Reputational risk in Latin American banks

Banks across Latin America are paying closer attention to reputational risk as they aim to expand their retail business to cater to a growing middle class across the region. OpRisk looks at the strategies they are employing to identify and monitor reputational risk

Numerous Latin banks have faced bank runs after their reputation crashed, often causing ripples that spread across the sector. In 2010, Brazil’s mid-sized Banco PanAmericano was investigated by the Brazilian central bank for accounting irregularities and forced into a $1.5 billion rescue before being bought by BTG Pactual. A fresh scandal at Brazil’s Banco Cruzeiro do Sul, now taken over by the central bank, continues to reverberate. These scandals hurt banks with similar profiles and are affecting their ability to raise funds.

Reputational damage has been one factor behind the consolidation of banks in the region over the last 20 years, with a flight to quality taking place in times of crisis, points out Robert Stoll, director of Latin America financial institutions at Fitch Ratings in New York. In Ecuador, the number of banks fell from 40 to 25 and in Brazil from 300 to 150 between the late 1980s and the early 2000s.

In general, Latin banks have only average to weak reputations among their domestic client base, but customers are relatively passive, says José Etchegoyen, a risk management specialist based in Miami. There is a perception in Latin America that banks make money, but don’t share the pain in the bad times, he says.

Overall, Latin customers grumble about bank service but “North American or Europeans say their banks are poor more often than Latin Americans. That’s a paradox as if you measure banks in the former on many standards they are better than in Latin America,” says Buenos Aires-based Alfredo Roisenzvit, executive director at RiskBusiness Latin America. In surveys of bank brands, banks involved in the financial crisis in developed markets have lost their high ranking and been replaced by banks in other parts of the world, adds Johan Manuel Tobón Cuartas, an operational risk analyst at Bancolombia in Medellin, Colombia.

Nor has Latin America been badly damaged by the financial crisis and market manipulation scandals, such as the Libor investigation, seen in Europe and North America. Latin banks are not facing heavy fines, sackings of senior management, or the questioning of their business model. “If we consider annual rankings such as ‘best places to work’ surveys and corporate reputation, Latin banks tend to rank low. However, compared with the rest of the world, Latin banks are in a better position,” says Etchegoyen.

There are a number of reasons that Latin banks have been relatively protected. They tend to be much more tightly regulated and more conservatively run; they have fewer retail customers and a less sophisticated product line-up. Poorer internet connections mean that even IT issues are less severe as physical bank transactions remain more common and banks in general play a much smaller role within national economies.

Divorced from society

“Banks don’t have as big an impact on the economy or on people’s lives and the economy doesn’t have such a big impact on the banks. A lot of Latin Americans don’t have a relationship at all with a bank,” says Roisenzvit. This is less true in Central America, where national economies depend heavily on remittances, than in economies in the Southern Cone, he says.

Roisenzvit points out that the broadest measure of money, which is a proxy for the participation of banks in the economy, M3, is generally small compared with gross domestic product in the region. In advanced countries, it is typically 180–300%; in Latin America, even in the most advanced countries, that figure is much lower, at near 80%, and in some Latin countries less than 40%.

The retail customer will remain passive and mainly unresponsive to reputational issues until such time as their purchasing power and alternate service providers become available, argues Mike Finlay, chief executive of RiskBusiness in London. “The majority of Latin American firms are not well prepared, do not have suitable crisis management plans in place and in many cases, are not really that bothered by reputational consequences,” he believes.

Other stakeholders take a different view of Latin banks, he points out. “Latin America has a reasonably unreliable reputation with investors outside of Latin America, resulting from the range of bank failures and economic crises over the past 100 years, coupled with political interference, nationalization and money laundering issues,” he says.

Still, Latin banks are now starting to worry more about their reputation – and for good reason. Latin banks are rapidly rolling out a more sophisticated line of products as the middle class grows, and are steadily increasing online services. Increasingly, employers are paying salaries through banks, particularly where the worker is employed by a national or local government, and that is making the banks more important players in the economy.

A history of hyperinflation, political emergencies and economic instability mean Latin Americans are used to crises. This tends to make them blasé when faced with minor difficulties, such as temporary loss of access to their bank account on technical issues, points out Roisenzvit.

But Etchegoyen notes that in times of crisis, banks will often face outbreaks of violent anger. “Riots against banks are very common when a financial crisis kicks in and it is not uncommon for institutions to have to cease operations for days or even weeks until the environment cools down,” he notes. Fear of accounts being frozen is still a concern in some countries given past experiences but is lessening as Latin regulators insure depositors. In Brazil, depositors are insured for up to 70,000 real ($34,298) per depositor, which should offer full protection to most customers.

Contamination affects all banks alike without differentiating between those entities that have acted responsibly, prudently and with principles, and those which have not, says Etchegoyen. In many instances, it is hard for Latin banks to control their image and this may contribute to making them passive. “Most Latin financial institutions are prone to conduct surveys on their internal image with their customers and employees, but tend not to spend much on measuring their public reputation,” he notes.

According to Tobón, there has not been significant progress in the region on pinning down reputation beyond the rankings of companies by specialised magazines. Even so, banks have worked on putting in place response plans focused on communications, he notes. Identification of reputational risks is today being undertaken by the risk management teams, mostly in the operational area, who map the possible effects, he notes.

Following the US subprime crisis, financial institutions are not only mapping out credit, liquidity and operational risks but also analysing reputational impacts. Inadequate risk management or aggressive risk taking without the ability to monitor and control such risks can lead to lower reputational value, says Tobón.

Latin banks are concerned by major events though: investor relations are communicating to the market and stakeholders that they have implemented enterprise risk management structures and are prepared to face risks from adverse scenarios generated by black swan events, says Marcus Manduca, partner at PricewaterhouseCoopers in São Paulo.

Experts agree that the biggest problem remains quantifying and calculating the impact of reputational risk and this is clearly not a problem confined to Latin America. The main basic framework and environment to manage reputational risk in the region is supported by the same principles and procedures as the rest of the world, says Lucio Anacleto, a partner at KPMG in São Paulo.

Regulation and preparation for Basel III varies greatly from country to country. In general, the larger countries, particularly Brazil and Mexico, are at the forefront of implementation of the Basel process. Brazilian banks will be able to start implementing Basel III at the start of next year, significantly ahead of the deadline, for example. Smaller countries in the region are on a more relaxed schedule. One of the difficulties in focusing attention on reputational risk stems from the Basel process in that there are no implications for capital allocations, notes Antonio Villarreal, a partner at KPMG in Mexico City.

Money laundering activities are a particular problem for the region, especially in Colombia, Mexico and throughout Central America with very tight legislation in place in many countries and scrutiny from the US. Arms and drug trafficking are present in everyday press reports and can drag in individuals and institutions. Corruption and government bribery exist in several countries and pervade all levels from the municipal upward, says Etchegoyen. Internal fraud within banks is a major problem, especially in large countries such as Brazil, he adds.

The region is dominated by international banks but many smaller banks are family-owned, which makes them more vulnerable to political interference. That is particularly true of countries where governments play a significant role in the economy, such as Venezuela, Ecuador and Argentina.

“When you have political uncertainty, people start to distinguish between owners of banks: that creates reputational risk,” says Roisenzvit. More subtle pressures are often exerted throughout the region by government criticism of bank policies, including calls to extend accounts to the poor or charge less interest for loans. Legal and political risks in Latin America blur with reputational risk, he believes.

Primitive measures

The external forces shaping reputation are complex to model and this has deterred Latin banks from seeking to define and measure reputational risk. Reputational risk has been considered in a qualitative manner because of the absence of appropriate models to quantify risks: most of the existing tools are not much more advanced than looking at stock market valuations and changes in cash flow, says Tobón.

Service providers are working on improved models. Etchegoyen says that once you have a database of events that can affect your reputation and you have put an expected impact scale on those events, you can start to model reputational risk. This works much better when information from as many banks as possible is pooled, he notes.

However, the measuring of local risk is made more complex as many countries in Latin America are dominated by large international banks which tend to use processes developed at home. “That makes it hard for such banks to measure their reputational status and to initiate meaningful reputation management programmes,” says Finlay.

The financial crisis is leading many international banks to focus on home issues. Experts say that a number of global banks, particularly European ones, have repatriated capital to cover domestic problems. That said, although Latin Americans are aware of the problems in Spain and its financial sector, events there have not greatly affected their thinking and there has been no move to withdraw funds.

One stimulus for more detailed reputational risk assessment is more independent coverage. In general, the media have become freer in the region over the last decade and Latin Americans have taken to social media with gusto. In Argentina, the banking presence on social media is growing fast. Diego Monteleone, chief technology officer at Zonabancos carried out a study of the presence of Argentine banks on social media. In 2010, 7% of Argentine banks had a presence on Facebook and Twitter. That had increased to 18.8% by last year’s survey.

At a recent risk seminar promoted by the Brazilian Federation of Banks, social media was a hot topic, according to Anacleto. “The subject was discussed by all the big banks: they are really aware of social media and its implications,” he says. Given the rapid spread of social media, it is not surprising that the public relations function has changed from a reactive area run by lawyers to a proactive department managed by communications professionals, says Etchegoyen.

“Risk management has changed the role of PR and communication departments that were traditionally designed to do crisis management,” he says. But so far, change has not been that far-reaching and analysis of social media “often happens in a very manual and dispersed way”, he adds.

That approach is being systematised. Technologies such as text mining and social network analysis are expected to play a key part in shaking up communications departments. Financial institutions are extending their coverage from customers and employees to a more comprehensive and holistic approach.

Some specific issues mark out the region’s social media presence. In Latin America, false rumours and exaggerated headlines are common and can bring unwanted attention to financial institutions, says Stoll. In the US, banks have more legal recourse against rumour. It is more difficult in Latin America to combat negative headlines through the courts, and cases are expensive, time-consuming and uncertain.

Many Latin American banks are also insufficiently aware of the risks involved in disclosure of internal emails, notes Armando Castro, chief marketing officer at Zurich Brasil – in particular, the casual use of racial terms could cause significant damage to a bank’s reputation if revealed.

This year’s brand awards by Brazilian financial magazine Isto é Dinheiro showed that some of Brazil’s most valuable financial brands have been affected by international trends as well as the slowing local economy, lower share prices and a government campaign to bring down interest rates. The banking sector lost 33% of its brand value over the previous year with public bank Banco do Brasil falling a full 45% to $4.6 billion.

Banks are becoming more involved in Brazil’s economy: bank penetration has arrived very rapidly, says Anacleto. More than 140 million accounts exist among a population of 190 million and that is likely to increase to 80–90% of the population soon, he predicts.

Although individual Brazilian banks do not usually suffer from overt political interference, the government has been putting its weight behind complaints about the interest rates charged by banks and the message is that banks need to do more, says Antonio Gouveia, partner at Ernst & Young in São Paulo, adding that the large banks regularly come in the top 10 most-complained about companies in Brazil.

Areas that might be politicised in Europe or North America, such as executive remuneration, are not commonly reported in the media and politicians have generally avoided commenting on the issue. Even so, January 2012 saw the introduction by the Brazilian central bank of rules that will provide more remuneration disclosure (the National Monetary Council’s regulation 3921/10). The financial crisis increased the awareness about reputational risk in Brazil and today the regulator is focused on updating legislation on laundering, foreign corrupt practices and bribery, Manduca notes.

The leading Brazilian banks are working hard to identify reputational risk factors and measuring the correlation between reputation and share price while seeking to establish the causes for reputational damage and elaborating action plans, says Anacleto. They are also keenly aware of the correlation between reputational and liquidity risk, he says. Gouveia agrees that Brazilian banks are increasingly focused on reputational risk but believes that banks are mostly reactive and few are trying to actively identify possible problem areas.

Piggy in the middle

Middle-market banks are particularly vulnerable to reputational risks and a scandal in one bank is easily transferred to others. “The quality of corporate governance for mid-sized banks is key,” Anacleto notes. On June 4, the central bank found that Banco Cruzeiro do Sul had reported “unsubstantiated asset items”: shares in mid-sized banks dropped 8.4% in the next 10 days while larger lenders saw their share prices rise on average.

Contamination among similar banks can also become a significant problem after a reputational risk event at one. Banks that have a payroll-deduction model – where repayment of loans is deducted from an employee’s pay cheque – suffered disproportionately as crisis-hit banks PanAmericano, Morada and Cruzeiro do Sul were in this line of business, points out Stoll. The situation has been handled well by regulators who encouraged larger banks to provide funding to the smaller banks that were properly conducting their business, he notes.

Some mid-sized banks are now actively seeking to improve their reputation with strategies that include requesting ratings from agencies and hiring third parties, such as accountancy firms, to produce reports on their financial health and risk controls.

The Mexican market and consumer profile are very different to those north of the Rio Grande: cash is still king and there is a reluctance to embrace credit cards, with only 16.7 million held by the country’s 112 million people, compared with 1.1 billion among the 311 million people in the US. Moreover, the Mexican retail market is highly controlled by the banking and securities regulator, the Comisión Nacional Bancaria y de Valores (CNBV), which has been working hard to define and mitigate reputational risk, notes Villarreal. The CNBV is considering different international frameworks with Basel III slated for introduction at the beginning of 2015.

Reputation and brand are increasingly recognised as key by individual banks although there have not been any significant scandals in the Mexican financial industry connected to reputational risk, KPMG’s Villarreal says. Banks are paying more attention to their reputation by reinforcing corporate governance guidelines, policies and manuals. Moreover, banks in Mexico are increasingly establishing a range of different risk committees covering operational risk, money laundering and early warnings where they analyse regulations and their impacts. These meetings often act as a forum for the discussion of reputational risk, he adds.

Widespread drug smuggling and money laundering in Mexico has led to a significant body of legislation especially around know-your-customer rules and large cash payments: the regulator is particularly vigilant and sanctions are severe. Fraud is also common in the country and an increasing source of concern for banks and their reputation.

Mexican banks have courses and training every year on laundering although surprisingly there have not been specific cases of banks being caught in the public eye, says Villarreal. Regulations are also stringent in regards to customer data and protection of sensitive information. Policies surrounding hacking and security and particularly the use of passwords are advanced, he says.

Overall, regulation in Mexico is moving to address more non-financial risks, believes Villarreal. However, there has been disappointing progress in seeking co-operation and information sharing on reputational risk and modelling.

Argentina has a long history of government intervention including the freezing of accounts following the crisis that started in 1999, says Roisenzvit. That led to a run on deposits from international banks to public banks as customers reasoned that public banks would be the most protected. This year, the Argentine government has restricted access to dollar deposits and caused a run on US dollar accounts with clients opting to hold dollars in cash at home.

Meanwhile, in Colombia, “the reputation of banks is characterised by a series of contrasts and in general society does not have a very positive perception of them”, according to Tobón. That is in line with the rest of the world – the recent deterioration in the image of banks is rooted in the crisis, he believes.

That said, professional analysts are more positive on financial institutions in the country, viewing them as responsible and solid, and most see them as having appropriate risk management approaches coupled with decent profitability, Tobón adds. Moreover, banks are seen as highly attractive places to work in surveys.

As Colombian banks are seen as offering costly services that are not client-driven, the regulator, backed by many financial institutions, is looking at measures to protect the consumer, simplify bureaucracy and reduce costs.

More competition, technological changes, greater access to information from across the globe and more consumer protection are causing institutions to take an ever greater interest in reputational risk and to include it as a key component in their risk strategy, Tobon adds. As more bank departments are brought into the process of devising strategies for managing and considering reputational risk, he believes that awareness of the importance of reputation will spread.

Although the same principles, framework and procedures apply to reputational risk, Latin America does present a number of peculiarities. The banking sector is generally tightly regulated and conservatively run as banks operate in uncertain political and economic environments and face high levels of criminality. In general, Latin banks have been shielded from criticism by low banking penetration and media coverage, but that is rapidly changing and banks are waking up to the impact new technologies can have on their brand.