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Risk Management w March 2008

Reputational Risk

Measuring and Managing Reputational Risk

by Daniel Diermeier

eputation has moved to the top of the agenda for many CEOs and senior executives. What used to be “nice to have” is now increasingly considered as a core asset that needs to be protected and managed. Reputational damage can hurt a company in many ways. Take the example of Wal-mart. Over the last two years, Wal-mart has been the subject of negative news coverage on topics ranging from environmental and labor concerns to allegations that Wal-mart has negative net effect on local communities. These accusa- tions (whether true or false) have already had an impact on Wal-mart’s busi- ness performance. According to a leaked internal study, about 2-8 percent of shoppers have taken their business elsewhere because they were no longer comfortable shopping at Wal-mart stores. Perhaps more importantly, Wal- R

Control. Companies cannot directly con- trol the messages received by third parties. Consider the example of a credit card company. If a customer is unhappy with a late-charge, a customer services representative can directly engage with the customer on a one-on-one basis and rectify the situation, e.g. by waiving the fee or at least explaining its rationale. In contrast, if the New York Times runs an article detail- ing the alleged abuse of late fees among credit card companies the company cannot reach all the readers of this article, certainly not among potential customers.

Daniel Diermeier is the IBM Distinguished Professor of Regulation and Competitive Practice and a Professor of Managerial Economics and Decision Sciences at the Kellogg Graduate School of Management, Northwestern University. He can be reached at d-diermeier@ kellogg.northwestern.edu.

mart has encountered increased resistance to opening new stores, especially on the West Coast and the North Eastern region of the United States. As a consequence Wal-mart’s stock price has been depressed over the last two years.

An important lesson from the Wal-mart case and related cases is that a company’s reputa- tion (even among customers) is only partially shaped by direct experiences with the company. In other words, perfect execution at the typical “touch points” with customers is not sufficient for building and maintaining an excellent repu- tation. Third parties, especially the media, play an important role in shaping customer percep- tion. In particular, there are three core difficul- ties in managing corporate reputations:

  • Lack of control.

  • Limited credibility.

  • Overwhelming complexity.

Complexity. Customers usually do not un- derstand the complexity underlying certain business decisions. As a consequence they will form their own beliefs on whether the company’s behavior was appropriate or not. In many cases they will rely on heuristics and rules of thumb when forming an opinion about a company. Social and cognitive psychologists have dem- onstrated that risk perception is subject to vari- ous biases and so-called “framing effects.” For example, customers will overestimate the risk to themselves if they empathize with the reported victim of allegedly improper business prac- tices. Food safety concerns are a prime example of such processes. Adult female customers, for example, will be measurably more concerned

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