1. Check Fraud and the Electronic Clearing Environment

2. © Copyright IBM Corporation 2002 2 Overview of the material  Why bank executives are increasingly interested in fraud  Background on check fraud  Eight control points every bank should have  The impact of electronic check clearing

3. © Copyright IBM Corporation 2002 3 Fraud is increasingly on the minds of bank executives.  Losses: Perpetrators are utilizing technologies to their advantage, gathering personal data and duplicating documents and signatures.  Studies: In a 2002 ABA survey almost 40 percent of respondents ranked “identity theft” as the number-one threat to the banking industry.  Press: Recent coverage has brought the issue into a public spotlight.  Customers: Increasingly involved as victims and aware of fraud risks.  New Regulations: Attention to risk has been raised by the USA Patriot Act, Basel II, Sarbanes-Oxley, Check 21, etc.

4. © Copyright IBM Corporation 2002 4 Overview of the material  Why bank executives are increasingly interested in fraud  Background on check fraud  Eight control points every bank should have  The impact of electronic check clearing

5. © Copyright IBM Corporation 2002 5 Total amounts of check fraud reported vary widely.  Attempted check fraud at the nation’s banks surpassed $4.3 billion in 2001, doubling for the second time in four years, according to an American Bankers Association Deposit Account Fraud Survey Report.  But the same study indicated actual dollar losses to the banks in 2001 remained relatively stable at $698 million. However, a 2004 Gartner study placed consumer’s losses to bank fraud at $2.4 billion, with most of that eventually covered by their banks.  A 2003 National Retailers Federation survey put total check fraud losses at $12 billion annually. Much of this represents losses taken by retailers. There may be value available for a bank that helps its customers avoid these losses. Thus, banks have the opportunity to create value by helping reduce their customers’ fraud losses.

6. © Copyright IBM Corporation 2002 6 The check fraud techniques vary but they tend to fall into one of two categories:  Bogus Credits (Deposited items returned) – These are primarily items deposited to a perpetrator’s account which are fraudulent and eventually returned by the paying bank. Attempts to charge these back to the depositor’s account are futile, as by the time the items in known to be bad the perpetrator has taken the funds out of the account and disappeared.  Bogus Debits (On-us items paid) – These are charges initiated by a perpetrator against a victim’s account. The the true account owner did not authorize the debits.

7. © Copyright IBM Corporation 2002 7 Per a Fed study, check fraud losses break evenly between depository and paying banks. An ABA study provides supporting data:

8. © Copyright IBM Corporation 2002 8 The once-pristine world of ACH is seeing fraud on the rise as ACH does more processing of checks.  Few fraud controls were built into the system since its typical file originators were major corporations, governments, and financial services companies, (unlikely fraudsters).  Access has been expanded over time and its use now includes… - POP (point of purchase): Creation of ACH debits at a cashier’s station based on a scan of the check presented by the retail customer. - ARC (accounts receivable conversion): Lockbox processors and utilities are capturing check data and clearing the payment via creation of ACH debits. - Returned checks: Banks are attempting to collect on returned checks by representing them as ACH debits. - Recurring payments: Companies providing monthly services offer customers the option of ACH debits to their accounts. - One-time payments authorized via phone or Internet leading to creation of ACH debits.  The result is a rapid increase in ACH related fraud: - Fraudulent ACH debit transactions are hitting both consumer and corporate accounts. - Fraudulent ACH credits received which will eventually be reversed or “reclaimed”. Regulation E provides that ACH transactions can be reversed for a period of up to 60 days (compared to a normal check return period of 24 hours).

9. © Copyright IBM Corporation 2002 9 Overview of the material  Why bank executives are increasingly interested in fraud  Background on check fraud  Eight control points every bank should have  The impact of electronic check clearing

10. © Copyright IBM Corporation 2002 10 Fraud should be addressing at every possible point. Eight points of control where fraud can be addressed are: Establishes false ID Tries to take over a valid customer’s account Maintains account undetected Uses ID to obtain a bank account Leaves patterns of bogus activity Spreads reach using other perpetrators Attempts transactions through other banks Attempts transactions at the bank Perpetrators’ actions: Bank’s controls: Perpetrators’ actions: Bank’s controls: 1. Avoid being a source of ID information 2. Verify identity at account acceptance 3. Verify legitimacy of existing customers 4. Validate identity during account maintenance request process 5. Stop bogus transaction at first point of touch 6. Recognize bogus payments at point of presentment by another bank 8. Analyze losses and create feedback to policy, process, and systems design 7 Apply analytical software to identify accounts with unusual activity patterns

11. © Copyright IBM Corporation 2002 11 Overview of the material  Why bank executives are increasingly interested in fraud  Background on check fraud  Eight control points every bank should have  The impact of electronic check clearing

12. © Copyright IBM Corporation 2002 12 Electronic check clearing soon lead to a shift in fraud vulnerabilities and controls. Banks should pro-actively address these issues.  On the plus side, opportunities for deposit frauds and kiting will be significantly reduced by faster clearing of checks and faster returns of bad checks. - Electronically cleared checks may post against the check writer’s account as early as the same day as it is deposited. The electronic return may be received the day after deposit. - Even checks converted to images and remotely printed (so-called “IRD”s) will also clear faster than in the current system of physical transport, delivery, and recapture.  On the negative side, all current paper-based controls will be of greatly reduced value in the new electronic clearing environment. - Special paper - Special printing - Special ink - Fingerprints (both teller station initiated and latent prints)  Net-net, the fraudsters will likely shift from frauds playing on returns float to frauds reliant on ID theft and other tools. We don’t expect to see them getting legitimate jobs.

13. © Copyright IBM Corporation 2002 13 There are several ways to add value in the area of fraud and each could be enhanced through check image tools.  Reduce fraud losses - These may be over $200 million per year in a large bank. - There may also be value in helping customers avoid losses.  Reduce total costs of the anti-fraud efforts by increasing efficiencies - New strategies and tactics - More and better tools - Better targeting/focus of efforts - Balance of reactive vs. proactive activities  Reduce costs related to "false positives" - Reduce the costs of placing unnecessary holds by better targeting - Reduce customer irritation (and loss of some customers)  Increase recoveries - From perpetrators - From other banks at fault

14. © Copyright IBM Corporation 2002 14 New techniques should be developed and employed in the new environment, possibly including…  Electronic signature verification of the maker and, potentially the endorsement.  Identification of counterfeit and modified checks - Revised paper and print authenticity techniques - Image-based analysis of payee and written amount fields  Use of workflow technology to speed and prioritize human review of suspect items as well as allow work to be performed at low-cost locations. This tool might also be used to strengthen the controls improvement feedback loop.  Straight through electronic processing of returned checks to the depositor.  Wider use and expansion of “positive pay” and “reverse positive pay” - Possible check number duplication controls applied to all accounts - Possible straight through “pay/no pay” decisioning by the customers themselves  Combined analysis of check and other frauds, as it is becoming less clear what items are “checks” vs. ACH, “E-check”, or some other payment form.  Identification and analytical techniques that require cooperation between banks or that can be more effective with such cooperation.