First-Party Fraud: Why It's More Expensive Than You May Think and What You Should Do About It
by Dale Daley and Rod Powers
First-party fraud (FPF) — fraud committed by individuals, typically a financial institution’s own customers who have no intent to pay — is not a new issue, but it is extremely costly and more expensive than you may think. The reason: It is so difficult to detect and address that it is most often misclassified as bad credit debt by the affected organizations, and therefore placed into collections. Industry analysts suggest that higher than average unemployment rates and lack of access to credit are key factors contributing to an upward trend of FPF. According to the Federal Reserve,1 charge-off rates have spiked to 9.95 percent, nearly double the average rate of five percent over the past 18 years. This translates to approximately $85 billion of the $850 billion outstanding in revolving consumer credit being written off each year. Of this amount deemed uncollectible, roughly five to 20 percent, or $4 to $17 billion, is misclassified as bad debt when it should be categorized as FPF.
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The problem is identifying and recording coupled with a risk manager trying to get it out of his bad debt budget and into the fraud budget and vice versa. The overall effect of this is bad recording and misunderstanding.
In the UK if all losses from applications were recorded by CIFAS category it would give a better view of losses in the UK and the reason for loss. The industry will not do this though but for the life of me I cannot understand why. No wonder the FSA is considered a quango that does nothing as it does not issue rules of recording or definitions to be followed.
The downside with 1st party losses is in order to classify it as fraud you have to find something fraudulent about the application or the transactions made. So if the customer has not lied on the application and does not try to make fraudulent payments to the account then you cannot categorise it as 1st party fraud. However, common sense dictates that if an account is opened the credit utilised and then no payments are ever made to the account (and there is no evidence to suggest 3rd party fraud such as identity theft etc.), it is fairly certain the case is 1st party fraud.
Similarly, where there is evidence to prove 1st party fraud, you are still left with the debt as it is highly unlikely the customer will repay.
To overcome this requires action on account opening to ensure we are dealing with a "genuine" customer and whilst this can never be guaranteed, good identify process and other risk profiling tools will reduce the incidence of loss substantially.
The problem lies in marketing departments insisting that loans or credit cards should be turned around in 24 hours or less which impacts on the checks that can be undertaken.
The business case is hard to prove but my view is the savings in bad debt/write, managing bad/debt write off cost reduction more than covers a belt and braces approach to account acquisition.
One prime example which seems so simple you cannot believe it wasn't done, is where you find a load of accounts that go bad in a postcode area in the UK (UK postcodes tend to cover on average 40 houses .. this can be much more if the area is flats). If you have 40 accounts opened in a single postcode then there may be something wrong. Why would so many people from one area open an account with you for a loan over all the competition?
Many do post code checks on applications to monitor the number of applications from a postcode and do a manual underwriting on them. Well the trouble with 1st party fraud is the underwriter will not find anything wrong with the application in most cases. This is where more sophisticated models need to be built on the level of exposure by postcode.
Sorry for rambling on, you all probably are aware of this already yet time and time again these things do appear to be overlooked.
Posted by David, 13/09/2010 5:51pm (2 years ago)
It is an interesting article.I would have thought that FPF would already be a part of the equation of issuing unsecured credit. I wonder what's new here? One would expect the bad economy to contribute to 'bust out' fraud and the 'change in motivation' fraud. If the underlying asset - income in most cases - disappears or is curtailed significantly, these behaviors would rise. This is not unlike people walking out of their homes - the credit quality is no longer worth saving. As such the spike off rates are really more about the existing debt portfolios. Any right minded credit issuers would see their acquisition adjust to the new economic realilty with or without an effort on their part.
What I am curious about is whether the organized fraud has increased.That may seriously change the equation on the acquisition and monitoring controls a credit issuer needs.
Does anyone know if that's true and what your or other organizations are doing about it?
Posted by dinesh, 13/09/2010 5:50pm (2 years ago)
I don't think anyone is in any doubt of the cost. The problem is containing it.
It is far wider and broader than people think and the industry is going through the usual hot air process (too much talking not enough doing) instead of focusing on the issue.
I could spout on for hours about this and what should be done but until the industry has gone through the same old process it always goes through (talking, analysis, arguments about definition etc.etc.) then little movement will be made.
In some ways the focusing on this as being something new will hinder rather than help anything us fraud professionals try to do to contain it.
I am not sure the white paper will, therefore, help anyone at all except perhaps to stir up some panic reactions.
Posted by David , 13/09/2010 5:50pm (2 years ago)
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