Check Fraud:
Just the Cost of Doing Business? Or Dereliction of Duty?

By Paul Carrubba
Senior Vice President & Managing Director,Carreker Corporation

New developments are causing small and mid-sized banks gear up, finally, against check fraud:

1. Check fraud is rising about 15% a year - outpacing check volume growth.
   
2. Small and mid-sized banks are increasingly the targets of check fraud.
   
3. Their primary defense, signature verification, is increasingly costly and ineffective.
   
4. In the event of fraud, they now shoulder greater liability.
   
5. Fraud mitigation technology has been scaled down to suite their needs and budgets.
   

Criminals are more wary of larger banks as they implement new technology to combat check fraud. Rather than risk exposure from the new technology, criminals tend to target institutions without protection: Increasingly that means small- to mid-size banks that have not invested in fraud-prevention technology.

Bankers at smaller institutions often have trouble justifying the cost of fraud prevention strategies, but that is often the result of not having the tools available to adequately gauge fraud losses. Many bankers work hard to capture new customers, cross-sell products and eke out a slightly higher interest rate without thinking of how those profits can easily be lost through fraudulent activity.

To be fair, many mistakenly believe that even with their best efforts, they will detect and avoid only a small proportion of attempted fraud, and that attempts to prosecute criminals will be even less effective. Many believe that fraud mitigation technology is affordable only for the very large banks. Other banks are simply not aware of how much money they are losing to fraud because they don’t track fraud - and often, the fraud numbers are categorized as “credit losses.”

However, technology has improved to the point that much of today’s check fraud can be detected and avoided through cost-effective PC technology. The bad news is that criminals have better technology, too. And they are increasingly adept at targeting banks that are less likely to have preventive technology - community banks and smaller regional banks.

The statistics tell the worrisome story. According to the American Bankers Association fraud survey released in December: Check fraud overall rose 32% for the two-year period. But it rose 35% at banks with less than $500 million in assets, and it rose a staggering 46% at banks with $500 billion to $50 billion in assets.

The ABA acknowledges this trend was unexpected. After all, large banks had long been the best targets for fraudsters because largeness offers anonymity, whereas community banks were more likely to recognize their individual depositors.

But the fact is, large banks have taken many of the necessary steps to mitigate their fraud losses. They have invested in the technology. They have done a better job of prosecuting criminals. And they have done a better job of sharing information with other banks to improve in both of these areas.

That hasn’t stopped fraudulent activity, though. According to the ABA study, attempted check fraud more than doubled from the previous two-year period. All of those attempts will go somewhere.

Large banks’ investment holds a lesson for smaller banks, now that fraud is moving downstream: fraud detection does pay. The ABA reports that of the $2.2 billion in fraudulent checks handled by banks in 1999, check fraud losses at banks were contained at $679 million.

Many of the smaller banks increasingly targeted by fraudsters still maintain, as their main line of defense, the practice of signature verification - manual inspection of all checks over a certain dollar size threshold. But today there is little doubt that signature verification alone is bound to be insufficient.

Moreover, as large check volumes cause banks to increase the threshold of inspected items, they open the window of opportunity for criminals. Today, many banks are setting their inspection threshold as high as $100,000, leaving them vulnerable to losses that can easily wipe out hard-won profits.

A size threshold is hardly an indicator of likelihood of fraud, though. These banks are allocating costly resources without regard to where they are most likely to be successful. When no information technology alternatives existed, that was understandable. But today, there exist powerful repositories of valuable information to indicate probability and predictability of check fraud.

Besides losses, small and mid-sized banks have an even greater incentive to protect themselves. Today, the standards of liability may be shifting to reflect what technology has made possible - the ability to use historical information to predict future instances of fraud, thus reducing the number of checks to be inspected.

Traditionally, when a check fraud had been perpetrated, the courts, in determining whether the bank had exercised reasonable commercial standards, would look to see if the bank had some form of signature verification. In the future, signature verification may no longer be considered sufficient. Courts may expect banks to deploy systems that have been proven more effective at fraud prevention. As a result, banks without such protections may find themselves liable for fraud losses that were once passed on to customers.

As fraud continues to increase, the question for mid-to small-size banks is not “can I afford fraud detection technology?” but “can I afford not to employ fraud detection technology?”