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Prevention of fraud in inward clearing

Thought Paper

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Prevention of fraud in inward clearing

Manual control to combat fraud in clearing

Types of financial fraud

The purpose of this paper is to provide an overview of fraud in both paper based and electronic banking transactions. Currently, customers are alerted after, and not before, their accounts are debited. A check truncation system

Financial fraud can be of different types, such as:

• Forgery of signature on checks

• Alteration of payee names

• Hacking of debit and credit card details

• Hacking of Internet user id and passwords etc.

• Forgery of signature to withdraw money from inoperative accounts

Fraudsters forge signatures of genuine account holders and lodge a change of address, along with a request for new check books, debit card and PIN etc., to be delivered to the new location. Then, it’s just a matter of forging the signatures to wipe out the accounts or using the PIN to withdraw funds at an ATM.

Sometimes, fraudsters also steal checks, forge or alter them, to take money out of the account.

(CTS) can be used to share the image or details of a check or payment instrument with customers, before it is debited to their account, and thereby reduce the incidence of fraud.

Over the years, banks have taken a number of measures to prevent frauds in clearing. Their manual controls include following the 4 eyes (maker checker) principle, introducing an additional checker when a debit or credit transaction exceeds a particular amount,

They could either withdraw the amount in cash or deposit the checks through clearing, into their own fraudulent accounts. At other times, fraudsters are hand in glove with bank staff, who help them with all they need to know. In the case of electronic fraud, hackers employ phishing and a variety of other creative techniques to hijack customer accounts.

Until the dawn of Internet/SMS/Mobile Banking, customers would not know that their accounts had been attacked until they visited the branch. Today, however, they are immediately notified of any irregular activity through automated alerts on mobile or email, or they come to know of it when they log into Internet Banking, or visit the ATM to withdraw funds or make an account enquiry.

double-checking debits to inoperative accounts, telephoning customers when in doubt, validating instruments under an ultra violet lamp etc. That being said, these measures, although extensive, are not enough to check frauds in paper or electronic clearing.

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Slow pace of automation

What is a check truncation system

Clearing workflow: image based

The progress of automation is not uniform across geographies, owing to different reasons such as lack of capital, lack of preparedness among

A Check Truncation System (CTS) is a process wherein scanned images of checks are shared with banks based on which clearing instruments are processed. There is no physical movement of checks, which generally remain with the presenting bank. There are some disadvantages associated with physical clearing, such as the possibility of losing checks in transit, delay in clearing and reconciliation etc. CTS overcomes

branches for computerization, inadequacies of technology and infrastructure etc.

these disadvantages of physical clearing and increases efficiency, reduces operational cost and expedites the clearing process.

Where CTS has been implemented

CTS has been implemented in countries such as India, UAE, Saudi Arabia, Hong Kong, US, Singapore and Sri Lanka etc. It is now being implemented in African countries, such as Kenya.

Why automation of clearing operationsThere is a need for automation of clearing operations, which could reduce frauds and increase transparency. One of the goals of automation should be to transmit images of clearing debits for customer verification, before they are actually executed. Such a system gives

customers the opportunity to reject a false instrument, such as a forged check. It also helps reduce fraud perpetrated by altering payee names. This can be achieved by adopting the Check Truncation System (CTS).

Y presents the

cheque (1)

Y’s account

credited after

agreed period (6)Customer

Y

Presenting Bank

Sorting of Cheques based

on images (3)

Scanned

images

presented with

image id (2)

Collected by

paying

bank (4)

Payee Bank

Inward returns

with Image id

X’s account

debited (5)

Customer

X

viewing of

scanned images

while processing

inward

instruments

Outward Return

with Image Id

Cleaning House

Scanning of

Cheques

Synopsis of fraud through clearing operations

Consequences of fraud

Forgers have been known to disappear after doing their stuff, leaving banks to deal with the consequences of passing fraudulent paper or electronic clearing-based debits, when they are presented in paper based clearing or through an Electronic Clearing System (ECS) or an Automated Clearing House (ACH).

The consequences of such fraud could be:

• Loss of banks’ reputation, and a long term effect of the resultant negative publicity on customer acquisition and retention, fund raising capacity, and so on

It is quite difficult for bank officials to identify the forgeries among the massive number of instruments that pass through their hands each day. What makes it harder is that customers are alerted about debits to their account, post facto.

• Banks’ legal liability to recompense customers

• Waste of time and effort in battling legal issues

• Higher provisioning for operational risk, and the cost and effort of monitoring and reporting the same

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Forged check fraud £22.4m £20.5m £17.4m £15.7m £13.1m -16%

Fraudulently altered checks £6.1m £9.2m £16.9m £9.3m £12.0m +29%

Counterfeit checks £2.1m £3.8m £7.6m £4.7m £3.8m -19%

TOTAL £30.6m £33.5m £41.9m £29.8m £28.9m -3%

2006 2007 2008 2009 2010 +/- (09/10)

Statistics on Check Fraud Losses in UK

50

40

30

20

10

02002 2003 2004 2005 2006 2007 2008 2009 2010

CHEQUE FRAUD LOSSES 2002-2010Tinted figures show percentage change on previous year’s total

£m

illi

on

s 36.0

45.0

+25

%

46.2

+3%

40.3

-13%

30.6

-24% 33

.5+

10%

41.9

+25

%

29.8

-29%

28.9

-3%

Best practices

Other instances of fraud and ways to combat them

Clearing instruments moving to ECS/ACH

In some countries, banks have taken the initiative of introducing 2-4-6 clearing under which they have set a maximum time limit of two, four and six working days for the completion of the following stages, after a check is credited.

• Customers earn interest from the 2nd day after a check is deposited

• They can withdraw the amount after the 4th day

• From the 6th day onward, they have the assurance that the checks will not be dishonored, and that their bank cannot debit the account without their consent.

This mitigates fraud insofar as the drawer of the check keeps a tab on transactions and should fraudulent clearing occur in the account within 6 days, intimates the bank, so that there is no loss.

Another type of fraud is the counterfeiting of checks, which are used to deposit money into the fraudsters’ accounts. Statistics reveal an alarming increase in such fraud. The banking industry is combating it by ensuring that checks are printed to the highest security standards, and only by the members of the Check Printer Accreditation Scheme (CPAS).

Electronic clearing is taking precedence over checks for periodic payments such as loan installments and insurance premium, and payment of utility, credit card, mobile bills, etc.

The Reserve Bank of India recently introduced a guideline that in case of alteration in the payee’s name on a check, the payee bank can return the same irrespective of whether the customer has validated the alteration with a signature, or not.

The US has adopted the Positive Pay feature, so that customers inform their banks about the checks that they issue. The list of checks is called an issue file, which banks use to cross check before making payment. Any mismatch between the issue file and checks actually received for payment, is referred back to the customer, and the concerned checks are paid only when the customer acknowledges having issued them.

The Central Banks in various countries have made it mandatory for the banks under their supervision to report fraud when it exceeds a certain amount.

Some countries allow customers to print their own check books (through a printing vendor ) and as a safeguard, require them to inform their bank about the checks they have printed and are about to issue.

While this will mitigate check fraud to some extent, it is still a drop in the ocean considering the current volume of check transactions.

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Process of implementation

Business benefits

The checks for inward clearing and debit instructions can be uploaded by banks late in the evening so that customers may check their accounts until the morning of the next day, which gives them sufficient time to report a discrepancy or return the instruments. To start with, banks can refer checks or debit instructions pertaining to premium accounts, with high average balances, instruments above a certain value, and also those pertaining to accounts with adequate balance for the debit to take place.

To enable this facility, banks should be equipped with software enabling them to refer the checks or debit instruction details through Internet/ mobile banking and receive customers’ remarks through email or message. The scanned images and debit instruction details should be available

A referral process has the potential to yield substantial benefits by preventing loss of reputation and saving the cost and time of reparation. Let us take the example of a large bank, with 3,000 branches processing 1,000,000

for customers to view on Internet and mobile banking, and should they not revert within the specified time limit, the instruments should be cleared.

In case customers report any discrepancy, their banks should return the instruments to the respective banks.

Customers using mobile banking should be provided with a PIN to authenticate themselves before issuing any remarks. In the case of debit instructions such as ECS & ACH, based on the debit amount, beneficiary details the customer can check through internet or mobile and provide the necessary remarks if the debit transaction is discrepant.

transactions each day, 10 percent of which is inward clearing. Even if just 2 of these are fraudulent or erroneous, it means that the bank is looking at 50 instances per month and 600 per year! Imagine the potential damage.

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How to prevent such fraudA mechanism to refer all inward clearing instruments to their respective customers before being passed by banks, can help counter such fraud. In fact, such checks should be made viewable over Internet/ mobile banking and in case of electronic clearing, it’s the debit details which must be made available. Also, there

should be a defined time frame within which the customer must act to report a discrepant transaction, if they fail to do so, they must accept the transaction as genuine. However this does not absolve the bank from ignoring the existing procedure of verifying customer’s signature etc., while processing the instruments.

LimitationsThere could be some limitations, such as:

• The referral process might result in some delay in clearing

• This might require interfacing the applications involved in processing these transactions with mobile/Internet banking, a costly proposition for small banks

• The referral system can only work with customers who have registered for e-banking or have registered their email or mobile numbers with the bank

• It is only workable in the few countries, which have implemented image based clearing

Vijay Kumar VandanapuPrincipal Consultant, Infosys

Harshad Laxmikant KirloskarIndustry Principal, Infosys

Conclusion

References

The referral process would mitigate inward clearing fraud and go a long way in protecting banks’ reputation. Banks can employ CTS to refer the images of inward clearing instruments to customers before debiting the checks to

1. www.financialfraudaction.org.uk/Publications/ #/46/ - For the statistics on frauds

their account. Customers can view the images through Internet or mobile banking and in case they find any discrepancy, instruct their banks to return the instruments. This would help reduce check forgery.

2. www.checkandcredit.co.uk/246/-/page/113/- For 2-4-6 Clearing

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