Magazine article American Banker

Comment: Character Trumps Controls in Fraud Prevention Efforts

Magazine article American Banker

Comment: Character Trumps Controls in Fraud Prevention Efforts

Article excerpt

Whenever a major fraud case, such as the Allfirst Bank currency trading scandal, is uncovered, I get calls from general circulation newspaper reporters asking why it happened.

Reporters often assume that such debacles could be avoided if better controls were in place, and they want me to say that the bank in question simply did not know what it was doing. Instead, I tell them what every bank officer knows: It is difficult to prevent someone inside or outside a bank from stealing if that person wants to.

The reporters then ask what banks can do to protect themselves. Again, I do not give them the red meat they want for their stories, and I think that bankers will agree that my response is realistic.

When it comes to lending, the first step in protecting your bank from loan losses, of course, is to evaluate carefully the character of your employees and customers. Of the four C's of credit (character, capacity, conditions, and collateral), most lenders will agree that character is the most important. If someone's character is deficient, no controls can prevent that person from committing fraud.

Also, every workout officer knows that collateral is a thin reed when you try to recover losses. That is why I teach my students that there are not four C's of credit, but three C's and a C-minus, collateral.

But beyond checking character with as much diligence as possible, what can a bank do to avoid the losses caused by rogue trades?

First, it is useful for a bank that takes a loss to examine why it happened. Usually, after taking an initial loss, the trader or investor sort of doubles up on a transaction to try to cover the loss, but instead makes things worse. That trader then takes bigger and bigger risks to try to make up for the loss, and the situation snowballs until it is uncovered.

Other times a loss begins with a counterparty's dishonest action. …

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