The recent failure of a Kansas-based community bank showcases the dangers of falling victim to a scam and how quickly it can lead to a bank's demise.
The July 28 failure of
In the fourth US bank failure this year, Heartland Tri-State had $139.4 million in total assets and $130.1 million in total deposits as of March 31. Dream First Bank NA agreed to purchase the assets and assume the deposits of the failed bank, for which the FDIC estimated a cost of $54.2 million to the Deposit Insurance Fund, or 39% of Heartland Tri-State's total assets.
"A fraud scheme to the tune of a few million could certainly impact a small bank of that size to the point where it might be very hard to recover," former FDIC examiner and current Bay State Savings Bank CFO Seth Pitts said in an interview.
Common scams
Shortly after the Kansas Office of the State Bank Commissioner received a call from Heartland Tri-State alerting the regulator to a "big loss problem" that led to the bank's insolvency, the regulator quickly handed the bank into FDIC receivership, Herndon said in an interview.
"We were focused on what we could do to protect the customers, depositors of the bank and that sort of thing," Herndon said. "I did not get at all involved in what happened or how it happened."
Both the Federal Reserve and the FDIC declined to comment for this story.
Observers said the failure of Heartland Tri-State came suddenly. The bank's net income totals had remained steady through the first quarter when it reported a profit of $300,000 and its asset quality was pristine with 31 basis points of nonperforming loans as a portion of total loans.
When a bank fails suddenly without showing signs of deterioration, it suggests that internal "fraudulent activity" may have played a role with loan fraud being a likely culprit, said Jim Adkins, a managing partner at Artisan Advisors, a consulting firm for community banks and credit unions.
Among banks that have failed as a result of fraud, loan scams are a common culprit, said Chip MacDonald, managing director of MacDonald & Partners LLP. Loan scams have the potential to leave a bank critically undercapitalized, Pitts said.
"A lot of bank failures were caused by loans to insiders or related parties that weren't good loans," MacDonald said in an interview. "Somebody or some group inside the bank that was acting hand in hand with outsiders."
One example is Washington Federal Bank for Savings, which failed in 2017 as a result of loan fraud by executives about two weeks after the suicide of its president and CEO.
"That bank had the highest rating you can have from a regulator and all of a sudden 45 days later, it's closed and the president's dead," Adkins said in an interview.
Another example is Batesville, Ark.-based First Southern Bank, which failed in 2010 due to a Ponzi scheme involving an individual who defrauded more than a dozen Arkansas banks.
At sufficient magnitude, other types of situations such as cybersecurity breaches and kiting schemes, or fraudulent use of financial instruments to obtain unauthorized credit, could also bring ruin to a bank, Pitts said.
How to avoid scams
Internal controls are key to avoiding potential scams and can prevent one or two people from manipulating a bank's records to create fraudulent loans or assets, MacDonald said.
Such controls include ensuring lending procedures, monitoring and administration are adequate, which can capture fraudulent activity before it becomes a serious problem, MacDonald said. Additionally, compliance with laws and regulators can prevent major losses from fraud, he added.
"There's a lot of stuff out there that if you comply with it and you build your internal controls to meet those as well, you shouldn't have a problem," MacDonald said, citing laws around loans to a single borrower, loans to related parties and requirements for board approval for insider loans. "It shouldn't be easy for one or two people to cause a bank to fail."
Internal controls might also include information security or operational risk management such as fraud insurance, though it can be difficult for smaller banks to get the talent or the resources necessary to combat more elaborate schemes, Pitts said.
It is also important for boards to be alert, have an understanding of potential cybersecurity threats and be in touch with regulators, who can often provide useful information, MacDonald said. Furthermore, boards should make use of "checks and balances" such as audit programs and third-party examiners, Adkins said.
"If you do the basics and you do them without fail, you're going to make a fraud situation very difficult to pull off," Adkins said.