use of the Internet is
not being done in the spirit of cooperation and enhancement of public trust. This set of
reputational issues comes in response to the recent substantial increase in cyberattacks, all
of which have the potential to undermine the fundamental trust that the public puts into
financial institutions.
Cyberattacks on banks are occurring with increasing frequency, and concerted cooperative
work between government and financial institutions is underway. Customers are increasingly
being affected by the cybersecurity threats that banks face. Recently, distributed
denial-ofservice attacks have caused temporary disruptions of some web services. In September, the
websites of several large banks were rendered inaccessible for several hours from attacks
now attributed to possible foreign state-sponsored hackers. One of the greatest threats
facing not just banks but many businesses and government agencies is hacking - and the
possible theft of proprietary data and personal information about customers.
This cybersecurity threat is increasing at a time when more and more bank customers
depend on electronic and mobile banking. Workers are using their own laptops and smart
phones or working remotely from home computers, and this increases the entry points to the
systems that need to be protected. In addition, customers and vendors are linking their
systems, enhancing efficiency, but also creating more opportunities for potential intrusions.
But even beyond the potential theft of data and disruption of service, cyberattacks can
represent significant reputational risk because they have the potential to create
dissatisfaction among many customers or, even more chilling, total loss of consumer
confidence.
Cooperative work between government and industry is underway. Through the Department
of the Treasury, many of the affected institutions have requested and received technical
assistance from the Department of Homeland Security, which has been helpful in mitigating
the attacks. Some institutions are researching new technologies for defense against
cyberattacks through their Internet service providers or security vendors, and others are
reviewing their incident response processes to better manage recovery time and
communications among information technology, employees, vendors, media, and customers.
The Financial and Banking Information Infrastructure Committee, the Financial Services
Information Sharing and Analysis Center, and the Financial Services Sector Coordinating
Council are serving as the forum through which the financial services sector shares important
information and develops critical infrastructure protection policies. Through their coordination,
affected institutions and law enforcement agencies can share threat information and
mitigation techniques.
In addition, a recent Executive Order issued by the President represents a continued
commitment to enhancing the security and resiliency of the nation's critical infrastructure to
meet future threats.14
Conclusion
In closing, these have been some of my reflections on reputation as it applies to the business
of banks. The concept of trust is relevant to how bankers engage in a business that is of
benefit to the public and provides meaningful innovation to the core function of financial
intermediation, as well as to how we as supervisors can engage in a process of observation
that is forward-looking and of benefit to both the public and the institutions that we regulate.
Thank you for your attention today. I look forward to taking your questions.