What Is Fraud And How To Prevent It In Retail Finance ?

Fraud as an aspect of corruption normally happens in companies where the governance structures are weak or have become corrupted themselves.

For many years, there have been no records of frauds and types of frauds committed in finance companies in India. Do they consider  fraud risk less important or as a part of business?

In contrast, MNCs give a lot of importance to frauds and more to internal frauds. They record all the suspected frauds, get them investigated thoroughly, ensure severe punishment, ensure legal action in severe cases and improve policies, processes and procedures to mitigate similar future occurrences.

Reserve Bank of India, the regulating authority for finance companies in India, requires all frauds to be reported and monitored, vide their circular DNBS.PD.CC. No. 121 / 03.10.042 / 2008-09 dated July 1, 2008. Record of fraud information in the format, as recommended for reporting in the above circular, may be used by companies, for both systamatic record and easy reporting.

More importantly, frauds contribute the most to credit losses in finance companies. It is estimated that 1-2% of asset financed are lost due to frauds.

What is fraud?

A fraud is an intentional deception made for personal gain or to damage another; Fraud is a crime, and also a civil law violation.

Defrauding people or entities of money or valuables is a common purpose of fraud.

It is a false representation of a matter of fact—whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed—that deceives and is intended to deceive another so that the individual will act upon it to her or his legal injury.

Fraud has five elements: (1) a false statement of a material fact, (2) knowledge on the part of the defendant that the statement is untrue, (3) intent on the part of the defendant to deceive the alleged victim, (4) justifiable reliance by the alleged victim on the statement, and (5) injury to the alleged victim as a result.

The Association of Certified Examiners of Fraud in the USA, define fraud as the “use of one’s occupation for personal enrichment through deliberate misuse or misapplication of the employing companys’ resources or assets.”

The Collins English dictionary (1999) defines fraud as “a criminal offence in which a person acts in a deceitful way. Fraud can therefore be categorized as either internal or external.”

How does RBI classify Fraud?

RBI based mainly on the provisions of the Indian Penal Code and frauds have been classified as under

• Misappropriation and criminal breach of trust.
• Fraudulent encashment through forged instruments, manipulation of books of account   or through fictitious accounts and conversion of property.
• Unauthorized credit facilities extended for reward or for illegal gratification.
• Negligence and cash shortages.
• Cheating and forgery.
• Irregularities in foreign exchange transactions.
• Any other type of fraud not coming under the specific heads as above.

RBI guidelines for reporting frauds to police:

Finance companies should follow the following guidelines for reporting of frauds such as unauthorized credit facilities extended by the NBFC for illegal gratification, negligence and cash shortages, cheating, forgery, etc. to the State Police authorities:

(a)    In dealing with cases of fraud/embezzlement, NBFCs should not merely be actuated by the necessity of recovering expeditiously the amount involved, but should also be motivated by public interest and the need for ensuring that the guilty persons do not go unpunished.

(b)   Therefore, as a general rule, the following cases should invariably be referred to the State Police:

(i)         Cases of fraud involving an amount of Rs. 1 lakh and above, committed by outsiders on their own and/or with the connivance of NBFC staff/officers.

(ii)        Cases of fraud committed by NBFC employees, when it involves NBFC funds exceeding Rs. 10,000/-.

Can 'handling of fraud' be left to the police?

Our law enforcers are too busy to detect fraud. Crimes involving personal injury or loss of life usually demand more immediate attention by police officers than do frauds. Besides, being a fraud investigator requires something more: a measure of financial knowledge and a criminal bent of mind.

Why fraud?

It is important to understand why people commit frauds. Crime group and / or employees, commit frauds because of:

• Greed ; they want to have it all and more than any one else
• Peer pressure especially where the peers have done very well financially
• Personal financial difficulties like gambling, drug abuse or alcoholism, habits that must be supported and which are very expensive
• Revenge or grudges that will motivate one to commit fraud
• Dishonesty by customer,employee, agents,etc.
• Greediness of customer and enticement og employee or agent
• Inefficient process, procedures, lack of control and oversight
• Fear of intimidation or threats that will lead to commit fraud
• Unrealistic targets that cannot be achieved
• Lenient penalty given to those who have been caught committing fraud; it will encourage others to attempt fraud since they will get away lightly
• Concealment of major incidences of fraud by companies earlier
• Employees’ awareness that management is window dressing accounts

How to prevent?

Companies must eliminate one or more of these three elements: perceived pressure, perceived opportunity, and rationalization. Only these three elements, which make up what's called the fraud triangle, are needed to make an honest employee do dishonest things.

Perceived pressure can be anything from pressure at work to produce results to pressure to cover personal financial obligations. Perceived opportunity is the perception that someone can commit fraud without getting caught. And rationalization is how employees convince themselves that there's really nothing wrong with their actions

There are two major factors involved in preventing fraud.

The first factor creates a culture that takes away opportunities to commit fraud and has the following components:

• Hire honest people and then provide fraud awareness training.
• Create a positive work environment.
• Have a well-understood and respected code of ethics.
• Create an expectation that dishonesty will be punished.

The second factor is directed at eliminating opportunities to commit fraud. Here are ways to do that:

• Have a good system of internal controls.
• Discourage collusion between employees and customers or vendors.
• Clearly inform vendors and other outside contacts, of the company's policies against fraud.
• Monitor employees.
• Provide a hotline for anonymous tips.
• Conduct proactive auditing.

Common frauds in retail finance companies:

• Theft and embezzlement of cash by employees
• Misapplication of installment received
• Misuse of cash receipts by employees, customers and/ or debt collection agencies
• Wrong identity of applicant; fudged documents by employees and/or by direct marketing agents
• Conditions of disbursement are not fulfilled
• Misuse of credit; no underlying asset bought
• Defective titles to the underlying asset
• Lien not marked; lien wrongfully cancelled; and lien of other financier marked
• Intentional misplacement of the file including, contract/agreement
• Asset repossessed, but not reached the yard; dilapidated asset repossessed; wrong asset repossessed; theft of components from the repossessed asset; and repossessed asset missing from storage
• Repossessed vehicle sold for lower price; unapproved sale; and unathorised return to customers
• Unauthorized settlement with customers by employees, repossessing agency and debt collection agencies; Unauthorized "No due" letters issued
• Over statement of expenses, charges and fees by employees and/or service providers.
• Unauthorized software alteration; data manipulation; and cyber crimes by accountants.

How proactive  is your company?

(a)    To what extent has the company established a process for oversight of fraud risks?

(b)   To what extent has the company created “ownership” of fraud risks by identifying a member of senior management as having responsibility for managing all fraud risks ?

(c)    To what extent has the company implemented an ongoing process for regular identification of the significant fraud risks to which it is exposed?

(d)   To what extent has the company implemented measures to eliminate or reduce through process reengineering each of the significant fraud risks identified ?

(e)    To what extent has the company implemented measures at the process level designed to prevent, deter and detect each of the significant fraud risks identified ?

(f)    To what extent has the company implemented a process to promote ethical behavior, deter wrong doing and facilitate two-way communication on difficult/ confusing issues?

Reduce Losses

Losses are a function of mindless orientation towards sales numbers and lack of credit management.

It is true that sales are important in any business, so is in finance business. Sales bring profits.

In many a bank, more so in MNC banks, I have heard that the top guy with orientation of marketing or credit is named alternatively for any branch. The first guy would show result in terms of sales and credit guy would clean up. It may be true because a country head or a product head in MNCs are normally for a three years term and they are under stress to show results to get a ‘better position’. Lest, they would be shown door.

In a competitive business like finance business, every thing gets measured by the boss, except the credit quality which shows up after an average period of 1-2 years. Losses occur after the term is over and the horse is bolted. It is important that banks and NBFCs have adequate credit analytics to show and even predict the quality of credit and portfolio regularly, at an interval not less than 3 months.

Probability of loss is 100% when there is lack of credit management in finance or banking business. They have a very high correlation with losses.

Credit losses arise because of:

1. External fraud by crime groups
2. Internal fraud by sales guys jointly with or without Direct Marketing Agents
3. Lack of credit history of customers
4. Bad credit policy
5. Too many subjective and qualitative assessment of credit
6. Too many exceptions because of interference of the top guy/ seniors.

Strong collection mechanism and strong credit management would deter crime groups and internal employees attempting to defraud by falsifying the application and documents. There are agencies like Experian is available, whose services will help avoid frauds in application stage to a large extent, at least in retail finance business, where number of applications is huge.

CIBIL

Credit history is made available by CIBIL in India; I believe they also offer credit score/ rating. They have done a commendable job of getting about 90 % of lenders to share the credit history of their customers. My experience, at least about 5 years ago, was that not many banks could share the right data in full, and from across India. More computerization of banks had happened since then and I am sure the data provided currently would be highly reliable. My suggestion would be to avoid all customers whose credit history is not traceable in CIBIL.

Should one use exclusively CIBIL credit scoring in approval process?

Rather not. CIBIL score is based on assessment of the ability of the customer to pay on the existing loans. It has no recourse to any other vital information that would be required to fully assess “ability and intention” of the customers and to quantify the credit risk of the customer more accurately.

Most of credit policies are made by "cut & paste" of competitor policies. It must be simple, clear and purposeful, supported by an internal credit scoring model, giving weight to credit history, credit score offered by CIBIL. Credit policy must be company specific and must be internal. There could be enough discussion on formulating the policy among heads of all departments including collection, sales & marketing. But, the interference must not be allowed with the policy till the next review meeting; feedbacks are welcome. Collection analytics like early default analysis, standard deviation of payments, ratio of high-risk accounts sourced in the last one year may be the bases for tinkering the policy and the norms like LTV, etc.

Strong collection department, and preferably internal recovery & legal vertical under collection department will go a long way in achieving better recovery ratio. Of course, the collection analytics will  help to direct efforts appropriately to achieve better collection and the right focus to mitigate losses.

Repossession of underlying asset is the most important activity to reduce or even mitigate losses. Why do you have an underlying asset as security, if you cannot have recourse to?

It is normal and easy to blame that collections are poor and losses are higher, because of inefficiency of collection department. May be. I recall here the famous statement of one my vice-president Carlos who once said, “Best of collections will not solve collections problem, but better credit will”.

Currently, the profit margins are 5-6% in retail finance business. Net margins are as low as 3-4%. It is clear that no bank or company can afford losses beyond this. What is important is that for, every 1% loss, the company's sales will have to be 33% more,  to have the same level of risk adjusted return.

Is it easy to do sales? Even if you can, is capital easily available? Even if capital is available, can you assure “return”? O boy! losses are too costly.

Is there an option? Reduce Losses.

Avoid Systemic Risk

In any finance company or bank, debt collection takes the back seat till losses mount to a rate higher than profitability. Typically, debt-collection is restricted to a small team reporting to sales structure.

As mentioned elsewhere, inaccurate customer accounts lead to a lot of confusion, erosion of brand image leading to lower sales and high delinquency & losses. In a decentralised set up, accurate accounts are almost impossible. Technology needs to be put to use to ensure that customer accounts are accurate to avoid systemic risk. That would ensure the right delinquency reports. In fact, delinquency reports may have to flow from central system to avoid any manipulation to delinquency rate/ collection rate. I am aware that in at least 4 large finance companies in India, companies still relay on delinquency reports prepared by branches for review meeting, despite huge investments made in collection system software.

Things are different in MNC banks and finance companies. There is a lot of importance given to debt collection and credit underwriting. Most importantly, both collection and credit department are placed under a single head, making him/ her responsible for any delinquency and losses. Bad credit and frauds are major reasons for creation of delinquency. Some external factors like dramatic change of economic conditions, natural calamity, etc. may contribute to delinquency and consequently to losses. Placing credit and collection under the same department would avoid systemic risk of passing of bucks and bring the necessary credit control leading to lower losses.

The companies need to put down in clear terms the credit policy and revisions if any very systematically and let all departments know on monthly basis so as to avoid sourcing bad files.

Mother Of All Losses

Losses contribute significantly to the closure of many organizations, especially banks, finance companies (NBFCs in India).

Losses are because of:

1.      Bad credit;

2.      Lower prices;

3.      Manipulation of accounts for varied reasons, including tax;

4.      Inefficient technology, wrong policies, bad processes; and

5.      Frauds.

Frauds are mother of all losses in any organization more so in banks and finance companies. Frauds emerge from external sources and in more cases with help of internal sources.

Internal source, we mean here, are employees. Human Resource (HR) contributes the most by recruiting and continuing with fraudulent employees.

Good, efficient and effective employees are rare; it applies to HR people as well. So, bad HR recruits bad employees. Even Good HR do compromise on reference check, etc., so necessary for employees in financial service companies, because of shortage of people. They come under pressure often, from the top management. Aren’t they expected to be professional? Is it fraud?

Interviewers are manipulated easily by these frauds; they are obviously smarter. It is easier with phone or web com interviews. There was a senior guy who can speak freely, only under influence of alcohol. He was recruited for #2 position of the company by a MNC, on an overseas call; he even hidden his heart ailment by resorting to a medical test in a hospital convenient to him. He went on to become the managing director, by default. He was dismissed unceremoniously when they found that he not only manipulated his resume and credentials, but also policies, processes and the worst, the people. Is it fraud?

The wrong policy and inefficient processes also contribute significantly and go to help frauds, leading to losses. Policies are set by the top management. They take policies which are at times are  high risk, just to achieve, in short term, some advantages over competitors in terms of TAT  = turn-around-time. Very rarely, even top management could orient policies just to facilitate achieving his main KRA/ KPI. Policy and process are commonly compromised when the top man is a sales guy. You cannot blame them, because a top man of any listed company in current times lives by quarters; they are under pressure to announce growth serially, QoQ and YoY.  Is it a fraud?

Major facilitator for fraud perpetrators are the decentralized credit underwriting, decentralized accounting and decentralized collateral storage. Common thread here is ‘decentralization’ and half the frauds can be stopped by having a centralized control on credit underwriting, customer accounts and collateral storage. With banks’ current service offerings and available technology on high speed Internet, centralization is cheap, efficient and effective. Branches and different regions cry foul for TAT (read ‘power’) and data. All are possible with advent of high technology, today. Inaccurate customer accounts are what all it starts with, in a decentralized environment. Is it fraud?

Credit underwriting is compromised quickly, when there is a pressure for numbers as month gets close. Many losses occur out of these end-of-month syndrome accounts. I knew a branch manager in Madurai, who would approve every file on the last days of any month while those were rejected by him at the beginning of the month. Fraudulent subordinates and the manager knew this too well, but this happened regularly every month till the company lasted. Is it a fraud?

Losses out of internal frauds are about 1% of assets under finance and run into a few thousand crores for India. Unfortunately, a fraction of it only goes to these internal frauds; remaining goes to facilitators.

What are they worth in terms of sales?

Loan-to-Value = LTV

Loan-to-Value = LTV

It is good to be in asset financing as assets become collateral to the loans offered by banking and non-banking institutions. It is on the premise that when loan repayments are delayed, the lenders could have recourse to assets by taking possession of assets and disposing them to realise the  outstanding.
It may be true if the lien is marked, the company has capacity to repossess and loan to value, say LTV is appropriate.

Many lenders may not verify, inspect assets and may not ensure lien marking properly and accurately. When the lien is not marked, it becomes 'clean' loans, call it unsecured loans,etc. This is a major operational problem especially when the loan is already disbursed. Worse, many lenders depend on 'service providers' to complete the lien marking. The lenders and its executives never get to see or verify the originals as only 'copies' are churned out by the services providers, leading to huge ineffectiveness, inefficiency or even fraud in this area. Non-lien marking helps the borrowers to dispose the asset fraudulently and bonafide buyers will never know that the assets are tainted.

This apart, loan-to-value (LTV) wrongly and fraudulently applied by appraisers create huge losses to lenders. Appraisers and underwriters are,  many a time misled by inflated information on value of the assets. Some marketing jokers in finance business use their clout with management to dismantle any good underwriting policy and process in place. They are forced to have different definitions at different times , leading to LTV exceeding the acquisition cost of the asset by borrowers; it is precisely the intention of bad customers. Lenders end up buying the 'pure' risk.

 Many companies try to finance, to win more customers and to achieve higher sales, all that borrowers spend on the assets.  For example, many governments collect huge money as road tax upfront for life time. This does not add any value to the working of an asset, say Truck. The same must be allowed to be financed by borrowers from his own funds; companies may take only ex-dealers price as 'value' and it may not include any add-ons/ extra-fittings' values.

Value of an used-asset is too difficult to arrive,especially if they are depreciating assets like auto cars, trucks,etc.In the case of used-vehicles financing, many valuation  models and processes are followed to arrive at the 'right ' value. Very little success is achieved in India, with lack of red/ blue books available elsewhere as reference. Appraisers are misled by wrong valuation reports generated by influenced  insurance surveyers/ valuers, to achieve the desired 'finance amount'.

The best policy and process are to have a own quantitative discounting model based on brand, make, model, age, usage, etc. This should reflect, may be up to maximum of 120% of sale price of its repossessed / seized vehicles, sold by the company.

More importantly, LTV may not be model or asset specific but borrower specific. Again, a quantitative score model developed on factors/ information which may reveal his 'ability' and 'intention' to repay.The score may decide the range of LTVs that may be considered as good , read along with many qualitative information in application,  that appraiser may have access to.

What if the top man is a 'sales guy' and thinks that profits flow from sales, so sales alone are important. He may not agree in the short term that credit losses reduce profits in the long run.

LTV is also called Loan-to-Cost or Credit-to-Cost. This ratio claculated accurately for the company as a whole is used a measure of credit; lower LTV/LTC/CTC means better credit underwriting and lower risk.