operational risk and reputation in the financial industry
DESCRIPTION
Operational Risk and Reputation in the Financial Industry. Roland Gillet (Sorbonne, Solvay) Georges Hübner (ULg, UM and LSF) Séverine Plunus (HEC-ULg) . AGENDA. Basel II : Operational risk and reputational risk Litterature Review Sample : construction and descriptive statistics Methodology - PowerPoint PPT PresentationTRANSCRIPT
Operational Risk and Reputation in the Financial
IndustryRoland Gillet (Sorbonne, Solvay)Georges Hübner (ULg, UM and LSF)
Séverine Plunus (HEC-ULg)
AGENDA Basel II : Operational risk and reputational risk Litterature Review Sample : construction and descriptive
statistics Methodology Results Evidence from other data Conclusion
Operational risk Basel II:
“The risk of losses resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic risk and reputational risk.”
(BIS, 2005, p140, n°644)
Reputational risk
• Basel II:“the risk of significant negative public opinion that results in a critical loss of funding or customers”
(BIS, 1998, p7). • More generally, reputational losses are all events
that, once known by the market, negatively affect the cash-flows of the company, either due to losses in the client base, lack of confidence of external parties materializing in increased discount rate, funding rates, or decreased cash-flows.
But do the markets really dissociate reputational risk from operational risk?
Literature Review (1)
• Murphy et al. (2004)– Their contribution builds on a previous line of results
showing significant negative price impacts of firms accused of fraudulent activities (Skantz et al., 1990; Karpoff and Lott, 1993; Reichert et al., 1996).
– Results:• significant declines in reported earnings, increased stock return
volatility, and declines in analyst’s estimates. • larger firms experience smaller negative impacts since losses
behave as fixed costs. • A strong brand name mitigates the impacts and is interpreted as
a protection against reputational damage.
Literature Review (2) Only two papers examine the reputation
impact on market returns of operational events affecting financial institutions. Cummings, Lewis and Wei (2004)
Results: Banks experience smaller negative impact than insurance companies. Both types of companies however experience significant negative price
reactions market value drops exceeding the amount of the operational losses
de Fontnouvelle and Perry (2005) Results
the announcement date only has a significant, negative impact on the price
negative price impacts are larger when the operational loss is due to internal fraud
Our study Stock market reaction after the announcement of
operational losses in listed financial companies.
154 financial companies listed on major Stock Exchanges
Three events per firm: First press release, Explicit recognition by the company, and, Settlement date.
Reputational risk: difference between the market value loss and the announced loss amount of the firm.
Sample construction OpVantage First, provided by the Fitch Group.
criteria to filter this data collection: company group incorporated either in United States or in
Europe; companies of the financial industry; operational losses higher than 10 millions US dollars; loss settled no sooner than January 1994. companies publicly listed “September 11th” events removed.
final sample: 103 largest losses having occurred in American companies 51 largest losses in European companies.
The sample – descriptive statistics (1)
Nb
Market Returns
betaValue
(in Mio $)Mean min Max SD
Europe 51 47184 0,02% -0,46% 0,54% 2,14% 1,09
USA 103 59264 0,05% -0,19% 0,37% 2,03% 1,20
Total 154 55370 0,04% -0,46% 0,54% 2,07% 1,17
The sample – First press release
Panel A - Full sample
Nb
Market Loss size (in Mio) Average Returns (t=0 to 10)
betaSharpe
ratio
Value
(in Mio)Mean Min Max Mean min Max SD
Europe 51 38138 277 11 3000 0.04% -1.83% 2.79% 1.82% 1,10 -0,51
USA 103 60462 196 10 2650 -0.13% -4.47% 1.44% 1.96% 1,26 -0,49
Total 154 53053 222 10 3000 -0.07% -4.47% 2.79% 1.91% 1,21 -0,49
Panel B - Known losses
Europe 28 45447 239 11 2923 -0.04% -1.83% 2.79% 1.90% 1,19 -0,60
USA 62 60873 165 10 2650 -0.01% -1.42% 1.44% 1.75% 1,22 -0,52
Total 90 55847 188 10 2923 -0.02% -1.83% 2.79% 1.80% 1,21 -0,55
Panel C - Unknown losses
Europe 23 27539 309 11 3000 0.13% -1.21% 1.12% 1.71% 0,99 -0,39
USA 41 62558 222 10 2160 -0.30% -4.47% 0.81% 2.27% 1,32 -0,43
Total 64 46646 254 10 3000 -0.14% -4.47% 1.12% 2.07% 1,20 -0,41
The sample – Recognition by the companyPanel A - Full sample
Nb
Market Loss size (in Mio) Returns
betaSharpe
ratio
Value
(in Mio)Mean Min Max Mean min Max SD
Europe 17 24601 596 35 3000 -0.49% -2.87% 0.44% 2.63% 1.0 -0,28
USA 28 61591 517 8 4371 -0.04% -3.27% 1.96% 2.24% 1.3 -0,38
Total 45 47299 368 8 4371 -0.21% -3.27% 1.96% 2.39% 1.1 -0,35
Panel B - Known before and unchanged losses
Europe 3 51781 1301 440 2923 -1.04% -2.54% 0.14% 2.74% 0.9 -0.31
USA 4 82849 201 73 372 0.70% 0.27% 1.96% 3.08% 1.3 -0.47
Total 7 69534 673 73 2923 -0.45% -3.27% 1.96% 2.93% 1.2 -0.42
Panel C – Learned or changed losses
Europe 9 22063 492 25 3000 -0.12% -1.18% 0.44% 1.91% 0.7 -0.35
USA 18 58870 657 8 4371 -0.17% -3.27% 1.10% 2.10% 1.2 -0.51
Total 27 46534 488 8 4371 -0.15% -3.27% 1.10% 2.04% 1.0 -0.46
Panel D - Unknown losses
Europe 5 12863 252 100 452 -0.84% -2.87% 0.35% 3.84% 1.4 -0.07
USA 6 49919 215 90 455 -0.16% -2.54% 1.12% 2.09% 1.2 -0.07
Total 11 33075 232 90 455 -0.47% -2.87% 1.12% 2.89% 1.3 -0.07
The sample – Settlement
Panel A - Full sample
Nb
Market Loss size (in Mio) Returns
betaSharpe
ratio
Value
(in Mio)Mean Min Max Mean min Max SD
Europe 23 27415 346 11 2923 -0.07% -0.73% 0.78% 1.33% 0.96 -0.33
USA 42 65114 322 10 2650 -0.05% -0.98% 0.85% 1.59% 1.10 -0.48
Total 65 54064 330 10 2923 -0.06% -0.98% 0.85% 1.50% 1.03 -0.43
Panel B - Known before and unchanged losses
Europe 2 25244 1508 92 2923 0.07% -0.30% 0.44% 1.40% 0.82 0.02
USA 6 59555 511 15 2650 -0.11% -0.98% 0.28% 1.46% 1.27 -0.62
Total 8 50977 760 15 2923 -0.06% -0.98% 0.44% 1.44% 1.14 -0.46
Panel C – Learned or changed losses
Europe 21 28301 207 11 691 -0.05% -0.73% 0.78% 1.32% 0.32 -0.36
USA 36 64926 284 10 2160 -0.04% -0.97% 0.85% 1.61% 1.04 -0.46
Total 57 51433 256 10 2160 -0.04% -0.97% 0.85% 1.51% 0.84 -0.43
Methodology Abnormal return for firm i:
ARit = Rit – αi – βi Rmt for t= -20 to 20
Abnormal return due to reputational effect:
Average and cumulative average abnormal return:
and
ARi0 (Rep) =Ri0 – αi – βi Rm0 + loss / Market Cap
N
iitt AR
NAR
1
1
20
20t
tARCAR
Results
CAR around the three event dates.
-8,00%
-7,00%
-6,00%
-5,00%
-4,00%
-3,00%
-2,00%
-1,00%
0,00%
1,00%
2,00%
3,00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
First press release CAR(Rep) First press release
Recognition Settlement
1st press release Recog. Settlemt
T CARCAR(rep) CAR CAR
-15 to 1 -5.28*** -1.82** -0.64 1.71**
-8 to 8 -4.35*** -1.57* -1.14 0.79
-5 to 10 -4.44*** -0.57 -0.88 0.78
0 to 13 -2.37*** 1.45* -0.80 0.53
CAR for American loss eventsUSA
-10,00%
-8,00%
-6,00%
-4,00%
-2,00%
0,00%
2,00%
4,00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
days
CA
Rt
First press release (Rep) First press releaseRecognition Settlement
CAR for European loss eventsEurope
-6,00%
-5,00%
-4,00%
-3,00%
-2,00%
-1,00%
0,00%
1,00%
2,00%
3,00%
4,00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
days
CA
R
First press release (Rep) First press release Recognition Settlement
Test statistics for US and European loss events
First press release Recognition Settlement
USA CAR CAR(rep) CAR CAR
T = -15 to 1 -5.09*** -3.55*** -0.53 1.87**
T = -8 to 8 -4.21*** -3.38*** -0.61 0.26
T = -5 to 10 -4.23*** -2.64*** -0.80 0.08
T = 0 to 13 -3.73*** -2.03** -1.17 -0.53
Europe
T = -15 to 1 -1.95** 1.87** -0.36 0.34
T = -8 to 8 -1.58* 2.07** -1.06 0.99
T = -5 to 10 -1.19 2.75*** -0.41 1.23
T = 0 to 13 1.18 5.39*** 0.21 1.65**
First press release
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
Days
CA
Rt
Known losses (90) Unknown losses (64)Known losses (rep) Unknown losses (rep)
Sub-sample analysis according to the knowledge of the losses – First press release
Known losses Unknown losses
T CAR CAR(rep) CAR CAR(rep)
-15 to +1 -3.46*** -0.73 -4.90*** -1.95**
-10 to +5 -2.71*** 0.45 -6.30*** -3.30***
-8 to +8 -2.60*** 0.53 -4.98*** -2.05**
-5 to +10 -1.94** 0.85 -4.39*** -1.89**
0 to +15 -0.17 2.33*** -2.87*** -0.82
Recognition by the Co
-8,00%
-6,00%
-4,00%
-2,00%
0,00%
2,00%
4,00%
6,00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
Days
CA
Rt
Known before losses (7) Changed or learned losses (27)Unknown losses (11) Série5Série6
Sub-sample analysis according to the knowledge of the losses – Recognition by the company
Known
before Learned or changed Unknown losses
T CAR CAR(rep) CAR CAR(rep)
-15 to +1 -2.97*** 0.32 1.23 0.44 2.09**
-10 to +5 -2.20** -0.04 0.64 0.61 2.01**
-8 to +8 -2.40*** -0.85 -0.21 -1.28* 2.51***
-5 to +10 -2.00** -0.22 0.59 -0.37 1.33*
0 to +15 -1.22 0.03 1.33* -0.54 1.16
Settlement date
-0,50%
0,00%
0,50%
1,00%
1,50%
2,00%
2,50%
3,00%
3,50%
4,00%
4,50%
-25 -20 -15 -10 -5 0 5 10 15 20 25
Days
CA
Rt
Known before (8) Learned or changed (57)Série4
Sub-sample analysis according to the knowledge of the losses – Settlement
Known before Learned or changed
T CAR CAR CAR(rep)
-15 to +1 -0.27 1.66 3.50***
-10 to +5 0.39 0.37 2.33***
-8 to +8 0.78 0.26 2.23**
-5 to +10 0.46 0.22 2.29**
0 to +15 0.05 -0.74 1.31*
First press release
-9.00%
-8.00%
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
CA
R
Internal and External Fraud (27) Clients Products and Business Practices (111)Série2 Série3
fey
Sub-samples according to the event typeFirst press release
CAR(Rep) First press release
T Frauds Clients…
-15 to +1 -4.22*** -1.94**
-10 to +5 -4.47*** -1.48*
-8 to +8 -3.66*** -0.47
-5 to +10 -4.66*** 2.22**
0 to +15 -4.22*** -1.94**
Recognition by the company
-12.00%
-10.00%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
CA
R
Internal and External Fraud (10) Clients Products and Business Practices (31)Série2 Série3
Sub-samples according to the event typeRecognition by the company
CAR(Rep) Recognition
T Frauds Clients…
-10 to +5 -3.37*** 2.17***
-8 to +8 -3.74*** 1.07
-5 to +10 -3.10*** 0.08
0 to +15 0.49 -0.48
Settlement
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
-25 -20 -15 -10 -5 0 5 10 15 20 25
CA
R
Internal and External Fraud (12) Clients Products and Business Practices (48)Série2 Série3
Sub-samples according to the event typeSettlement
CAR(Rep) Settlement
T Frauds Clients…
-10 to +5 2.39*** 1.14
-8 to +8 1.53* 2.07**
-5 to +10 1.39* 2.11**
0 to +15 -1.11 1.82**
Evidence from other data
Evidence from other data Volumes
average volume for each companies on a 250 days basis,
daily variation of the volume -20 + 20 days around the three announcement
date. Garch
Student test : H0: the average conditional volatility during the 10 days
following the announcement is the same than the average conditional volatility of the estimation period.
H1: conditional volatilities are different.
tttt
ttt xR
2
12
12
Evidence from other data (2) Cusum of squares
The CUSUM of squares test (Brown, Durbin, and Evans, 1975) aims at assessing the constancy of the parameters of a model and is based on the test statistic:
where w is the recursive residual defined as:
The expected value of S under the hypothesis of parameter constancy is :
VolumesVolume variation (USA + EUR)
-50%
0%
50%
100%
150%
200%
250%
300%
350%
-25 -20 -15 -10 -5 0 5 10 15 20 25
Press Recognition Settlement
Garch effects
0 to +10d
Average
(estimation
period)
1st press release Recognition Settlement
p-value p-value p-value
USA 0.0009% 0.12% 0.02 0.07% 0.15 0.01% 0.00
EUR 0.0011% 2.64% 0.11 0.03% 0.00 0.01% 0.07
Total 0.0010% 0.96% 0.05 0.06% 0.10 0.01% 0.02
2t 2
t 2t
Cusum of squares - USA
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
Cusum of squares - Europe
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
-0.4
0.0
0.4
0.8
1.2
1.6
5 10 15 20 25 30 35 40
CUSUM of Squares 5% Significance
CONCLUSION
Conclusion CAR < 0 around the first press release and the
recognition by the company date. As far as reputational risk is concerned, it is
significantly negative before the first press release, and significantly positive after.
CAR significantly positive around the settlement date The investors overreact when they do not know about
the loss size. automatic correction of the stock returns 10 days after the recognition by the company date.
if the loss is due to frauds: market reaction significantly worse and negative effect on the reputation of the company.
Conclusion Volumes variations: significant peak in trades
whenever the company recognizes the loss event, which corresponded to changes in market alphas and betas confirmed by a cusum of squares test.
anticipation before the first disclosure happens, correction of the settlement returns for the initial effect.
The timing of the resolution of uncertainty also matters to a very large extent, especially when one has to assess at what moment the market perceives a shift in the risk profile of the financial institution that has suffered from a large operational loss.