WASHINGTON There can be little doubt that fraud is the Achilles heel of the banking industry, as the failures of three banks this year and the disappearance of $750 million from another served to remind.
In light of these and other notorious cases in recent years, analysts and academics are getting louder in asking why regulators have not done more to prevent the problem. For years, supervisors have repeated the same defense fraud is hard to find and its detection is not the primary purpose of an exam.
We are safety-and-soundness examiners we are not auditors, said Scott ODonnell, the Ohio state banking supervisor. Oakwood Deposit Bank Co., which collapsed this month after authorities accused a bank executive of secretly diverting millions of dollars to a personal investment, was in Mr. ODonnells jurisdiction.
The supervisor added: We are not certifying to the annual report we are doing an asset examination. But when it comes to more finite auditing practices, that is the reason someone hires an outside auditor.
That position rankles some former regulators, who argue that an exam is not sound if someone can make off with more than half of a banks assets as was the case with Oakwood.
There is a sort of twisted logic here Our job is to evaluate the quality of assets, but that job doesnt require us to make sure the assets exist, said William Isaac, the chairman of Secura Group, in Falls Church, Va., and a former chairman of the Federal Deposit Insurance Corp. Lets say you go into a bank in Oakwood, Ohio, and you take a look at assets to evaluate and see they are high-quality. No problem. But then it turns out half of the assets are missing. Can you really say you did your job right?
The Office of the Comptroller of the Currency said managers at Hamilton Bank in Miami, which was shut down Jan. 11, willfully misled and deceived examiners. Bank of Sierra Blanca in Texas collapsed Jan. 23, the FDIC citing an embezzlement scheme, and Oakwood Deposit Bank was shuttered Feb. 1 after regulators accused the chief executive officer of funneling $40 million to a South Carolina casino.
Then on Feb. 6 regulators said they had discovered that a rogue trader at Allfirst Bank, the Baltimore subsidiary of Allied Irish Banks PLC of Dublin, had lost $750 million through what the regulators said were fraudulent currency trades.
Prosecutions are continuing in an egregious case of fraud exposed by the 1999 failure of First National Bank of Keystone, when regulators discovered that half of the West Virginia banks $1.1 billion of assets was missing. Several bank executives have been convicted of participating in an elaborate scheme in connection with that case.
Regulators insist they are vigilant and have the expertise, but there are signs that these failures are changing the ways regulators look for fraud.
The Comptrollers Office and the FDIC said that it has fraud specialists in each of its regions. A spokesman with the office said that looking for potential fraud is part of its standard procedures, and both he and FDIC officials emphasized the importance of pushing banks to strengthen internal controls. The OCC spokesman said it currently has 12 certified fraud examiners and is training approximately 36 more.
John Lane, associate director of the FDICs division of supervision, said that in the last two years the agency has tried to be less reliant on external auditors and focus on internal procedures in fraud prevention.
Weve conducted more reviews of accountants work papers since 2000, and focused more on internal audits and testing of controls, Mr. Lane said. We have identified deficiencies, and employment at some places has been affected. In other instances, where we cant take action, weve referred the matter to law enforcement.
Mr. Lane said that since Sept. 11 the agency has tightened internal controls in an attempt to stop the flow of dirty money through legitimate institutions.
A Federal Reserve Board spokesman said the central bank expects the institutions it supervises to have robust controls designed to prevent and detect fraud.
Though in an examination it is not possible to look at every transaction a bank undertakes, the Fed spokesman added, examiners look closely at banking organizations risk management policies and procedures, at the internal control systems designed to ensure compliance with those policies and procedures, and at the external and internal auditing used to validate those controls. When necessary, examiners also test individual transactions to validate the efficacy of a banks policies, procedures, and controls.
Mr. ODonnell would not discuss specifics of the Oakwood case, which was also regulated by the Federal Reserve Bank of Cleveland, because their investigation is ongoing, but he and other regulators contend that fraud can be very hard to spot. Some industry representatives pointed to the Ohio case as a perfect example.
Until the person committing the fraud does something out of the ordinary, or lets something fall out of balance, it is just tough to find, said Neil Milner, the president of the Conference of State Bank Supervisors. The guy in Ohio was not living a high lifestyle. There were no signs he was pulling money out. Investing it in a South Carolina casino is not something you would anticipate a small banker doing.
But others disagree, and say regulators are not doing enough.
Fraud is the most dangerous thing to banks, said George J. Benston, the economics and accounting professor at the Goizueta Business School at Emory University in Atlanta. Most bank failures, other than the savings and loan crisis or a big economic downturn, are traditionally caused by fraud. The idea that examiners say that it is not their business is crazy. That is exactly what they should be concerned about. Clearly, there is a problem here that is not being solved.
Mr. Benston said change has to start with examiners view of the banks they investigate.
They could reduce fraud very substantially just by thinking about it, Mr. Benston said. By asking what are the various ways someone can cheat? By now they should be able to figure out all the ways to defraud a bank there arent that many.
But some fear the creation of more rigorous procedures that would unfairly punish the vast majority of bankers who do their jobs correctly.
Fraud goes to the integrity of the individuals, and that is a hard thing to identify, Mr. ODonnell said. Ninety-nine percent of people in the banking business have very high integrity and carry out their responsibilities in their communities.
