Comment: To Fight Fraud, Phone Before You Loan

Over the past 10 to 15 years banks have reacted predictably to economic growth.

In the '80s we threw caution to the winds. Competition drove CEOs toward growth, at fatal risk to quality. Then came the inevitable crash. Banks failed as the result of bad loans, a percentage of which were blatantly fraudulent.

The failures prompted congressional and regulatory restrictions on credit. For two to three years, lenders became "collectors" of bad loans, and credit became so restricted that it took a series of congressional remedies to correct the economy's course.

Today the economy is growing again, but the playing field is much different. Compressed spreads on loans mean less room or, in some cases, no room for mistakes. With reduced spreads come greater risks.

Competition is at fever pitch; lenders are literally bumping into one another in the hallways of the borrowers' offices.

A year ago, Verne G. Istock, chairman of Detroit's NBD Corp. before its merger with First Chicago Corp., was quoted in The New York Times as saying: "We have really seen a deterioration of standards. Banks are planting the seeds of the next wave of problem loans.

"We're reminding our people that bad loans are made in good times."

To answer the challenge, banks must change their focus from responding to losses after the fact to becoming more proactive.

This would require banks to verify information taken in connection with a loan before money flows out the door.

Several major banks have already instituted due diligence programs. Bank of America has adopted an excellent plan in its Chicago office under the direction of Douglas Griffin, a vice president and manager of business investigative services.

First Chicago NBD Corp., Chase Manhattan Corp., and Wachovia Corp.'s Atlanta bank subsidiary have also set up due diligence departments.

For a number of years Bank of Boston Corp. has used a "know your customer" program to prevent problem loans from going on the books. Under J. David Brady, director of security, this program has paid for itself many times over in the past six years.

What can community banks do to accomplish the same goal?

In the past five or six years, many companies and individuals have initiated due diligence services for banks, law firms, insurance companies, and many other risk-based businesses.

Some of these companies have huge proprietary data bases and, through modern technology, access to other data bases with literally hundreds of millions of names and other valuable verification information.

The simple exercise of verifying a Social Security number can be done in eight cases out of 10 via the social search program of the TRW data base for about $1.25.

Is it worth that amount to verify a Social Security number on a major credit for a new customer with limited background information? One bank in the Northeast lost $2.5 million to an individual who used his father's Social Security number and first name because he had just gotten out of a Texas prison after serving time for loan fraud.

Sophisticated crooks don't steal money; they take money banks give away.

Banks generally do a good job of gathering information from borrowers, analyzing numbers, fulfilling legal obligations, and processing forms. However, banks do an extremely poor job of verifying information submitted on those forms and in some cases verify none of the data. This is a serious weakness.

Bankers must be trained in street smarts. A street-smart lender will invariably find the flaw in an application - whether it be fictitious documents; a nonexistent corporation; overstated collateral; stolen, counterfeit, or nonexistent collateral, or fictitious identification.

The most effective way to accomplish this is through proven verification procedures. Simple things like verifying employment, addresses, telephone numbers, schooling, and banking relationships can be done using a most effective tool - the telephone.

We need to adopt a simple motto for all lenders: "Phone before you loan."

One of the most underused resources in the banking industry today when it comes to verifying information is the security officer. Many security officers are former local, state, or federal law enforcement employees. Each has his own network within law enforcement circles and through various banking associations.

For example, through the Bank Administration Institute and ABA, a security officer can gain access to a network of other officers that offers a wealth of knowledge and communications capability.

Is $250 for a detailed due diligence inquiry on a major credit of $250,000 a sound investment? I suggest that it certainly is when you consider that it takes $6.25 million of new loans on the books for a year at a 4% spread just to recover that $250,000 loss.

Mr. Gearin is a financial institutions security consultant. In 1993 he retired after 27 years as the director of corporate security for Shawmut National Corp.

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