Financial Institutions And The Increase In Fraud Finance Essay

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Financial institutions have experienced an increase in the number and types of fraud causing significant losses. A series of accounting scandals back to 2002 has shaken the confidence in the market. Fraud had been remains alarmingly high and is one the leading cause of bank failures. Corporate fraud has always been part of the business. Business history records major failures derived from fraud, financial scandal and other corruption and yet, no one learn from the mistake. It is important to focus on the vulnerability of financial firm with the existence of fraud. The reason why frauds continue to be successful is that customer, lenders, investors and auditors have failed to learn from previous mistake. An understanding to financial institution is to look at the history of incident that caused the failure is important to effectively overcome them. Why does a wave of financial scandals occur? How these disasters could unnoticed and uncheck in a financial institution? Appearances can be deceiving until it's too late to save the disastrous incident.

Financial fraud is a serious threat to market participant's confidence in published audited financial statements. Frost (1999) noted financial markets world is less efficient and vulnerable with the existence of accounting scandal. Many traders that caused large losses at financial institution have been accused of acting fraudulently to hide their trades. The greatest fraud in the past include Charles Ponzi's scam in early 20th century Boston, the collapse of the MMM investment fund in Russia in 1994, and the scams that led to the Albanian Lottery Uprising of 1997 (Siddiqi, 2009). Why do financial frauds continually occur again? What are the causes of this failure? There are the questions that will be addressed.

Swecker (2004) said booming mortgage market has attracted fraudulent activities that could cause multibillion-dollar losses to financial institution due to by low interest rates and soaring home values. Many Savings and Loans failed because of poor management, risky loans and investments, and fraud back to 1980s (Frieden, 2004).

Fraud in mortgage financing has been listed to be one of the possible causes of 2008 subprime mortgage crisis. On 23 September 2008, FBI was investigating the possible fraud in AIG. Black (2009) stated 80% of the fraud was done by the lenders, who encouraged customers to lie on loan applications or altered documents to make them more likely to be approved. One of the common characteristics is corporate greed. CEO's goal was to maximize profit in the short run. Concepts like honesty and loyalty to an institution became old fashioned. The greed of the CEOs soon turned into personal acquisition. They did not hesitate to indulge in fraud in which they were joined (Dubhashi, 2008). Risk and more complex deals are increasing for huge profit. There are few types of fraud such as earnings manipulation, used brazen and unsophisticated approaches or used new, sophisticated devices to defraud and hiding losses.

Credit default swaps are financial instruments used as a hedge and protection for debt holders. It is the world's fastest growing markets with $62 trillion, almost 10 times the amount of the U.S. government's debt outstanding at the end of 2007 (Mosses and Harrington, 2009). CDS is a transaction that was meant to hide and manipulate the capital position of the business from investors and other financial institutions. The way CDS operate is insurance company treats its CDS business as the same way they operate their business line. Investors alarmed the serious threat of credit default swaps to the failure of financial institution in 2008 (Reuters, 2008). Buffett (2009) has called it a financial weapon of mass destruction. Why American Insurance Company (AIG) willing to gamble its future on CDS in the risky business?

Palmer (2004) has viewed insider corruption is easier to occur with poorly paid jobs with access to company's information that are important and contains billion dollars of transactions. Davinson (2008) said the attraction of money was too high to attract AIG to bet in the financial system. CDS is profitable when defaults are low; however it can turn bad when defaults are high. AIG had lost $10 billion in 2007 and 14.7 billion in the upper year of 2008 caused AIG's capital reserves dropped resulted credit defaults swaps (Fox.J, 2008). Market observers said CDS had been completely unregulated and collateral deposits were too small to cover losses when financial situation went into trouble (Booton.J, 2009).

Weisenthal (2009) said AIG never believed that the CDS would ever be paid when AIG issued out billions of dollars in the CDS agreements. The fraudulent act of AIG has no capital to back up the insurance it sold. CDS market was far from transparency. From 2005-2007, the default rate on mortgage securities is unexpected. In some case, the securities which the banks claimed were triple A is actually worth less than $0.15 (Stansberry.P, 2008). Credit default swaps allowed company to collect huge bonuses. AIG has no real capital to sell unlimited swaps as long it maintained a triple-A credit ratings (Stansberry, n.d). Soros (2009) said AIG mistake was sold huge amount of CDS without the implementation of properly precautionary methods.

Fraudulent activities are the main reason that led to its downfall. Pricewatercoopers (PWC) concluded that AIG had material weakness in its internal control on financial reporting as how AIG valued its credit default swaps portfolio (Zuill, 2008). Their credit ratings were downgraded, which made them unable to access any funds to overcome the liquidity problem (Ygoy, 2010). The moment AIG was downgraded; it was immediately forced to come up with tens of billions of collateral. The world largest insurance company was unable to meet its obligations and be forced into liquidation (Stansberry.P, 2008).

Falvey (2009) said fraud is done by skillful individual and a work that are resource-intense cases. Fraudsters have the ability to cover the fraudulent transactions and posses a big treat to company found by Serious Fraud Office (West, 2004). One of the greatest frauds of this century brings down Barings Bank, one of the oldest and most conservative financial institutions in the world. This is caused by Nick Leeson through his illicit and risky trading in foreign exchange options (Pressman, 1998). Huge incentives caused Nick Leeson took risk on Baring Bank. Leeson unrevealed the information on Baring Bank using "88888" account which set up in July 1992. This error account was designated in Barings Singapore to accommodate trades that cannot be reconcile immediately without acknowledge Barings London (IFIC Risk Institute, n.d). "88888" account enabled to unauthorized trading, submission of falsified reports and misinterpretation of the trading and false trading transactions. (Numa, 1995). This caused a massive losses mount to $1.8 billion by making $27 billion of bad bets on Japanese markets that led Barings to failure (Clark and Jolly, 2008).

In 2009, the FBI was aware of the fraud that contributed to financial collapsed (Shukovsky, 2009). Bank of England let Bank of Credit and Commerce International (BCCI) to collapse with debts of $12bn after found out the evidence of corruption (BBC, 2001).The collapse of the Bank of Credit and Commerce International (BCCI) in July 1991 was found with $13 billion spread all over in bank accounts (Atkinson, 1999). In the investigation of Beaty and Gwynne (1991), never in the history of financial scandal like BCCI involved so much money so many nations in Europe, Africa, Asia, and the Americas or so many prominent people in a single scandal. BCCI has multiple layers of complex entities and able to avoid ordinary legal restrictions on the movement of capital and goods on daily transactions. BCCI admitted to Justice Department and New York District Attorney in 1991 that they seek deposits from people attempt to avoid U.S income taxes, lied to regulars and falsified regulatory documents ,created false bank records and engaging in false transaction to deceive regulators to Justice reported by Kerry and Brown (1992). Gokal involved in fraudulent loans in Bank of Credit and Commerce International (BCCI) to the Gulf Group and a fraud to keep BCCI afloat while hiding it from Price Waterhouse. Wright (1999) said Serious Fraud Office sends a clear signal that fraud is a serious case. Gokal was sent to 14 year jail sentence and £2.94 million due to his conviction on charges involving £750 million (Atkinson, 1999).

One of the largest insurance companies in Britain, Independence Insurance collapsed was brought down by the founder and chief executive, Michael Bright and two of his deputies (Leroux, 2007). The downfall cost them to compensate more than £366 million to Financial Services Authority in 2001 and 100 jobs cut (Inman, 2007). Figures were manipulated, huge amount of liabilities wad unrevealed and loss-making contracts to insurers were kept from being seen. Losses were recorded separately from the main system to deceive customer from 1998 to 2000. The judge said the failure of the company might be prevented and fraud played a role in the financial disaster (Leroux, 2007).

Palmer (2004) said banks disclose suspicious transactions for the sake of their reputation on outsiders view. There is no incentive for bank to report the true situation and deceive investors. Arthur Anderson discovered several fraudulent transactions and misguides Enron auditors with questionable deals until it was too late. Anderson told its people that Enron's top management allowed the decision while Enron would tell its employees that Anderson had approved the deals (Chicago Tribune, 2010).

Trading Scandal in Societe Generale was sophisticated and varied techniques done by Jerome Kerviel. The losses amount to $7.2 billion Dollar are four times greater than those caused by Nick Lesson, who bought down Barings Bank. Shares dropped 50% in the fourth quarter of 2007 after the trading (Peston, 2008). The loss caused two credit rating agencies to reduce the bank's long term debt ratings from AA to B-. Societe Generale said the scandal had caused the net profit dropped to £450-600 million from £3.72 billion a year (Allen, 2008).


Wilson (1999) said financial scandal could happen again due to its temptation of great rewards to people. Financial scandal has continued to rise in US, UK and Asia. McLean and Elkind (2008) noted investment bank scandals are deal with profitable agreements with the encouraging of earning and environment fraud. Profitable deals increases more risks and more complex agreements and thus increase the chances of fraud.

Carter (2010) said criminal charges on fraud that filed recently reflect on the entire U.S mortgage market operated for more than five years. Plenty of lenders that engaged in similar activities were saved by taxpayer bailouts. Therefore, prolonged campaign of fraud and deception should be raise.

Financial fraud is a serious case and The Mortgage Bankers Association had announced to stop fraud with the establishments of a website. The Federal Bureau of Investigation found 11,466 indictments, 11362 convictions, and $8.q billion in your years operation from 2000 to 2004 September (Setzer, 2005).

Swecker.C, 2004

Frieden.T, 2004

(Carter. Z, 2010)

Teather.D, 2005

Dubhashi, 2008

Hirsh.M, 2009

Setzer.G, 2005

McLean.B and Elkind.P, 2008

Allen.P, 2008

Clark.N and Jolly.D, 2008

Peston.R, 2008


IFIC Risk Institute, n.d

BBC, 2001



Chicago Tribune, 2010,0,7490166.story?page=4

Beaty.J and Gwynne.S.C, 1991

Kerry.J and Brown.H, 1992 The BCCI Affair

Akinson.D, 1999

Wright.R, 1999

Leroux.M, 2007

Palmer.H, 2004

Farrow.S.K, 2004

West.R.M 2004

Inman.P, 2007

(Shukovsky.P, 2009)

(Falvey.J, 2009)

(Pressman, 1998)

Black.W, 2009

Siddiqi.W.H, 2009

Weisenthal.J, 2009

(Booton.J, 2009)

(Soros.G, 2009)

(Mosses.A and Harrington.S.D, 2009)

(Buffet. W, 2009)

Davinson.A, 2008

Fox.J, 2008,8599,1841699,00.html

Stansberyy.P, n.d

Reuters, 2008

(Ygoy, 2010)

Zuill.L, 2008

Stansberyy.P, n.d

Refco Inc. 2005 Declared bankruptcy after hiding $430 million of debt

Allied Irish Banks Plc 2002 Trader hid $691 million in currency market losses

Bank of Montreal 2007 Wrong-way bets on natural gas led to a pretax loss of about c$680 million ($663 million)

Amaranth Advisors LLC 2006 Trader Brian Hunter's bad bets on natural gas triggered $6.6 billion of losses

Farrow (2004) noted large amount of cases of employees forced to carry out fraudulent activities get caught but not the one that gave order.

Palmer (2004) examines there are 3000 active fraudsters working in 500 London bank and it's a huge mistakes to retain the employees for a second chance.