Limiting a Bank’s Exposure to Fraud: The Latest Tools and Strategies

Banks allocate significant resources to fighting fraud, both in prevention and in maintaining reserves for potential losses. No matter how good the performance is, fraud losses remain a burden on their balance sheets.

Instnt, under the leadership of CEO and founder Sunil Madhu, has been at the forefront of developing innovative ways to combat bank fraud. Madhu recently sat down with Tracy Kitten, Director of Fraud and Security at Javelin Strategy & Research, in a recent PaymentsJournal podcast to talk about the kind of fraud he’s seeing now, and what banks can do to stop it.

A Fraud for Each Silo

Banks have traditionally had to address various types of fraud in different areas of their operations. For example, first-party and stolen ID fraud are common in lending, while checking and savings accounts are vulnerable to fake ID fraud. Credit cards face challenges with e-commerce fraud, and the bank itself may encounter ACH and chargeback reversal fraud.

To fight this, each line of business puts together its own toolbox pattern. To stop the fraud risk while keeping compliant, each line of business assembles half a dozen vendor tools and data providers from the industry, which they then implement in an orchestration waterfall.

Regardless of how good each of those tools are, the overall toolbox performance is generally very poor. Banks constantly have to retool that toolbox to keep abreast of the different types of fraud. This is how the businesses have been operating for a very long time—in their own operational silos.

Too many financial institutions have come to see fraud as just part of doing business.

“But it’s not just about the fraud loss,” Kitten said. “It’s are you funding a terrorist organization? Is there something else behind some of these transactions that you as a financial services entity should be doing the due diligence on? It’s not going to be long, whether it’s in the decision or the Court of public decision or something legislative that comes down before financial institutions are going to be held accountable.”

Challenges from Changing Technology

Fraudsters are increasingly leveraging automation to expand their reach and impact. For instance, a scammer might use a collection of stolen or fake IDs to target numerous businesses, hoping to breach the security of at least one or two.

The financial industry is particularly susceptible to synthetic ID fraud, where fraudsters use fake IDs to open up new accounts and evade detection. In cases of third-party fraud, perpetrators can easily purchase identities of legitimate taxpayers online for minimal cost, bypassing a financial institution’s verification processes.

Within the lending industry, first-party fraud or credit defaults are significant concerns. Compliance regulations like Basel III require financial institutions maintain capital reserves to offset losses from first-party fraud. The requirement ties up capital that could otherwise be deployed for productive purposes within the institution.

“This is very expensive and inefficient use of resources of the institution, and we’re not talking, but small change here,” said Madhu. “We’re talking about hundreds of million or even billions of dollars in terms of first-party fraud loss. If you add the cost of compliance on the back of that, it’s really a terrible cost in terms of not only expenses, but resources allocated in tools they have to acquire and manage.”

The traditional way to stop first-party fraud involves approving the individual for the loan and then monitoring whether they make the initial payment. Typically, a fraudster will fail to make any payments, especially the first one, as they intend to abscond with the money. In contrast, a legitimate borrower would have initiated payment attempts. This type of fraud is commonly referred to as no-pay fraud.

According to the Federal Reserve, no-pay first-party fraud takes 10% to 25% of every dollar receivable for consumer loans, which is a significant amount of money.

“It’s a type of fraud that cannot be reduced to zero because it’s committed by real people,” said Madhu. “But what we can do is use insurance to reshape the loss curve.”

Insurance as a Solution

Fraud loss insurance can not only offset these losses but also prevent businesses from incurring losses in the first place. Rather than having capital set aside for a rainy day, the CFO can convert those reserves into working capital for their businesses. By instilling trust in a customer who has already been onboarded and approved, insurance also increases the top-line revenue for the business. They can say yes to customers who otherwise might have been rejected because their existing risk system couldn’t accommodate a millennial or a thin-file individual.

As Madhu explains, the actual balance sheet risk is held by a separate entity, one of the world’s largest insurance companies. They write the policies and handle the management of the claims payments through instant Insurance agency.

“They’ve managed to create a unique and exclusive partnership with our company because the fraud prevention technology we’ve created allows us to be able to uniquely shift the losses,” Madhu said. “It’s an entirely different type of risk here, given that we’re talking about businesses onboarding new customers, creating new accounts, running transactions through the system, accessing additional products and services through upsells. It is different from liability risk insurance, which businesses hold in terms of handling personal information of customers, privacy, regulation compliance and data breach threats. It’s an entirely new way of dealing with the threat.”