DEALING WITH FRAUD RISKS IN THE BANKING & MFI SECTOR

Last week, we looked at how the Central (or Reserve) Bank could use capital adequacy – part of national requirements for banks – to control and manage the financial institutions in a particular way. This was based on Basel II and Basel III. We also looked at the reason why some banks and financial institutions do fail.

Today, we shall look at how the financial institutions could avoid or prevent such occurrences. One of these steps the financial institutions could adopt is called Risk Management.

What is risk management?

Risk management is the process of identifying, assessing and controlling threats to an organization’s capital and earnings. These threats, or risks, could stem from a wide variety of sources, including financial uncertainty, legal liabilities, strategic management errors, accidents and natural disasters (Source: Techtarget.com)

The chance of something happening that has an impact on the objectives of the Organisation (Source: Elwin Chiwembu Sichiola; FCCA, Risk Management Expert, Malawi)

What types of Risks are Banks and Financial institutions exposed to?

The risks to which a bank is particularly exposed in its operations are: liquidity risk, credit risk, market risks (interest rate risk, foreign exchange risk and risk from change in market price of securities, financial derivatives and commodities), exposure risks, investment risks, risks relating to the country of origin of the entity to which a bank is exposed, operational risk, legal risk, reputational risk and strategic risk (Source: National Bank of Serbia)

Definition of various types of risks

  1. Liquidity risk is the risk of negative effects on the financial result and capital of the bank caused by the bank’s inability to meet all its due obligations.
  2. Credit risk is the risk of negative effects on the financial result and capital of the bank caused by borrower’s default on its obligations to the bank.
  3. Market risk includes interest rate and foreign exchange risk.
  4. Interest rate risk is the risk of negative effects on the financial result and capital of the bank caused by changes in interest rates.
  5. Foreign exchange risk is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rates.
  6. A special type of market risk is the risk of change in the market price of securities, financial derivatives or commodities traded or tradable in the market.
  7. Exposure risks include the risks of bank’s exposure to a single entity or to a group of related entities.
  8. Investment risks include the risks of bank’s investment in non-financial sector entities, fixed assets and investment real estate (do you remember this is one of the major causes of some banks’failures as mentioned last week?)
  9. Risks relating to the country of origin of the entity to which a bank is exposed(country risk) is the risk of negative effects on the financial result and capital of the bank due to bank’s inability to collect claims from such entity for reasons arising from political, economic or social conditions in such entity’s country of origin. Country risk includes political and economic risk, and transfer risk.
  10. Operational risk is the risk of negative effects on the financial result and capital of the bank caused by omissions in the work of employees, inadequate internal procedures and processes, inadequate management of information and other systems, and unforeseeable external events.
  11. Legal risk is the risk of loss caused by penalties or sanctions originating from court disputes due to a breach of contractual and legal obligations, and penalties and sanctions pronounced by a regulatory body.
  12. Reputational risk is the risk of loss caused by a negative impact on the market positioning of the bank.
  13. Strategic risk is the risk of loss caused by a lack of a long-term development component in the bank’s managing team.

Institutional Failures

The Office of the Comptroller of the Currency (OCC) is an independent bureau within the United States Department of the Treasury that was established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and thrift institutions and the federal branches and agencies of foreign banks in the United States. In 2001, the OCC issued an Examiner’s Guide to Problem Bank Identification, Rehabilitation and Resolution, which identified four “Red Flags and Other Identifiers” of problem banks, a sampling of which included:

  1. Rapid growth/Aggressive growth strategies: most of the banks and financial institutions are in the habit of disbursing loans rapidly with little or no due diligence. It is aimed at capturing customers from the existing institutions or to grow quickly in order to satisfy its owners.
  2. Management oversight deficiencies: weaknesses in processes, monitoring, and procedures, mostly due to over-familiarity and observance of best practices.
  3. Risk management deficiencies (e.g., internal controls, management/staff expertise and training, risk tolerance limits, etc.)
  4. Insider abuse and fraud

For the purpose of today’s write-up, I would like us to focus on the point # 4 – Insider abuse and fraud.

What is fraud?

A wrongful or criminal deception intended to result in a financial or personal gain (Source: Dictionary.com). According to the Association of Certified Fraud Examiners (ACFE), fraud is defined as any intentional or deliberate act to deprive another of property or money by guile, deception, or other unfair means.

Why do people Commit fraud?

Many white collar crimes aren’t committed by hardened criminals. It’s often normally moral people under financial strain, those under severe pressure from their bosses or shareholders, or people who get away with something minor then try to test their limits. Trusted persons become trust violators when they conceive of themselves as having a financial problem which is non-shareable, are aware this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their own conduct in that situation verbalizations which enable them to adjust their conceptions of themselves as trusted persons with their conceptions of themselves as users of the entrusted funds or property (Source: Donald R. Cressey).

The Fraud Triangle

The above sentences of Donald R Cressey were built into what is called the Fraud Triangle. The triangle is based on three points as follows: –

  • Perceived un-shareable financial need (Pressure): the first leg of the fraud triangle is the person has financial needs but could not share these facts with anybody. This person begins to falsify documents in order to gain advantage financially through illegal means. Pressure could be coming from family members, debts incurred, inability to pay bills or a game of chance like in lottery and inability to meet performance targets and therefore there must be some kind of cover-up.
  • Perceived opportunity: flowing from the above pressure, the person sees opportunity whereby the crime could be committed with the vain hope that s/he will not be caught. This opportunity may be due to weaknesses in the internal control systems or just that s/he is in a position of trust and could not be easily checked, at least for a while.
  • Rationalization: the vast majority of white collar crime culprits are first-time offenders. They see themselves as ordinary and honest people who are in a bad situation and wanted to solve it quickly. They, therefore, justify their actions with the following; “I am only borrowing the money”, “I can pay back when salaries are paid”, “I am underpaid, my employer is cheating me”, “my employer is dishonest to others and deserves to be cheated”, etc.

Conclusion

Professor Stephen Adei, the former Rector of GIMPA (Ghana) posted a placard at the entrance of his office: “In God we trust; all others we monitor”. Staff monitoring is the key to having a risk-free institution.  However, there a number of failures even in this bid.

The issue of risk management is a vast area. We cannot cover all the issues in a short write up like this. We shall take the concluding part of this article next week and we shall focus on how to prevent fraud. We shall also look at how to prevent institutional failures in the banking and financial services sector.

 

 

 

 

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