By Ray Birch
BOSTON—Lenders have become better at detecting fraud in business loans, and one reason is the Paycheck Protection Program (PPP), says one analyst.
But while lenders have improved their fraud detection skills, a big issue with preventing criminals from gaming the business lending system is a lack of budget dollars to fight the crimes, according to David O’Connell, senior analyst with Aite Group’s wholesale banking team.
While the percentage of respondents to a recent survey who said fraud was connected to more than 1% of the business in their small business lending portfolios has declined—down to 18% in Aite Group’s 2021 small business lending study from 28% in the previous Aite report—the fraud rate remains “concerningly high,” said O’Connell.
O’Connell attributes the decline to lenders sharpening their fraud detection pencils during the PPP process, during which a still-undetermined number of borrowers committed fraud or attempted to. O’Connell said he believes the widely publicized reports of the attempted and actual fraud soon had lenders on their toes as the PPP process unfolded.
“They began looking at these PPP loans more closely for fraud, and then they took those same practices back to the rest of their business lending portfolio and they educated their entire teams on what the crooks have been doing,” O’Connell explained. “This rate is still concerningly high. But lenders have seen more of the fraud attempts during the PPP process, they’ve read more about them…”
Four ‘Vectors’
O’Connell said there are four primary approaches, or fraud vectors, criminals are using to commit their small business loan-related crimes: loan stacking, submission of counterfeit statements other than tax returns, submission of bank statements that have been tampered with, and submission of financial statements from which data has been omitted.
O’Connell said loan stacking represents 19% of the fraud based on survey responses. Loan stacking is a practice in which fraudsters—at a criminal enterprise or legitimate but credit-abusing business—simultaneously apply for, and accept, credit at multiple lending institutions.
“When this technique succeeds for a legitimate business committing credit abuse, multiple lenders extend loans to a single business, and only a portion of them are likely to be repaid,” O’Connell said. “When criminal enterprises succeed with loan stacking, typically with bogus businesses, the result is multiple loans extended by multiple creditors, none of which are likely to be repaid.”
Counterfeit Statements, Real Fraud
Submission of counterfeit financial statements other than tax returns comprised 16% of fraud in the latest report.
“This fraud vector has fraudsters creating from scratch entirely fictitious financial statements that not only support the supposed legitimacy of the credit-seeking fraudulent entity, but also purport the supposed business to have income and cash flow sufficient to support servicing of the debt that’s being sought,” O’Connell said.
The submission of financial statements that have been tampered with has fraudsters behaving much like college students creating fake IDs to purchase liquor, according to O’Connell.
“But in this case, the goal is to modify the data on a bank statement or other financial document that’s relied upon by a lender when underwriting, by adding characters and values that inflate the perceived cash flow or revenue of a business so credit would be extended where it otherwise wouldn’t—or more credit would be extended than would otherwise be loaned,” he said.
‘Potent’ Fraud
Financial statement data deletion is also a “potent” form of fraud, said O’Connell.
David O’Connell
“Legitimate businesses seeking to commit credit abuse can inflate their perceived revenue by providing a creditor with an incomplete bank statement, leaving out the pages with recorded returns or chargebacks, dilutive to both revenue and cash flows,” he said.
Despite the decline in fraud being seen by commercial lenders, it still remains high, said O’Connell, who noted it is likely to remain elevated until business lenders build stronger business cases to share with executive leadership to get more dollars in the budget to fight these crimes.
He noted the detection of fraud takes, time, talent, technology and money.
“It is hard to have fraud-specific talent, and it's also hard to have fraud-specific analytics,” said O’Connell. “With lack of a business case you don't get budget. And while business lenders are identifying more fraud, they're still not reporting it well enough to get the money to get the tools and talent they need.”
Missed Opportunities
According to the latest Aite data, drawn from a survey of 32 financial institutions that are lenders to small businesses, if lenders more accurately captured the fraud occurring in the business lending portfolio, executive teams would listen, O’Connell said.
“When I asked people in the survey what percentage of fraud that happens in the business lending portfolio actually gets identified as fraud, rather than a credit loss, they said they believe the percentage is in the mid-40s,” explained O’Connell. “When I asked them what percentage of fraud that happens gets properly accounted for, they placed that percentage in the high 30s. If you are under quantifying the magnitude of financial impact of these crimes by two-thirds, you have just missed the opportunity to have a business case.”