Flourishing Fraud

PKF Partner and expert in fraud risk management David Dearman discusses the effects of the current economic climate on fraud levels.

The current economic climate is bad news for most businesses – and the problems don’t stop at the difficulty of sourcing corporate finance. Historically it has been shown that, as growth falls, so is there a rise in the incidence of fraud.

The collapse of the sub-prime market in the US, and he resulting impact on the British banking industry, is notorious enough to have popularised a new phrase in he language: ‘credit crunch’. This crunch has slowed own or even reversed the rapid growth in house prices experienced by the UK in recent years, and mortgage enders have become increasingly cautious about whom they lend to, and how much. Added to this is the rise in global oil prices and diminishing confidence in the economy as a whole. As a result, inflation is increasing at a rate unlikely to be matched by wages. The Bank of England has cut interest rates, but these savings have not been passed on to borrowers by banks and building societies, who are trying to recoup their losses. Such torrid conditions, unfortunately, provide an ideal environment for the growth of fraud.

The big picture

The economic cycle in the UK has traditionally been one of boom and bust.

GDP in the UK grew rapidly in the late 1980s as house prices increased and consumer confidence was high. However this growth was unsustainable and in the early 1990s a major correction occurred in the housing market, leading to a fall in prices and leaving many home owners faced with negative equity. This led to a recession, with the GDP not growing again until 1993. During this period of recession a number of previously unrecognised frauds were uncovered: the collapse of BCCI and the plundering of pension funds by Robert Maxwell being the largest.

This resurgence of growth was impeded in 1995 by the fraudulent trading of Nick Leeson which resulted in the collapse of Barings Bank. Despite this, the economy did start a cautious recovery in the late 1990s, mainly due to the growth of the internet and dotcom companies. Yet, paradoxically, the huge influx of these companies onto the market led to investor confidence decreasing at the end of the millennium, with many of the dotcoms failing, resulting in another decline in the economy. Lo and behold, another round of corporate frauds emerged: Worldcom, Equitable Life and Enron, dragging its auditors Arthur Andersen down with it.

Such patterns can hardly be coincidence. It is often said that the recipe for fraud is threefold: personal and organisational pressures + opportunities + belief that the fraud will go undetected. When the economy is rosy, the first of these ingredients is less likely to be present. But when individuals in organisations come under pressure to perform against unreasonable odds – such as in an economic downturn – then the foundations are laid for potential fraud. It is also the case that fraud is more likely to be detected in such a downturn, as more attention is paid to internal controls and allocation of revenue is more closely monitored.

It remains to be seen whether the current ‘market correction’ will be as severe as the 1990s downturn. Still it is likely that, as belts begin to tighten, more large scale corporate frauds will emerge. This in turn will impact on the economy as consumer confidence decreases in their wake.

The impact

CIFAS, the UK’s fraud prevention service which compiles statistics from its member organisations, has shown the number of identified fraud cases is growing each year:

  1997 1998 1999 2000 2001 2002 2003 2004 2005
False Identity 2231 1902 2189 12310 27270 42029 57669 69512 80894
Victim of Impersonation 17847 16810 18075 22538 26266 32737 43094 50455 56200
Application Fraud Facility Granted 15338 15348 11531 13524 13213 18354 18893 19865 22466
Application Fraud Facility Refused 54284 60710 66006 86077 123606 146431 152070 162911 153290
Conversion 1180 1238 775 751 800 662 832 875 1140
First Party Fraud 13343 13014 17608 21867 30507 36453 36526 41588 41313
Aiding & Abetting - - - 6 24 37 12 27 47
Insurance Claims Fraud - - - 10 144 993 960 802 488
Total 104223 109022 116184 157083 221830 277696 310056 346035 355838

Amongst the largest categories of fraud identified by CIFAS are false identity and false impersonation, where personal data is obtained and then used by the fraudster to their own advantage. The main reason for the increase in this type of fraud is undoubtedly the rise of online shopping, where the purchaser is absent; but it is probable that the credit crunch will indirectly exacerbate this type of fraud, as more consumers buy online to take advantage of cost savings.

Although it is the large corporate scandals which hit the headlines, many smaller organisations also suffer fraud, and instances of this are likely to rise during times of economic pressure. Fraud is usually perpetrated by employees who find themselves in financial difficulty and have the opportunity to remove funds from their employer, believing that their actions will go undetected. With the potential increase in unserviceable debt caused by the credit crunch, there is a greater risk that hitherto honest employees, if provided with an opportunity, may feel under pressure to defraud their employer in order to meet their liabilities.

A climate for fraud to flourish A credit crunch is not a new phenomenon. It is, rather, a natural part of the economic cycle. During these periods of slowdown, large scale corporate frauds tend to emerge, shaking consumer confidence and weakening the markets further. As inflation rises faster than pay-scales, there is increased incentive for employees to defraud their employers in order to make ends meet. In the internet age, with more information publicly available, it is also easier for career fraudsters to ply their trade, thus leading to an overall increase in fraud across the board. How many of these frauds come to light depends on the vigilance of organisations, and their attitude to litigation will affect how such frauds are treated. Is an example to be made of the fraudster to act as a deterrent to others, or is it something to be investigated internally and kept quiet to avoid publicity? It is almost certain that fraud is on the increase, and the current economic environment only heightens the risks for all categories. Companies may find that their systems of internal controls are tested to their limits in the months and years to come.

To find our more about fraud risk management contact partner David Dearman: david.dearman@uk.pkf.com