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How to Detect and Manage Fraud in Credit Risk

Date: March 26, 2015 Author: Ramzi Watfa
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Fraud plays a role in many aspects of a bank’s credit risk environment; and needs to be detected and managed closely.

Following my article on Name Lending, a friend of mine pointed out that in many cases, fraud also plays a role in confusing the bank’s perception of the reputation of the obligor, and hence renders the bank’s judgment useless. So I thought it best to provide a paper on the topic of fraud, covering some areas where this syndrome occurs, and what banks should do to manage or mitigate it in terms of Credit Risk.Fraud PixVarious Forms of Fraud In this paper I am focusing on commercial fraud. This manifests itself in various degrees, from companies that are run by down-right criminals (believe it or not there are many), those that have experienced cash flow shortages due to bad practices or negative engines and have their backs to the wall, or those that are trying to portray a better image to access more credit.

Financials Let’s start with data and fraudulent financials. To avoid tax, many companies try and hide their real operating details in the financials, particularly in the SME sector. In Lebanon for example, the banker is told categorically that there are three sets of financials, one for the tax man, one for the bankers, and one for the owner. Call it what you will, this is pure fraud, and the banker ends up providing credit lines to someone who is deliberately cheating. Obviously the banker can either choose not to conduct business with such entities, or given their economic importance, bight the bullet and offer them credit facilities. Hopefully the banker accounts for the character of the obligor in rating its Management appropriately.

So how do obligors fake financials? Below is a short snap shot of what can be manipulated in the numbers:

  1. Sales: Fake invoices, reporting of sales of undelivered services or goods, reporting of contracts only (cases such as Xerox or more recently Mobily of Saudi Arabia).
  2. COGS: Changing of reporting methodologies: switching between FIFO, LIFO, and Average; and adjusting Depreciation rate in manufacturing companies.
  3. SGA: Over or under reporting of expenses, fake expenses, changes rates of depreciation and amortization, and Unrealized gains and losses estimations.
  4. Provisions: Under estimation of provisions on receivables and inventory.
  5. Depreciation: Changing of reporting methodologies: straight line, activity, or accelerated methods.
  6. Fixed Assets: Faking original invoices, re-evaluation of very depleted assets, or simply faking ownership.
  7. Investments: Over estimating original value or not accounting for losses.

Obviously if you were a traditional bankers who tireless examines balance sheets and income statement, the above practices play havoc in your psyche. To minimize the impact of such practices, bankers are encouraged to do the following:

  1. Use cash flow in analyzing credits instead, as changes on the income statement items are canceled by counter-entries in the balance sheet.
  2. Ask questions, and investigate trends and ratios as we promote in our e learning modules.
  3. Ask for clarification on accounting methodology used and how numbers are captured.
  4. In case of need, perform a focused audit on the books.

Remember, the data that is used by bankers to make credit risk decisions have to provide them with comfort of genuineness and applicability. So unless it is audited by a very articulate auditor, the banker would have to do some investigative work. This means that bankers have to be up to speed on accounting knowledge and cash flow analysis.

Perceived Efficient Operations These are related to how the operations of the firm are shown to the banker, and where bankers can be mislead:

  • Location: Showing someone else’s, ie non-existent operation, or expiry of sublease.
  • Inventory: Non-existent, empty boxes, expired items, non-moving items. So kick boxes to see if they are empty, check the third row for expiry dates, and check for dust on shelves. Also be wary of misrepresentation on documentation (lead instead of silver alloy).
  • Machinery: Leased not owned, borrowed rather than purchased, not connected and not operational.

Perceived High Networth Bankers, especially junior ones, are enamored with wealth, assertive characters and exuberant charm. These theatricals can manifest in physical attributes, such as exuberant life styles, fancy cars, luxurious offices and houses, and reported numerous real estate holdings. Remember to spot the traits: kiting or passing the hat syndrome, and check ownership documents.

Trade Trade remains one of the softest areas for fraudsters. This is probably due to (a) bankers are involved in paperwork only providing little by way of due diligence on the transactions, and (b) banks lack the knowledge of how to spot fraud. The paperwork in question includes:

a) Letters of Credit b) Bills of Lading c) Invoices

And the issues that may arise that should be spotted by bankers are:

  1. Will there be two bills of lading in circulation at the same time?
  2. Who issues these bills of lading and when?
  3. Does the cargo exist? If not, could this be part of a bigger scam such as money laundering?
  4. Insurance does not cover non-existing goods or if goods are damaged before loading on ship.
  5. Non-Vessel Owning Common Carrier (NVOCCs) fulfill an important role in filling slots on container vessels, but in some cases their close relationship with cargo owners makes them a convenient partner in the production of false documents.
  6. Transferable LCs or Back to Back arrangements using related parties and faking transactions.

In these cases, one of the most affective mitigants is for banks to undertake independent random checks into transactions, ie authenticate bills of lading and other documents from amongst a variety of clients. Checks can be done for FREE by the CCS Bureau for their members.

In addition, and despite the fact that banks must honor their obligations to pay under documentary credits (as the credit is autonomous from the goods or contracts), banks can refuse payment if:

  1. Docs are not compliant (obviously) OR
  2. There is clear evidence of fraud; and the bank has clear notice of this evidence of fraud; and the bank’s awareness that the fraud is “timely” and non-coincidental.

All told, the most effective way to minimize fraud is to conduct thorough due diligence on your clients. Simple Credit Risk Management .

For more details on our training modules, please visit www.credit-risk-store.com

While the information contained herein is believed to be accurate, neither 6 Sigma nor any of its affiliates or subsidiaries or its employees makes any representation or warranty, express or implied, as to the accuracy or completeness of the information set out in this document or that it will remain unchanged after the date of issue of this document, and accordingly neither 6 Sigma nor any of their respective affiliates or subsidiaries or employees has any responsibility for such information. This document is not intended by 6 Sigma to provide the sole basis of any credit decision or other evaluation and should not be considered as a recommendation by 6 Sigma that any recipient of this document should purchase an equity stake in, provide credit facilities to, or conduct any business with any company(ies) listed in this document. Each recipient should determine its interest in the information provided herein upon such independent investigations as it deems necessary and appropriate for such purpose without reliance upon 6 Sigma.

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