91.Reputational risk of the bank can be defined as the risk arising from negative perception on the part of customers, counterparties, shareholders, investors, debt-holders, market analysts, other relevant parties or regulators that can adversely affect a bank’s ability to maintain existing, or establish new, business relationships and continued access to sources of funding (e.g. through the interbank or securitisation markets). Reputational risk is multidimensional and reflects the perception of other market participants. Furthermore, it exists throughout the organisation and exposure to reputational risk is essentially a function of the adequacy of the bank’s internal risk management processes, as well as the manner and efficiency with which management responds to external influences on bank-related transactions.

92.Reputational risk can lead to the provision of implicit support by the bank, which may give rise to credit, liquidity, market and legal risk – all of which can have a negative impact on a bank’s earnings, liquidity and capital position. A bank must identify potential sources of reputational risk to which it is exposed. These include the bank’s business lines, liabilities, affiliated operations, off-balance sheet vehicles and the markets in which it operates. The risks that arise must be incorporated into the bank’s risk management processes and appropriately addressed in its ICAAP and liquidity contingency plans.

93.A bank must incorporate the exposures that could give rise to reputational risk into its assessments of whether the requirements under the securitisation framework have been met and the potential adverse impact of providing implicit support.

94.Reputational risk also may affect a bank’s liabilities, since market confidence and a bank’s ability to fund its business are closely related to its reputation. For instance, to avoid damaging its reputation, a bank may call its liabilities even though this might negatively affect its liquidity profile. This is particularly true for liabilities that are components of regulatory capital, such as hybrid/subordinated debt. In such cases, a bank’s capital position is likely to suffer.

95.Bank management must have appropriate policies in place to identify sources of reputational risk when entering new markets, products or lines of activities. In addition, a bank’s stress testing procedures must take account of reputational risk so management has a firm understanding of the consequences and second round effects of reputational risk.

96.Once a bank identifies potential exposures arising from reputational concerns, it must measure the amount of support it might have to provide (including implicit support of securitisations) or losses it might experience under adverse market conditions. In particular, in order to avoid reputational damages and to maintain market confidence, a bank must develop methodologies to measure as precisely as possible the effect of reputational risk in terms of other risk types (e.g. credit, liquidity, market or operational risk) to which it may be exposed. This could be accomplished by including reputational risk scenarios in regular stress tests. For instance, non-contractual off-balance sheet exposures could be included in the stress tests to determine the effect on a bank’s credit, market and liquidity risk profiles. Methodologies also could include comparing the actual amount of exposure carried on the balance sheet versus the maximum exposure amount held off-balance sheet, that is, the potential amount to which the bank could be exposed.

97.A bank must pay particular attention to the effects of reputational risk on its overall liquidity position, taking into account both possible increases in the asset side of the balance sheet and possible restrictions on funding, as well as the loss of reputation as a result in various counterparties’ loss of confidence.

98.In contrast to contractual credit exposures, such as guarantees, implicit support is a more subtle form of exposure. Implicit support arises when a bank provides post-sale support to a securitisation transaction in excess of any contractual obligation. Such non-contractual support exposes a bank to the risk of loss, such as loss arising from deterioration in the credit quality of the securitisation’s underlying assets.

99.By providing implicit support, a bank signals to the market that all of the risks inherent in the securitised assets are still held by the organisation and, in effect, had not been transferred. Since the risk arising from the potential provision of implicit support is not captured ex ante under Pillar 1, it must be considered as part of the Pillar 2 process. In addition, the processes for approving new products or strategic initiatives must consider the potential provision of implicit support and must be incorporated in a bank’s ICAAP.