Financial Crime: Risks For New Formal Finance Customers

Financial inclusion proponents often react with unease to the topic of financial crime. It is certainly not a topic that is foremost in their minds. There are however a range of financial crimes that may occur in the financial inclusion space. This post highlights the most relevant risk elements from a financial inclusion perspective. It makes the case that financial crime in general and fraudulent investment schemes in particular should feature on the financial inclusion agenda.

For starters, it is important to acknowledge that low-income people who “live in cash” face daily risks in carrying out their financial business. Those who rely on informal financial services are exposed to crime risks such as theft, robbery, fraud and extortion. Financial inclusion aims to give them better options through access to affordable and appropriate formal financial services that complement or substitute their informal options. Security and safety are often major selling points. And indeed, consumers generally enjoy more legal protections when they use regulated formal services and providers.

But it is impossible to provide customers who switch from “living in cash” to formal services a complete guarantee against loss. For example, sometimes regulated service providers fail and customers lose money as well as access to services. In other cases, fraudsters abuse the formal structures to target consumers with a pyramid or Ponzi scheme. Occasionally new consumers are left regretting their reliance on formal financial services.

What risk elements do customers face when they begin to use formal services?

Policy messages that stress the benefits of financial inclusion to consumers - including greater consumer security and empowerment - may even unintentionally create an environment that makes it easier for professional fraudsters to dupe people by using apparently legitimate (and politically-blessed) insitutional forms. In 2009 for example, fraudsters set up a fake bank in a town on the Uganda-Kenya border. They operated for two months, advertised on radio, took $100,000 in deposits and then fled.

Formal services introduce different risks that may be unfamiliar to new consumers: Those who rely largely on cash-based informal services are generally knowledgeable about cash-related crime risks and the steps they can take to reduce their exposure to loss. When they begin using formal services, new risks – that may not be obvious to less experienced customers – can come into play. For example, new consumers often allow their accounts to be used by non-accountholders who wish to send or receive money. They do so to assist family members or community members but fail to appreciate the risk that they may be acting as money mules in money laundering or terrorist financing schemes.

Consumers may relax about crime risks believing that they enjoy legal protection. New consumers may overestimate the protection that they enjoy when using formal financial services. They may have overly high expectations of regulators and law enforcement.

Lack of regulatory and law enforcement capacity increase crime risks. The chances of successful fraud prosecution are diminished by the lack of capacity to do so in many developing countries. Fraud investigations require extensive and appropriate supervisory and law enforcement resources. Fraudsters may be attracted by the low levels of risk of successful prosecution.

The management vulnerability of small providers of formal financial services creates opportunities for fraud. Whether investors’ funds were lost due to mismanagement or misappropriation (also in the form of “control fraud,” a risk that Milford Bateman has highlighted in the context of microcredit in Bosnia-Herzegovina) can be difficult to determine. Even in large fraud schemes fraudsters often blame the loss on market conditions, bad investments, their bankers or regulators, etc. Only a careful analysis of the financial and management records by forensic accountants may reveal breaches of fiduciary duty, theft or management fraud.  In smaller institutions records may not be sufficiently complete to support an accurate forensic assessment. When the management of the financial institution is not knowledgeable about the law, it may also be difficult to determine whether bad management decisions were the result of a lack of knowledge or whether they were taken in bad faith. This uncertainty complicates regulatory and law enforcement action and may render the abuse of such business forms more attractive to fraudsters.

A consideration of fraud risk in this sector would be incomplete without a reference to one of the obvious characteristics of the financial inclusion environment: Many consumers have limited funds to invest. Transactions as well as investments often involve small amounts. That feature would tend to render the environment unattractive to most professional fraudsters. However, fraudsters come in all shapes and sizes. Value that may appear low to one may provide a sufficient incentive to another.  In addition, low value schemes often rope in investors with larger investment amounts too. Low individual investment values therefore do not provide a sufficient deterrence to prevent  the types of schemes highlighted in the previous post.

Why should financial crime feature on the financial inclusion agenda?

Given what is said above it can be argued that crime is part of both the formal and the informal financial services market. In fact, some might say that on balance, financial inclusion measures diminish the risk exposure of consumers and that the inclusion agenda is sufficiently crammed with other important matters. On the other hand, it is also clear that fraudsters can capitalize on financial inclusion initiatives. Careful design and management of such initiatives, combined with the right consumer awareness and empowerment can, on the other hand,  reduce the potential for and negative consequences of pyramid investment schemes and other scams. I would argue that that fact on its own provides sufficient reason to include this topic in the financial inclusion agenda.

If you are not yet persuaded, let me offer two additional arguments:

a) Focusing on this type of financial crime from the inclusion perspective will assist to align national policies on crime prevention with the policy to extend more and better financial services to those with low levels of access. Otherwise, general measures against financial crime may impede useful financial inclusion initiatives. An obvious example is the impact of anti-money laundering and combating of financing of terrorism measures on client identification requirements. The registration of users of mobile phones to prevent criminal abuse of telecommunications is another example of a measure that can impede mobile money development. Bringing financial crime into the financial inclusion agenda can help strike the right balance in crime measures and other related issues such as privacy and data protection.

b) Large financial crime schemes can threaten political, financial and regulatory stability. The large-scale devastation wrought by Ponzi schemes in Albania in the 1990s led to civil unrest, deaths of civilians and a change in government. Once the schemes implode, regulators and regulatory frameworks suffer reputational damage and investors lose trust in the formal financial system. The failure of these schemes may therefore disrupt financial inclusion initiatives. 

Financial crime may therefore be an uncomfortable topic for financial inclusion proponents but it is a part of the financial inclusion landscape. By including it in the financial inclusion agenda we increase our ability to develop the system in ways that provide users not only with better services but also with improved protection against financial crime. 

In the next post, guest blogger Nicola Jentzsch will share data and analysis from Kenya on the extent to which lower-income consumers are targeted and caught up in pyramid schemes and the consequences of their participation.