13 February 2009
Fraud was an underlying cause of the current recession, and is bound to become a growing problem as the economy worsens. Jim Gee discusses the measures both public and private organisations should take to tackle the new risks
‘Greed’ and ‘irresponsibility’ have been cited frequently by government and media as the main causes of the economic downturn, and have been the focus of this week’s Treasury select committee grilling of Britain’s banking chiefs.
But there is another culprit: fraud. And this is a problem that is likely to increase as the recession deepens. Already, fraud and forgery offences have risen by 16%, according to the latest Home Office statistics. Organisations need to take action now to counter this, first by ensuring they have a much more accurate assessment of post-credit crisis fraud risks, and secondly by making concerted efforts to reduce the cost of fraud.
Governments and citizens have struggled to understand what has happened over the past few months. Some politicians in the UK initially described the unfolding events as ‘Gordon Brown’s recession’, but it has become clear that this underestimated the public’s intelligence and understanding of the real origins of the crisis.
The Right-of-centre historian, Niall Ferguson, professor of history at Harvard University and a senior research fellow of Jesus College, Oxford, is, as you would expect, very focused. In his book, The ascent of money, he writes: ‘The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a spasm in the credit markets caused by mounting defaults on a species of debt known euphemistically as sub-prime mortgages.’
What is clear is that mortgages were knowingly sold to individuals and families who did not have the income or resources to repay them and, sometimes, where the value of the properties was significantly less than the value of the mortgage. To ‘sweeten’ the deal further, those who were contemplating buying mortgages were offered repayment holidays for periods ranging up to two years.
How could a gain be made when these mortgages could not be repaid? Well, the loans were grouped together with other loans of the same type and repackaged as collateralised debt obligations. These financial securities were then sliced and diced and sold around the world by US and UK banks, so as to be able to claim that the real level of risk of default was no greater than that of a UK or US government bond. Ferguson writes: ‘This took financial alchemy to a new level of sophistication, apparently turning lead into gold.’
Of course, once the repayment holidays on the original mortgages expired, borrowers began to default on their payments, and the US property market slumped. The major banks had to write down the value of their assets, and, eventually, we reached a position where what had started off as a US problem, with the risk of default minimised by virtue of it being spread around the world, eventually engulfed the world.
Another example is the $50bn alleged fraud involving Bernard Madoff, the former chair of the Nasdaq stock exchange. He is currently under house arrest, with his indictment expected later this month, having supposedly persuaded thousands of personal and corporate investors to invest in a fund that paid out interest at a much higher rate than others. In fact, it seems he was paying out interest to existing investors using new investors’ funds, a classic ‘Ponzi’ scheme investment fraud (named after Charles Ponzi, who ran such a fraud in 1910).
Three of the largest losers were Banco Santander (owner of Abbey National and the Alliance & Leicester), HSBC bank and the Royal Bank of Scotland, which between them lost more than $4.7bn. At a time of bank recapitalisation and lending restrictions, these losses will help to deepen the recession.
What can be done to try to avoid such fraudulent behaviour, and its consequences, happening in future? And what can be done to mitigate the worst effects of the recession?
It is difficult not to see the behaviour at the heart of the credit crisis as linked to a failure of regulation, risk management and fraud risk management. If the question is whether we can do better to stop a recurrence of such behaviour, then the answer is, yes, much better.
This recession has resulted from fraudulent and irresponsible behaviour in the financial services sector in the US, the UK and globally. Regulation has been avowedly ‘light touch’ in this sector for two decades.
On the other hand, over a similar period, the public sector has had a grossly unfair image as a haven of fraud and corruption. In fact, it has been tightly regulated, by organisations such as the Audit Commission and the National Audit Office, with the former now assessing public sector bodies against CIPFA’s Managing the risk of fraud guidance.
As a result, problems are comparatively rare and, for the most part, there is a strong ethos of ‘protecting the public purse’.
Major failure in either the public or private sectors can have a severe impact on us as citizens. If this is the case, it must be logical to have comparable and therefore, perhaps, much stronger regulation of the latter. Trust and confidence have to be earned. While public sector organisations have been earning that trust for years, often working in highly difficult circumstances, financial services organisations have shown themselves to be capable of taking the most appalling risks and condoning behaviour that, at the very least, is distinctly unethical.
If it is appropriate for public sector organisations to be reviewed and rated according to the extent to which they use resources effectively and protect themselves against fraud, then it is also appropriate for financial services organisations to be regulated in a similar manner. The government is committed to a ‘cross-economy’ approach to fraud and if the private sector wants to earn the trust of the public again, it could do worse than learn from the public sector about how effective regulation can work.
But there is work to be done by the public sector too. Efforts to manage risk are always important but sometimes these are undertaken without all the factual information that is needed. For example, some organisations put too much confidence in a register of risks. This should not be a shield to hide behind but a fact-based guide to action. Public sector organisations need urgently to consider how existing risks have changed and what new risks they face as a result of the credit crisis – especially from fraud.
A major difficulty in assessing risk is that we are likely to know more about the less damaging risks (because they have happened previously and we have survived and studied them) than those that are likely to have the most drastic effects – the ‘black swans’ as Nassim Nicholas Taleb describes them in his book The black swan – the impact of the highly improbable.
However, even if detailed information is available, the psychology of a period can make people reluctant to consider it. In the early part of 2007, it was almost impossible to find a commentator or major investor who believed that the circumstances of autumn/winter 2008 could come about. This was despite the availability of detailed economic data since 1870 on the 235 instances where countries have suffered serious recessions (where either gross domestic product or consumption has fallen by at least 10%) during that time.
Risk assessment also assumes that we can identify all relevant risks but this is difficult in an increasingly complex, fast-moving society. In fact, we need to look more and more widely for the information needed to undertake comprehensive risk assessments. By merely applying the same processes we will probably be considering a progressively smaller proportion of relevant risks.
And there is the human factor. In calculating risk, human beings tend to veer from over-optimism to over-pessimism (often depending on their proximity to a particular risk), while thinking that their current state of belief is entirely objective.
In respect of fraud, there has been a great improvement in the assessment of risk in the past decade, in some ways going beyond more general risk assessment techniques in the extent to which it is based on statistically valid data. The great change has been to treat fraud as a business cost, an economic problem that is best addressed by measuring and reducing it.
By the end of 2008, more than 50 statistically valid, highly accurate fraud-loss measurement exercises had taken place in more than 40 organisations in nine countries, covering many different types of expenditure in both the public and private sector. Only two of these exercises have shown losses of less than 3%, with five showing losses of more than 8% and the remainder between 3% and 8%. As well as providing highly accurate information about the size of the problem, fraud loss measurement can provide a statistically valid picture of how and where the fraud is taking place. This information can identify weaknesses in policies and systems and can allow the fact-based rewriting of risk registers.
These techniques, pioneered by the public sector, in the Department for Work and Pensions and the NHS in the mid-to-late 1990s, are now being adopted by the private sector. Interestingly, this work also shows how tackling fraud effectively can free resources for better systems and services, even in a recession. With the likelihood of losses of between 3% and 8%, there are substantial gains to be made from reducing them. In the NHS, losses were reduced by up to 60% by 2006, saving £811m. This sort of work can provide resources that are unlikely to be available from any other source and that could help public sector bodies to maintain the quality of services on which the public relies.
The immediate tasks for public sector organisations are: to revise their risk registers to make sure they reflect the changing nature of risk in a period of recession; to ensure that their assessment of risk is based on factual information, not conjecture; and to focus on the real financial benefits that can be realised from measuring and reducing the losses associated with risks such as fraud.
So fraud lies at the heart of our current economic woes, alongside greed and irresponsibility. However, stopping it also provides opportunities to mitigate the effects of the recession and to maintain the resourcing of public services. Rarely has fraud been such an important causal factor in a recession and never before have the benefits of reducing it been so clear. As with any recession, we have the opportunity to learn and implement many lessons to prevent a recurrence. However, time is not on our side, and we need to move quickly. These changes need to be made before we start to hear and read revisionist views – that really everything is all right and no fundamental change is needed.
