This year Southwest Bancorp. of Texas in Houston began using custom-designed software to check the backgrounds of its commercial loan applicants.
The Web-based program, designed by Teledata Communications Inc. of Hauppauge, N.Y., verifies applicants' Social Security numbers, checks to see if their names show up in civil or criminal court records, and pulls their personal credit reports and those of their companies, among other things.
One would expect a bank to thoroughly review the background of its commercial customers before giving them seven-figure loan deals, but industry analysts say Southwest is in the minority among community banks.
"A lot of bankers never really check much into the background of their borrowers," said Kenneth W. Proctor, the director of risk management for Brintech Inc., a New Smyrna Beach, Fla., financial institution consulting firm. "They say they do, but they don't."
In fact, Jack Vonder Heide, the president of Technology Briefing Centers Inc., an Oak Brook, Ill., firm that advises banks on risk management, estimated that nine of 10 community banks do nothing beyond obtaining an audited financial statement and a Dun & Bradstreet report.
But experts are predicting that bankers' attitudes toward background checks are about to undergo a radical change - much like their attitudes toward privacy did a few years ago.
John Reber, the vice president for risk management at the $1 billion-asset Sun Bancorp Inc. in Selinsgrove, Pa., predicts that within a few years Southwest's practice of conducting automated background checks on commercial loan applicants will go from being the exception to being the rule at community banks.
The change will have everything to do with fraud. Industry analysts and many bankers say community banks are increasingly vulnerable to commercial loan scams.
Joseph D. Reid, the chairman and chief executive officer of Capitol Bancorp in Lansing, Mich., went so far as to tab fraud, not credit quality or interest rate risk, as the industry's biggest threat.
"If there's anything that keeps me up at night, it's fraud," Mr. Reid said.
Mr. Vonder Heide said CEOs at money-center banks probably worry less about fraud than Mr. Reid, but that may be because most already use background-checking software, including programs that search the Internet constantly for information about their borrowers.
Crooks know this, he said, and there is evidence that they are focusing their attention on small banks.
A 2002 survey by the American Bankers Association found that fraud rose between 1999 and 2001 at banks with less than $5 billion of assets. When the survey was released bankers and fraud experts said small-bank fraud had risen because criminals were aware that bigger banks had more sophisticated fraud-detection systems.
Since the start of 2002 a number of community banks have reported losses on loans where the borrower put bogus personal or financial information in the application. In March 2003, for instance, federal authorities indicted a prominent Ocean City, N.J., developer for allegedly using falsified documents to obtain $36 million of loans from five banks.
James M. Dwyer, 61, defaulted on most of those loans, U.S. Attorney Christopher J. Christie said in a press release issued last month.
Another case involved Sun, which uncovered a $2 million of fraudulent commercial loan 18 months ago. Though it recovered most of the money, the incident prompted it to conduct a comprehensive review of its underwriting policies.
As a result, Mr. Reber said, Sun will not lend money to a company until it receives an audited financial statement delivered by the accounting firm that did the work, not by the borrower. "We feel a CPA firm is someone you should be able to place your trust in."
Sun does not yet perform automated checks, but it will almost certainly invest in a program similar to Southwest's if it continues to grow and expands into more urban markets, he said.
Mr. Vonder Heide who advises the Conference of State Banking Supervisors on security issues, praised Sun's policy and called it a good example of a bank tightening its procedures after being victimized by fraud. However, he also said a comprehensive background check should go even father than obtaining verified financial statements.
For example, a civil litigation check, to ascertain whether an applicant is being sued, is a "key" component in a comprehensive background check, he said.
Regulators in several states are reviewing the effectiveness of background-checking software, though they do not require banks to have such systems in place, Mr. Vonder Heide said.
Pennsylvania Secretary of Banking A. William Schenk 3d said instances of loan fraud are "a pretty rare occurrence" in his state. But he also said he would consider recommending that state-chartered banks conduct background checks on loan applicants if the situation changes.
"In the short run, I don't think" background-checking software "is … going to be a big seller, but if we begin to see a trend toward increasing commercial loan fraud, we'll start asking questions and looking at background checks," he said.
Like Mr. Reber at Sun, Ray Weilage, the CEO of the Roswell, Ga., consulting firm TayBridge Compliance Inc., learned the value of a good background check the hard way. Mr. Weilage has worked in banking for 30 years, as a CEO and more recently a consultant, but that experience did not prevent him from getting stung recently.
He said his troubles started last year, when he agreed to do some of the groundwork for a Florida man who said he was interested in starting a bank.
"I went forward and did all the due diligence," Mr. Weilage said. "When it came time to pay me, I got three checks for $40,000 that were all returned for insufficient funds."
At that point, he said, he paid for a computer background check and found that his client had several felony convictions on his record.
Since then, Mr. Weilage said, his firm has formed a strategic alliance with InsightAmerica Inc., a Broomfield, Colo., company that offers several background-check software for banks.
"The data they can pull down is incredible," he said. "They can check billions of records in seconds."
Bill Palko, Southwest's senior vice president of credit investigations, said it is possible for banks to conduct the kind of investigations that Mr. Weilage, Mr. Vonder Heide, and others advocate without purchasing expensive software, but not without investing hundreds of employee hours in the effort.
"Before we integrated this technology into our system, it was a laborious, painstaking, and expensive effort to identify potential fraud," he said. "It's the best of all possible worlds if you can catch fraud before it occurs, but we had reached a stage where we were more likely to catch things after they'd happened."
Though he would not give details, Mr. Palko said Southwest's new software has already flagged several applications "where a potential for fraud existed."
According to Mr. Palko, the software is more efficient and more thorough than the manual checks Southwest was conducting. "I've been in banking 21 years, 17 of those dealing with problem assets. I've never had something this comprehensive before."
In addition to searching various databases for adverse information, the software generates a score - much like the one on a credit report - that lets the bank know whether further investigation is warranted, or whether an application should be rejected outright.
"What it does in a nutshell is what I was going out and doing manually," Mr. Palko said. "It pulls the various reports, looks at them, and makes a decision. There was a cost to this, but we feel like we're on the leading edge of attempting to detect credit fraud."
