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14 May 2013

Financial Institution Fraud

Author: Pavlo Odnokoz
Source: The Ukrainian Journal of Business Law. – 2013. – May. – p. 35-37

One of the recent trends in the Ukrainian banking sector is multi-million sales of non-performing loans (the NPL). The highly anticipated sales, usually with significant discounts, have attracted a lot of interest from investors seeking to acquire such assets to make extra profits. According to the official statistics of the National Bank of Ukraine, the total amount of NPL in the banking system came to USD 9.5 billion as of 1 March 2013, which constitutes approximately 9.3% of all loan portfolios of Ukrainian banks. Despite this percentage falling recently, it still remains pretty high considering the fact that the official statistics have always been artificially understated compared to the actual market situation.

NPL are an inevitable part of the banking business and normally demonstrate the health of a country's financial system. There are a variety of reasons for non-performing loans. General market trends (e.g. global downturn) are among the most common roots of all evil. However, the origins of the problem are more complicated and systematically pose a real threat to the stability of the financial system. Inadequate risk management, lack of collateral security, poor credit monitoring, and manipulations with insider loans are only few of the actual reasons of NPL.

According to the Association of Certified Fraud Examiners' (USA) Report to the Nation on Occupational Fraud and Abuse (the Report) the banking and finance services industry was the most commonly victimized sector by fraud perpetrators in 2012. The data presented in the Report reveals that about 16.7% of all reported fraud cases from more than 100 countries worldwide appeared in the banking industry.

Oil and gas, construction, government and public administration, manufacturing were far beyond the top leader — the banking and finance industry.

Interestingly enough, the median loss in banking industry caused by fraudulent activities was approximately USD 232,000.

Drawing parallels between worldwide practice described in the Report and Ukrainian realities, the professionals express doubts that the situation in Ukraine is any better. The lack of efficient, transparent and reliable methods of recovering debts, significant level of corruption, weak system of collateral registration, absence of reliable sources of credit history, low moral standards of doing business and other systematic problems in the Ukrainian banking sector allow dishonest borrowers to manipulate loan collection rules.

Common fraud schemes

Generally, the term "banking fraud" has a very broad scope and includes a wide range of fraudulent activities perpetrated against financial institutions (i.e. cheque and credit card fraud, cash theft, etc.). However, one of the most damaging fraudulent activities in the banking sector is loan fraud. Loan fraud is one of the important factors affecting the quality of banking assets and, as a consequence, profits earned by the banking system. Loan fraud represents a high risk area for banks because the actual dollar amount and overall financial consequences tend to be dramatic to business activity in a given country.

Despite the fact that the banking sector is highly regulated, practice suggests that the most   complicated procedures of fraud prevention and detection have deficiencies which allow con men to carry out their fraudulent schemes. This article intends to describe the most common fraudulent schemes perpetrated by fraudsters worldwide and discusses areas where Ukraine needs to develop its regulations and implement effective risk controls.

Loan procedure manipulations

The core of the scheme is false documents that a potential borrower provides to the banks to verify creditworthiness, including sufficient collateral for loans. In this case, the loan application often contains artificial information about property owned by the applicant, forged documents certifying ownership of the assets or their value. Sometimes as a condition precedent of such a loan scheme, borrowers commit financial statements fraud. In particular, to qualify for loan requirements, borrowers may not simply forge digits in financial statements, but use more advanced techniques that are harder for banks to trace and reveal. For example, accounting techniques used by dishonest borrowers usually include asset/revenues overstatement, fictitious revenues, concealed liabilities and expenses, etc. Such techniques allow borrowers to cover their inability to generate cash flow, show increased earnings, financial stability of the company, etc.

Bribes for loans

In this type of scheme the most vulnerable to a fraud breach in banking security is a dishonest loan officer or other people responsible for making loan-related decisions. Two possible scenarios are generally most common. In the first scenario the loan is provided to a borrower who is either unqualified for such financing or the loan is provided on more favorable terms. In exchange for such preferential treatment, the loan officer receives cash kickback from a borrower. On the due date, the borrower is often unable to make payments to the bank and the real price of the collateral cannot cover the financing. Following the second scenario, a so-called "sham loan" is provided — responsible bank officers provide financing to accomplices who then share all or part of the cash from the loan received. Payments from these kinds of loan agreements may sometimes be covered with the "proceeds" from following loans.

Loans to construction industry

Construction lending has vulnerabilities that are quite different from other types of lending. The construction industry is a complicated area which demands large amounts of financing, work force, project management efforts, etc. More risks are associated with construction projects than with already-built projects. It is not always possible for banks to establish proper control over the borrower's construction activities, disbursement of funds, cost of materials, engaged subcontractors pricing and other cost-related issues. Construction fraud schemes are numerous, but the more common ones are those related to estimates of costs structure of the projects, developer overheads, draw requests, etc.

When approaching a bank for construction financing, borrowers typically have a budget for construction costs along with different documents justifying the budget (a development plan, an engineering report, appraisal, etc.). From the very beginning, the construction cost is an estimate, which gives room for maneuver for dishonest borrowers. The total amount of financing may be higher than really required for this type of project, while the cost of the collateral may be artificially inflated. As the project proceeds, certain over-budget costs are incurred and represented as change orders to the budget. In such instances, the developer/borrower might misrepresent the true nature of incurred costs so as to mislead the banks.

Appraisal fraud

When it comes to loan fraud, one of the key components of a con scheme and a condition precedent is the value of the property which will be used as collateral. Often the value of assets is based on a fraudulent appraisal in an attempt to increase the success of receiving financing. Fraudulent appraisals may result from any number of situations, some of which are intentional use of an incompetent appraiser, giving the appraiser improper or false assumptions to use, direct collusion with the appraiser to commit fraud, etc. The most common appraisal fraud schemes that go back to 2008 and are still in place, involve value inflation, incorrect or fabricated comparables and omitted information. In many cases the value of the property in an appraisal report may be based on misused comparables, which justify the inflated value of the appraised assets. The examples of material omission of relevant information that may affect the value are incorrect property condition, zoning, square footage, etc.

Position of the perpetrator

Speaking about fraudsters in the banking industry, practice shows that fraudulent actions can be conducted by either outsiders or insiders (employees) of the financial institutions. However, when fraud was perpetrated with the collusion of both outsiders and bank insiders, the median loss tends to be much higher and the investigation of such cases became a much more tricky assignment.

According to the official data presented in the Report, there is a strong correlation between the fraudster's level of authority and the losses resulting from the fraud. The position a perpetrator holds within an organization has a very significant effect on the size of losses in a fraud scheme. Generally, the higher the level of authority the perpetrator has, the greater the access to an organization's assets. As illustrated in the diagram, owner/executives caused losses about three times higher than managers, and managers in turn caused losses about three times higher than employees. However, according to the Report, the fraudulent actions perpetrated by employees are more frequent than owner/ managers.

Another question relevant to the banking fraud is liability for fraudulent actions. The Ukrainian Criminal Code, which deals with fraud, contains several descriptions of crimes that are usually applicable in similar kinds of fraud, i.e., articles 190 (fraud), 192 (infliction of damage by deceit or breach of trust), 222 (fraud with financial resources), 364 (abuse of authority) of the Criminal Code of Ukraine, etc.

However, taking into account court practice, Ukrainian banks face real challenges to bringing suspected persons (including employees) to actual trial. Besides, criminal conviction is not always an effective mechanism for banks in restoring losses incurred due to practical difficulties and the inefficiency of the bailiff service in Ukraine.

Considering the business environment in Ukraine, the prevention and detection of fraudulent activities is a core of a successful banking business in Ukraine. To effectively prevent fraudulent activities in the banking sector, new legislation covering clear loan and collateral procedures should be implemented. Furthermore, the banks need to incorporate effective corporate policies, by-laws and internal regulations disallowing inappropriate and unethical behavior. As worldwide practice suggests, the organizations that implement and strictly follow proper standardized lending policies, independent review of loan applications, segregation of all the duties related to loans, have control and monitor procedures in place, successfully reduce the fraud risks and, of course, financial losses.

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