“A stitch in time saves nine”

GardaWorld, a service agency entrusted with the work of distributing the monies (mostly coins) on behalf of various banks. In the process, GardaWorld maintains the stock in its warehouses, accounts for what is being maintained, and carries out the distribution with its resources which include armored trucks and people. All went well till it was reported that some of the money went missing. Who stole the money, without being noticed?

The very first thought would be a robbery or someone stealing it. Robberies cannot go unnoticed and stealing truckloads of money from a secure & guarded location also equally ruled out. Employees taking money every day, filling their pockets while changing duties? It has to be a daily activity, as obviously one cannot carry bags full of money from a guarded vault. So many people and so many days of theft – sounds crazy! May not be the cause.

If no one steals anything – physically – where is the money gone? Before getting into the fundamental question, let us see how money(coins) are measured, monitored, and secured – in general – across various financial entities, while storing or distributing. While currency is generally counted before changing hands, coins are “weighed” when dealt in large quantities. However, weighing is not practical when container loads of coins are handled, as packing material would alter the calculations. So, the first issue here is – coins are generally counted as boxes/ containers/ drums when stored or transferred in large quantities. So the possibility of accurate accounting is less.

Secondly, the warehouse stores money from different banks – just like a regular warehouse storing different products like electronic items or meat products. The difference here is all the items are the same from different owners – at least the content within the packages. So, practically no need to segregate the boxes based on the owner bank. The second issue is lack of seriousness on segmentation and at any point in time, the accountability would be on “total” and not on detail.

Next, comes, where do you get this money from? Always receive from the mints/bank vaults or sometimes from your customers too? Is it always an issue to customer/branch or sometimes the receipt as well? It is more complex to handle issues and receipts both, why? The reason being whatever received from the banks are always in standard sizes/volumes/ quantities and simple measurement of packs will give a full measurement of value. The same cannot be true in the case of customer/branch receipts. So, the third issue is difficulty in quick measurements. This can be easily translated into a time-consuming handover/takeover process for each shift. So what? Practically ignored by its employees! A weak control obviously paves way for fraud. When no one knows how much money lying in all those hundreds of boxes, some crooks will make use of the opportunity.

Now, the chances of fraud. The money belongs to multiple owners (banks) and obviously, some inspection or audit takes place periodically by individual banks, as a global best practice adopted by all banks, almost. When you have a warehouse with similar items stocked everywhere – everything is the same in terms of value- what inspection do you do count a few items, which you think belongs to you? How easy it is to show the inspecting officer and tell him – “see, all those 25 boxes are yours”. Practically, every auditor can be given a similar reply and possibly they leave happily forever.

This kind of fraud happened at numerous places across the Globe where the custodian keeps huge sums of money on behalf of many banks or different branches on the same bank. Typically, they are given tasks like refiling ATM machines or maintain local vaults. At any given point in time, the fraudster (who manages the money) can show any visiting auditor, his money. Even when there is a shortfall, he can always make good from the huge balances he is maintaining. Unless and until all banks plan a single audit, this kind of fraud is hardly detected by auditors.

While fraud cannot be ruled out, another culprit could be weak systems and processes for accounting, transitioning, and reporting. As already discussed, the systems issues will multiply when money from different banks is pooled and stored together; money consists of receipts and payments as well; all packages will not be containing equal amounts of money and finally when the employees are overburdened with work.

Weak systems and faulty accounting practices could be a major culprit. It is likely that the money could be lying somewhere in some of the vaults, perhaps unnoticed/unreconciled, and not bothered about its existence. Also, it could be an issue of undercounting of packages like a box that may contain higher denomination but labeled as a lower denomination. The second probability, less likely, could be a major fraud where the money is siphoned out temporarily with an intention to replace it at a later date.

By and large, the episode talks about the need for a carefully designed and monitored system and associated processes. “A stitch in time saves nine”. Truetech’s Consultants helped many of its global clientele in designing and strenghtne their systems and process.

BANK FAILURES:EARLY WARNINGS WE MISSED – VIII

The  Louisa Community Bank, USA (2019)

Brief

The Louisa bank has been operating since 2006 and had nearly $30 million in total assets. In late October 2019 Kentucky’s Department of Financial Institutions had taken possession of the Bank after determining it was “critically undercapitalized.

Events Unfolding

Between 2007 and 2012, the Bank was subject to six annual examinations, five onsite visitations, and quarterly reviews of the bank’s progress reports and financial information. During that period, the Bank received a “3” composite rating at each of the annual examinations except in two instances. The Bank was also subject to a Memorandum of Understanding (MOU) starting in 2008. In 2012, the FDIC upgraded the Bank’s composite rating from “3” to a “2” because of management’s efforts in addressing prior examination criticisms. The FDIC also terminated the MOU. 

However, in 2014, examiners found that the Bank’s overall condition had declined. In 2014, while financial metrics were stable, examiners downgraded both the Management component rating and composite rating from a “2” to a “4” due to deficient internal controls and inadequate risk management practices. Examiners also reported that since the 2012 examination, the Bank’s President/Chief Executive Officer and Operations Officer had left the Bank and were not adequately replaced. 

Between 2015 and 2019, the Board and management did not demonstrate the ability or willingness to correct problems. Consequently, examiners progressively downgraded the component ratings of Capital, Management, Liquidity, and Sensitivity to market risk. In 2015 and 2016, credit administration and underwriting practices deteriorated significantly and problem assets began to rise. 

The Bank’s financial condition continued to worsen in 2017 and 2018. Examiners downgraded the Bank’s composite rating from a “4” to a “5” in 2017. In 2019, capital depletion accelerated from continued operating and loan losses at the Bank.  The Bank became Significantly Undercapitalized on April 30, 2019 and Critically Undercapitalized on July 31, 2019.

Failure Analysis

Based on the review of key FDIC documents, the Bank’s failure resulted from an “ineffective and dysfunctional” Board of Directors (Board) and executive management that led to poor risk management practices, operational deficiencies, weak internal controls, and inaccurate accounting and reporting that adversely impacted every facet of the Bank. The Board and executive management also failed to maintain adequate and qualified staffing in key management positions, and were unable to address the many financial, managerial, operational, and regulatory issues that examiners started to identify in 2014. 

Learnings

In addition to the weak management control and ineffective risk management practices, the failures are apparent when key officials left the bank and no competent personnel were recruited. Continuous FDIC reviews and critical observations against the bank, apparently the management was not prepared to handle the issues. Lack of apathy, seriousness, commitment or willingness resulted in the end of business. The reports of regulators, succession failures in key levels, declining financial strength as reflected in annual financial statements, insufficient compliance to regulatory findings – all of these could be detected as early warning symptoms of the future to come. 

BANK FAILURES:EARLY WARNINGS WE MISSED – VII

The Resolute Bank, USA (2019)

Brief

The Resolute Bank was an insured,full-service federal stock savings association chartered in 2006. The bank had been a subsidiary of PrinCap Holdings One LLC since 2013, which owned approximately 92 percent of outstanding bank shares. As of June 30, 2019, the bank had total assets of $27.1 million. On October 25, 2019, the Office of the Comptroller of the Currency (OCC) closed Resolute Bank and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver.

Events Unfolding

Resolute Bank began in 2006 under the name Bank of Maumee, one of 57 separately chartered banks affiliated with Lansing, Mich.-based Capitol Bancorp Ltd.. Bank of Maumee had a single branch in a suburb of Toledo, Ohio. Capitol Bancorp’s business model did not survive the financial crisis, and it sought bankruptcy protection in August 2012. At that point, it had 12 banking subsidiaries, five of which eventually failed, not including Bank of Maumee. Bank of Maumee was sold to private investors in November 2013 and escaped the fate of its affiliate banks. But the bank began losing money in 2016, while its nonperforming assets and loans more than 90 days past due rose to over 13% of total loans and other real estate owned as of June 30, 2019.

Failure Analysis

The primary cause of Resolute Bank’s failure was the board and management’s poor planning and lack of oversight over bank operations. The board and management ventured into mortgage banking operations, focusing on the origination and sale of government insured and guaranteed loans, without a valid strategic or capital plan. Ineffective oversight of these ventures, combined with excessive overhead expenses, resulted in operating losses and critically deficient earnings, asset quality, and capital. 

Corporate governance deficiencies also contributed to the bank’s failure; specifically insufficient oversight by the board and management, and weak communication between management and members of the board. These corporate governance problems kept the board and management from addressing OCC’s Matters Requiring Attention and other bank operation issues.

Learnings

An increase in non-performing assets is a nightmare to any financial institution. However, linking the numbers to changed strategy could have given an early indication of strategy failure. Often, the strategy risk assessment is overlooked by the management. An AI model, linking the operational performance via-a-vis the board level strategy could through interesting insights and early warnings.