About Me

My Photo
Reputability LLP are pioneers and leaders in the field of reputational risk. We help business leaders to find the widespread but hidden behavioural risks and organisational risks that regularly cause reputational disasters. Here are our thoughts, and the thoughts of our guest bloggers, on some recent stories which have captured our attention. We are always interested to know what you think too.

Wednesday, 16 April 2014

Imminent FRC Rulings on Behavioural and Organisational Risks

The banking crisis probably reflects the largest ever failure of risk management and internal control by boards, risk managers, internal auditors and regulators.  It was system-wide and its root causes remain largely outside risk management.

Risk management failed because of a major gap in the science of risk management, first identified in 2011, in 'Roads to Ruin' the Cass Business School report for Airmic.   Two of the four authors are partners in  Reputability.

The report identified and classified a series of previously unrecognised risks from individual and collective human behaviour at all levels of organisations, from the bottom to the very top including boards.  We now call these risks 'behavioural' and 'organisational' risks.

Our own report, 'Deconstructing failure - Insights for boards' subsequently extended the research into the role of boards in corporate failure.  The findings can be summarised in the bar chart below which shows the frequency with which we identified various root causes across 41 case studies.

Source: 'Deconstructing failure - Insights for boards'. © Reputability 2013

Last November, we reported that the Financial Reporting Council is tackling this dangerous but under-recognised family of risks head-on.  You can read the background here.

The FRC's timetable is now becoming clear.  As a result, it is now a priority for boards to gain a systematic understanding of behavioural and organisational risks.

As we explained last November the FRC has two regulatory actions in the pipeline.

The first is the ‘Draft Guidance on the Strategic Report’.  A revision to the Companies Act 2006 requires boards to disclose, in the Annual Report, their company's ‘Principal Risks’.  The FRC's draft guidance on how to do this states:

"Principal risks should be disclosed and described irrespective of how they are classified or whether they result from strategic decisions, operations, organisation or behaviour, or from external factors over which the board may have little or no direct control." (underlining added)
Many of the Principal Risks to a company have their origins in the way its people, at all levels, behave individually and in the context of the organisation in which they work, though these origins often remain unrecognised until it is too late.  Boards cannot fulfil this duty without an adequate understanding of behavioural and organisational risks.

This guidance, which seems set to be issued in September, is expected to apply to accounting periods beginning on or after 1 October 2014.

The second is the FRC’s ‘Draft Guidance on Risk Management, Internal Control and the Going Concern Basis of Accounting’. This revises the old so-called ‘Turnbull’ Guidance and implements the Sharman Report on the ‘going concern’ basis of accounting.

Laced with dozens of practical questions for boards to ask themselves about behavioural and organisational risks, the draft Guidance on Risk Management is designed to help boards oversee the practicalities of managing such risks below them and to recognise the issues that surround them.  Here too, boards cannot fulfil their duties without an adequate understanding of behavioural and organisational risks.

This guidance too seems set to be issued in September, and is expected to apply to accounting periods beginning on or after 1 October 2014.

So what needs to be done?  The first requirement is for boards to gain adequate knowledge to understand and supervise these newly recognised risks.  The shape of the solution comes from the Corporate Governance Code, which requires boards regularly to ‘update and refresh their skills and knowledge’.   

The first step is therefore for Chairmen and Company Secretaries to commission tailored board education about behavioural and organisational risks and their relationship with reputational damage.  Everything else flows from that.

Anthony Fitzsimmons
Reputability LLP

Tuesday, 8 April 2014

PR - How not to improve your Reputation!

The success of the PR industry has recently been measured, and some surprising findings have emerged.

YouGov, who carried out the research found that the PR industry in the UK is forecast to be worth £9.62 billion, that's 28% more than in 2011, when the research was last carried out. There are now 62,000 employees in the industry.

YouGov also reported that 'Overall, PR professionals are confident of continuing growth in revenue and headcount'.

It is all the more surprising, perhaps, to note that the incidence and scale of corporate crises has continued undiminished over this PR golden age. Could it be that there is little correlation between an increased spend on communications and a reduction in business catastrophes? Could it be that the money that is being pumped into Public Relations is a waste of time and resources? Is it that professional communicators cannot prevent crises? Perhaps they miss the warning signs altogether? Or are they aware of the behavioural and organisational complexities which underpin crises, but are powerless to influence them?

Reputability's research, 'Deconstructing failure - Insights for boards', demonstrates how often the root cause of most reputation-damaging activity stems from the organisation's board and, to date, few PR professionals are represented here. Equally worrying is the fact that most Risk Managers are also too junior to have board positions. The combined absence of these two key functions contributes to the information 'glass ceiling' where boards simply miss out on knowing what is actually happening on a day to day basis in their companies.

My own view about the growth and buoyancy of Public Relations is that the greatest impact made in recent times has been as a large contributor to the excellent marketing seen in most organisations today. But even this can be seen as a double-edged sword. In fact, the very success of PR and marketing can raise customer expectations to such a level that when the delivery of the product or service proves to be distinctly underwhelming there is a consequent rise in customer complaints and a massive dent in corporate reputation.

PR can never be a substitute for sound policy-making and good governance. Those companies which seek to exclude communications professionals from decision-making, and view the PR function merely as a convenient mechanism for glossing the corporate reputation are likely to receive a very rude awakening.

Jane Howard FCIPR
Reputability LLP

Friday, 28 March 2014

Big bonuses lead to poorer performance, says new research

Groundbreaking new research, based on the study of hundreds of firms over almost 15 years, has challenged the widely held belief that pay packages including large bonuses translate into better performance and enhanced shareholder returns.

Almost ten years ago, Dan Ariely and colleagues reported some unexpected findings. Big bonuses produced worse performance. As the authors concluded, in their report for the Reserve Bank of Boston, “Our results challenge the assumption that increases in incentives necessarily lead to improvements in Performance”.

Commenting on the findings in 2010, we questioned whether these results, obtained from experiments on poor Indian villagers and broke MIT students, would translate to real life.

New research has answered that question “Yes” at least as regards the most generously paid business leaders.

Researchers Cooper, Gulen and Rau, respectively at the Universities of Utah, Purdue and Cambridge (England) took data on CEO earnings and corporate performance for all NYSE, AMEX and NASDAQ companies from 1994 to 2011. They looked for relationships between pay and performance.

The disparity of company types and sizes meant that some adjustments were needed to make meaningful comparisons, so they measured what I will call generosity of pay after adjusting for the company size and the industry type.

The results are stark. For the top 10% of CEOs by generosity of pay relative to their peers, who typically receive more than 80% of their pay in incentives for performance, CEOs earned negative returns of about 5% over one year and 9% over three years, again relative to their peers. To put values on these percentages, $21million of extra generosity in CEO pay translated into a typical annual loss of $1.4billion in stock market valuation. These CEOs also led their businesses to a fall in Return on Assets.

The researchers dug deep for correlations between different elements of CEO pay and the effect on the stock market valuation. They found that for generously-paid CEOs, incentive pay was closely - and negatively - correlated with stock market valuation and ROA, with stock options being the key predictor. Fixed pay was not found to be a predictor of stock price rises and falls.

The team went on to investigate various theories. They began by identifying “over-confident” CEOs which they defined as those who retained un-exercised but exercisable in-the-money stock options.

There was evidence that CEOs with the most generous pay are typically “overconfident”, at least by this definition, and are more frequently involved in acquisitions than their less confident peers. It is a dismal truth that acquisitions are an exceptionally good incinerator of shareholder value for the acquiring company. As Michael Porter of the Harvard Business School put it years ago:
“The weight of research evidence indicates that the majority of corporately sponsored acquisitions, alliances, new ventures and business re-definitions fail to create value.”
Markets understand this: they react more negatively to mergers announced by highly paid CEOs.
The researchers eventually settled on the suggestion that overconfident CEOs accept large amounts of incentive pay and then try to realise the incentives by embarking on value-destroying activities that reduce future firm performance.

This may well be the case but there are other possible explanations. It is not improbable that many of these ‘overconfident’ CEOs were also dominant. ‘Roads to Ruin’, the Cass Business School report for Airmic and Reputability’s follow-up study ‘Deconstructing failure found that the behaviour of dominant CEOs was a regular cause of severe trouble. An important mechanism, amongst others, is that a dominant CEO’s dominant behaviour can easily make the firm dysfunctional, leaving its leaders unknowingly operating in the dark as regards important information and blind to alternative views that may be better than their own.

The lesson for risk professionals and remuneration committees is however simple. Employing a CEO who demands a very generous pay package can be dangerous to shareholders’ wealth, especially if incentives such as stock options form a large proportion of pay and even more so if he has a history of not exercising exercisable in-the-money options.  Those risks need to be identified and actively managed.

Anthony Fitzsimmons
Reputability LLP

Tuesday, 18 March 2014

Pay Contests Are About Status, Not Talent

We are delighted to welcome a Guest Blog from Margaret Heffernan, author of 'A Bigger Prize' and 'Wilful Blindness'

To get good people, you must pay competitive salaries. That's the argument of boards and compensation committees across the company. But it isn't true.

Charles Munger, vice chairman of Berkshire Hathaway and the business partner of Warren Buffett, has argued just the opposite. "People should take way less than they're worth when they're favoured by life," he says, further arguing that when you have risen high enough, you have a "moral duty to be underpaid - not to get all you can, but to actually be underpaid."

The board of Barclays, the Co-op and companies across the country should take note. The competition over pay has nothing to do with talent.

By demonstration, Munger pointed out that the CEO of Costco - the second largest retailer in the U.S. - quite radically underpaid its CEO, when compared to the pay of the CEOs of Walmart, Home Depot and Target. Munger similarly argues that company directors - typically people who are already successful - should not expect high pay for their service. And it's striking that Berkshire Hathaway itself pays its directors $900 for each meeting attended in person and just $300 for those who simply call in.

Munger is very clear that the fate of the company and its leadership should be tightly coupled. Romans, he argued, had to stand under the bridges they built as the scaffolding was being removed. Similarly, no one should build a company and be able to walk away, their fortune intact regardless of what happened next.

The old argument that pay must be competitive implies that, in a global market place for talent, you can't get great people without high pay. But Munger demonstrates what we all know: that this isn't true. In fact, the opposite is true: if you expect people to work for money, then that's all they're working for. And that is never good enough.

We know this. Euan Sutherland as much as confessed it when he complained that details of his pay were leaked. Why would he mind the leak if he weren't implicitly ashamed that he flourished even as the Co-op struggled? The competition for high pay isn't about a market for talent; it's about a contest for status and importance: my pay's bigger than your pay. That's why transparency has made pay more problematic than ever; accepting less than your peers looks like failure in the business pecking order.

Buffett and Munger are quite fond of understatement and they both clearly enjoy an absence of flash. They're secure in their success and confident enough of their own talent that they don't need stratospheric pay packets to prove it. Mike Darrington, the former boss of Greggs has a similar style. His pay was modest compared to his peers and he's been a consistent critic of lavish pay. They all call the bluff of compensation committees too weak and often themselves too greedy to say 'no'.

Let's call this what it is - a contest for status - and give up pretending it has anything to do with business.

© Margaret Heffernan 2014

The views expressed in this blog are the views of the author and not necessarily the views of Reputability.  www.reputability.co.uk

Friday, 24 January 2014

Bankers’ Bonuses - solving the risk conundrum

The reputation of the banking industry has been battered harder, and for longer than any other industry in the last 5 years. For many, the root cause has been the bonus culture which produced perverse incentives and very high levels of pay.

The advent of the bonus culture can be traced back to the "Big Bang” in 1986, which reformed the way the stock exchange worked and which allowed the banks to buy the member firms.

Originally bonuses looked like a sensible way of handling the very volatile revenues in stock brokers. They allowed the employees of stock brokers to participate in the years when revenue was high, but kept salaries and fixed overheads down for the lean years. Individual success could be rewarded by a discretionary bonus paid by the partners, but everyone got something in the good years, but equally, very little in the bad years.

Post "Big Bang” the world changed, not simply the nature of the parent bank’s business, but the risks it faced. Gone were the small unlimited partnerships where the partners had joint and several liability for all the firm’s debts. Under the old rules, the risk taking allowed or even countenanced by partnerships with limited financial resources was always going to be very modest. But these partnerships were now swallowed up by merchant banks and in due course they in turn were swallowed by the bigger clearing banks and big international banks. Competition became intense; hardly anybody made any money out of equity broking, so they diversified into new areas, which developed in the wake of the City reforms in the “Big Bang”. Big banks began to throw capital and funding at their investment banking subsidiaries in an effort to squeeze out the competition. And the pell-mell expansion in the decade after the “Big Bang” needed a massive expansion of personnel, which drove up salaries and bonuses.

The scene was now set for the bonus culture to take off. New rich parents allowed individuals to settle into a style of behaviour which maximised their personal income. Increasingly employees began to appreciate that for the risks which they took on, it was a case of heads I win a big bonus, tails the bank picks up the loss. But this style of behaviour involved the parent bank’s reputation in an unexpected way. Not only did the parent supply capital to its investment banking subsidiaries, but they provided cheap funding to oil the wheels. This cheap funding came from the parent bank which on-lent funds raised in the wholesale money markets, at fine rates where the parent bank had a well-established market reputation.

Investment banking subsidiaries could make good use of abundant cheap money whilst things went well, but in 2008 question marks began to emerge about the quality and value of the assets held in the investment banking subsidiaries. This led to a massive haemorrhage of liquidity from wholesale money markets, which not only threatened the supply of cheap funding to their investment banking subsidiaries, but the funding of the parent itself. Without help from the government, disaster beckoned.

Now the banks are under pressure to undo the bonus culture, but to date there is little evidence that bonuses have really been cut back. Are the banks in denial? Don’t they understand how much they are loathed for bringing the country to its knees?

But it would be a brave bank which radically reduced its bonus structure today. The haemorrhage of staff to banks which were not doing the same thing would be evident within a year. The investment banking business may not be making as much as it was pre-2008, but it would still be a big chunk of profits to leave at risk. If all banks were to take action together, and at the same time, it might be possible to cure the bonus cultural problem. Is it conceivable that all the world’s investment banks would agree to take action at the same time? Probably not; but there are signs of a belated recognition of the damage of recent years. Things are changing in ways that should help reduce bank risks if not public outrage.

Following Goldman Sach's example would require top management to hold up to 75% of bonuses as share awards until they leave the company, with many senior staff similarly obliged to hold 25% of any bonus award as shares.

HSBC has followed Goldman’s example, requiring bonus shares to be held to retirement with a clawback arrangement. UBS not only has a bonus/malus system but pays most senior bonuses in bonds and shares and requires Executive Board members to hold at least 350,000 shares and the CEO to hold 500,000. At about twenty francs apiece this means holding from 7 to 10 million francs in UBS shares. And it has just emerged that Credit Suisse now pays part of bonuses in "bail-in-able” bonds that have to be held for 3 years and can be converted to equity or wiped out in the case of trouble.

Progress towards reforming the bonus system is late and slow, but there are signs that the banks are responding. Putting years between the award and the realisation of the bonus helps weaken the perverse incentives arising from a ‘heads I win tails you lose’ approach to risk taking. Bad consequences have time to arrive. It could to lead to regulators seeing such banks as less risky.

Paying bonuses in shares puts bank leaders in the same currency as shareholders, who have still not recovered from the terrible beating of recent years.  Paying bonuses in bonds that 'bail in' is even better.  So may be be the leviathans are starting to get it, and more importantly are doing something about it.  In a way that probably reduces risk.
John Tyce
Reputability LLP

Thursday, 23 January 2014

Behave yourself; Someone is always watching!

The media spotlight focussed on President 'Malchance' (or Hollande as we Brits know him) illustrates perfectly how individuals and their organisations become overwhelmed by unwelcome attention as soon as a story captures the public's interest.

What started as a report of a personal peccadillo soon gained traction as the beleagured President made a desperate attempt at his news conference to focus interest on his economic policies. This worked with the generally compliant French broadsheets for about a day. Since then, journalists have had a field day, using the ongoing saga as a basis for 'breaking news', 'in-depth features and opinion articles ranging from an examination of the cultural differences between the French and British media to more lurid pieces on the libidos of powerful men. Photographers and cartoonists have joined in with relish!

This damaging episode illustrates a truth, more relevant now than ever before, which is that nothing, but nothing, is private. We may have laws that purport to protect privacy, but anyone can publish information. This information may or may not be accurate, but if redress is to be had, it often comes after the event, giving mischief-makers another opportunity to rake over the embers of the original story.

This reality of modern life is as true for business as it is for individuals. If the media get scent of a story, then their investigative processes are just the same. In our era of complete accessability there is now no part of business life that can genuinely be considered confidential. We may think of something as private or secret, but as News International's former executives, the Care Quality Commission, BBC Trustees, the NHS, the Coop Bank, MPs and even the USA's National Security Agency know, unpalatable stories will eventually emerge.

So, if you are doing something of which the public might not approve you must assume they will eventually find out -and probably in the most inconvenient and embarrassing circumstances. There has never been a better time to renew that commitment to ethics in business - and in life!

Jane Howard
Reputability LLP

Tuesday, 14 January 2014

People Risks - Achilles' Heel strikes again!

Behavioural and organisational risks have caused yet another corporate crisis despite a risk management system described as top quality.  Why does this keep happening?  And what are the lessons for boards?

Last week RSA, the UK’s second largest general insurer, announced the results of reviews by KPMG, PwC and its own Internal Audit function into the £200m black hole in its Irish business.  Revelations of the debacle had led to the resignation of Group Chief Executive Simon Lee in December and a share price drop of over 25%.  The reviews describe how senior managers in Ireland had ‘inappropriately collaborated’ in the accounting of premiums and reporting of large claims so the accounts did not reflect the true financial position of the business. The managers involved have since been dismissed.

Fortunately for RSA, the reviews confirm that the problem is confined to Ireland and that other parts of the Group are unaffected. They go on to say the Group system of governance includes a control framework built on the ‘good market practice of three lines of defence’. They emphasise that it is appropriate in terms of structure and design for an international insurance group of RSA’s size and complexity, and elements of its design compare favourably across the market.

So why did a conventional risk framework, in this case apparently as good as it gets, fail to pick up such a key risk to an insurer? After all, improper manipulation of premiums and claims reserves is hardly a new phenomenon.  Those who know the history of the insurance industry will remember many other examples including Michael Bright’s Independent Insurance and HIH; some memories will go back as far as Emil Savundra’s Fire Auto & Marine in the 1960s.  Analagous ‘financial irregularities’ regularly occur in other sectors. 

An important pointer can be found in 'Roads to Ruin' the seminal Cass Business School report for Airmic and in Reputability’s follow-up report 'Deconstructing Failure'.  The root causes of almost all the catastrophes studied emerged from human behaviour and the way in which humans are organised within a firm – behavioural risks and organisational risks or ‘people risks’ for short.  These include people risks right up to people at board level. 

Unfortunately it has recently become clear that conventional risk frameworks, including the ubiquitious 'three lines of defence' approach, provide no systematic defence against people risks.  They just don’t to go there.  This is partly because conventional risk management hasn’t evolved far enough.  But it’s also because the area is far too dangerous for anyone below board level to delve into.

As the Parliamentary Commission on Banking Standards put it, the officially approved and widely used ‘Three Lines of Defence’ approach gives firms ‘a wholly misplaced sense of security’.

The Financial Reporting Council is one of many regulators that has tuned into the importance of behavioural and organisational risks.  Their latest proposals require companies explicitly to disclose and describe significant risks with their origins in behavioural and organisational issues; and they list dozens of practical questions for boards to ask themselves about behavioural and organisational risks.  The aims are to help boards oversee the practicalities of managing such risks below them and to recognise that such risks surround and permeate boards themselves.

RSA's crisis provides a timely warning to all boards.  Few if any risk management systems have behavioural and organisational risks systematically in their sights let alone under control. These potentially devastating risks are unrecognised and thus unmanaged.

Boards need to gain a deeper understanding of the underlying issues before they can lead their risk teams in the right direction to bring these dangerous risks under control.  Board leadership is essential.  Specialist education for boards is the first step.  

Anthony Fitzsimmons
Reputability LLP