Banks reveal exposure to alleged fraud

The financial papers are abuzz with the news of leading European banks' exposure to the alleged fraud committed by Bernard Madoff of Bernard L. Madoff Investment Securities, headquartered in the US.

HSBC, RBS, Spain's Santander and France's BNP Paribas reportedly have varying levels of exposure to Mr Madoff's "alleged $50 billion pyramid scheme", which according to the Financial Times, prosecutors allege operated on the basis of paying old investors with money raised from new investors.

RBS, a recipient of the UK government's bail out package in October, reported a potential exposure of £400 million to the alleged pyramid vehicle. According to the Financial Times report, HSBC's potential exposure may be considerably higher (approximately $1 billion). Not good news at a time when banks are already experiencing a significant reversal of fortunes thanks to their exposure to subprime assets. And with counterparty risk high on everyone's agenda, this revelation will come as yet another blow for an already beleaguered banking industry which is likely to face some pointed questions from investors regarding the due diligence they undertook before placing money with Bernard L. Madoff.

It appears that the regulators (in this case the US Securities and Exchange Commission) have also come under fire for ignoring early warning signs pertaining to Bernard L. Madoff Investment Securities. If there had been no credit crisis, then perhaps Madoff's alleged "pyramid scheme" would never have come to light. It also highlights the increasing number of links being made between fraud and the credit crisis.

Before the Madoff incident, a couple of Bear Stearns hedge fund managers were arrested on securities fraud charges and since the subprime meltdown, the US Federal Bureau of Investigation has launched investigations into the collapse of Lehman Brothers, the insurer AIG, and mortgage providers Fannie Mae and Freddie Mac.

According to newspaper reports, the FBI is investigating whether these firms unduly influenced agencies to "inflate" their ratings. It is also looking at whether these firms misled investors about the true state of their assets. The FBI is also believed to be investigating a number of firms over what it terms "subprime lending practices".

The following is taken from a Financial Crimes Report published in 2007 by the FBI and alludes to the potential for fraud in light of the subprime meltdown:

"As publicly traded subprime lenders have suffered financial difficulties due to rising defaults, analyses of company financials have identified instances of false accounting entries, and fraudulently inflated assets and revenues. Investigations have determined that many of these bankrupt subprime lenders manipulated their reported loan portfolio risks and used various accounting schemes to inflate their financial reports. In addition, before these sub prime lenders' stocks rapidly declined in value, executives with insider information sold their equity positions and profited illegally."

The FBI's 2007 Financial Crimes Report shows that the incidence of pending cases related to corporate and securities and commodities fraud has been steadily increasing every year since 2003. The Serious Fraud Office in the UK is also reported to be targeting corporate fraud in the wake of the crisis, calling on bankers and City "whistle blowers" to come forward with any information.

Anti-fraud technologies get smarter

With card fraud and other forms of fraud reportedly on the rise during the economic downturn, anti-fraud management software vendors are having to up their game to play catch-up to the fraudsters.

Business intelligence and analytics vendors such as SAS, focus on not just looking at fraud in terms of monitoring card transactions, but the ability to match seemingly unrelated events across different parts of the business. Its real-time card fraud detection system which is used by banks such as HSBC, reviews card transactions alongside other changes in customer behaviour and then based on that analysis advises in real time as to whether a card transaction should proceed or be flagged for further investigation. Using such a system, HSBC claims to have reduced false positive rates, which is one of the biggest bug bears of any fraud detection system.

But while banks may deploy a system to try and combat the different forms of fraud that are prevalent today, it needs to be flexible enough to predict and detect changes in fraudsters' behaviour patterns in order to avoid detection. Analytics and decision management vendor, Fair Isaac Corporation, is trying to do this in the debit and credit card space with version 6.0 of its Falcon Fraud Manager scoring server, which uses recent advances in fraud analytics and profiling to help banks more quickly identify changing fraud patterns.

Using what it calls, "adaptive analytics", Fair Isaac provides "dynamic, real-time self-calibration of fraud detection models" to help firms more quickly identify changing fraud behavior patterns and improve fraud detection performance.

Another software provider, Actimize has incorporated IBM InfoSphere's Global Name Recognition (GNR) technology into its risk management platform. GNR is designed to help firms overcome challenges in matching names across different cultural and language barriers as part of their financial crime fighting efforts and works by analysing the order of a name, cultural spelling variations, nicknames and different spelling variations.

"[Global Name Analytics] ... can help to identify and correct names that may have been presented in non-standard or incorrect sequential order." It can also identify the "cultural classification" of a person's name using linguistic and statistical tools, which can be useful for Know Your Customer regulations and anti-fraud projects that entail matching names against lists or databases of suspected terrorists or Politically Exposed Persons.

Risk management in your Xmas stocking

This post first appeared on FinancialTech Insider

Go to a Christmas lunch these days and most people will be talking about what they are filling their Christmas stockings with or how they are looking forward to eating turkey yet again for the fourth time in a week. While the conversation at business intelligence and analytics vendor, SAS's Christmas press lunch may have been peppered with such conversational tid bits, the real subject of today's lunch was for SAS to publicise its recent foray into the capital markets space.

Building on its already strong base in the retail banking sector, particularly in the areas of operational risk, credit risk, market risk and financial crime, SAS has put together a team based in the UK that is wholly focused on selling its analytics and risk management solutions to capital markets firms.

2009 is likely to see increased regulatory oversight, particularly when it comes to the overlooked areas of liquidity and counterparty risk; and not one too miss an opportunity, SAS is eager to sell its solutions to a business that is drowning in information, but not quite sure what to do with it or how to make sense of it in order to determine risk, fraud liability etc.

It seems the poor old trader is likely to come under increasing surveillance with intelligent software algorithms monitoring their every move and looking for unusual patterns of behaviour (the ability to match seemingly unrelated events across different parts of the business). The technology certainly exists to provide such surveillance, but the cynic in me says most banks are only likely to embrace these technologies as a 'box ticking' exercise in order to comply with regulation, rather than seeing it as good business per se.

Risk management is suddenly the business to be in, but one has to wonder where was all this wonderful bells and whistles technology when things started going wrong in capital markets? And at the end of the day technology can only do so much.

If the people in charge still view "betting on the bank" as a necessary part of making money, or don't want to listen to those 'little voices' in their risk department warning them that something bad is about to happen; then no amount of technology can account for the fact that the culture within firms has to fundamentally change if risk management is to be viewed as a strategic asset and not something that is ferreted away in a back office somewhere filing reports to regulators that no one really concerns themselves with.

Interestingly, while we only get to hear about the multi-billion dollar losses racked up by rogue traders like Jerome Kerviel, there are plenty of other million dollar losses within banks, which occur on an almost daily basis (be they the result of human error or internal fraud) that we don't get to hear about.

Mark Hudson, industry consultant, Capital Markets, SAS, believes if firms can start minimising those million dollar losses we don't get to hear about via market or trader surveillance technologies then perhaps the industry will have achieved something.

Surely saving the bank a few 'mill' from combating accidental or internal fraud is going to make a CFO's ears prick up in this challenging business climate? And even if it doesn't, then Hudson believes the banks' customers and may be even their shareholders (which lets face it is the government these days) may insist on more risk management oversight.
Posted by Anita Hawser