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Understanding 1st-party fraud: Risks and resolutions

Terri Luttrell, CAMS-Audit, CFCS
September 20, 2023
Read Time: 0 min

How financial institutions can prevent losses from 1st-party fraud

Learn strong approaches to identifying, preventing, and detecting 1st-party fraud that will keep your AML program on top of fraud trends.

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Takeaway 1

1st-party fraud is especially disheartening because it is an inside job and indicates that KYC has been ineffective

Takeaway 2

KYC procedures during onboarding and throughout the client relationship are keys to mitigating 1st-party fraud. 

Takeaway 3

Prevention and detection best practices can curb hard dollar 1st-party fraud losses while protecting clients. 

Introduction

The seriousness of 1st-party fraud

In the financial services industry, fraud has stood as a grim monument to the enduring nature of financial deception. Determining what different fraud types are trending and how they work can help financial institutions counteract hard dollar fraud losses. 

1st-party fraud is one typology that continues to cause losses for financial institutions and their clients. This type of fraud is perpetrated by an account holder in their own name. Rather than stealing someone's identity or using a friend or family member's details, the account holder is who they say they are and uses their account to commit fraud—for example, applying for a loan with no intention of paying it back or filing a false chargeback claim. The scam here is an inside job, making it inherently more elusive. 1st-party fraud is especially disheartening to financial institutions, who are tasked with knowing their customers and ensuring that they are trustworthy. 

Given the current economic climate in the United States, it is essential to understand the effect personal financial security has on 1st-party fraud. 1st-party fraud costs merchants $89 billion annually, with an estimated 60% of charge offs due to fraud. Nearly 62% of fraud reported by financial institutions is considered 1st-party fraud.  Economic downturns or challenges might spur individuals towards 1st-party check fraud as an emergency financial lifeline. And those same economic factors might lead financial institutions to curtail vital investments like anti-fraud technologies, making themselves more vulnerable. 

Recognizing the gravity of the situation, the Financial Crimes Enforcement Network (FinCEN) identified fraud as a national priority. FinCEN's emphasis underlines financial institutions' need to incorporate fraud within their risk assessment framework. It's no longer a discretionary measure but an imperative one. Moreover, an AML program that is robust and comprehensive becomes a vital component in this fight, with fraud detection software being essential. If they haven't already, it would benefit financial institutions to examine their AML and fraud functions to ensure collaboration between the lines of defense. Regulators will be expecting this as they examine institutions for FinCEN priority preparedness. 

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KYC for 1st-party fraud

Ensuring customers are trustworthy

Know your customer (KYC) procedures during onboarding and throughout the life of the client relationship are important to mitigating 1st-party fraud. Effective KYC starts with identifying the typical demographic associated with 1st-party fraud. Often, perpetrators of this type of fraud are younger males with a strong understanding of technology, residing in cities and usually not financially well-off. While these traits alone don't necessarily identify someone as a fraudster, they could be important markers to consider during onboarding.

Careful new account procedures, background checks, and ongoing monitoring can help spot individuals who have the potential to commit fraud against your financial institution. The goal is to eliminate the threat before any inside fraudulent transactions occur. Develop a consumer risk rating process encompassing the possibility of 1st-party fraud on consumer accounts. 

Common models for 1st-party fraud

Here are some examples of common 1st-party scams that financial institutions should be looking for: 

  1. Kiting: Kiting occurs when an account holder knowingly writes a check from their account without sufficient funds, exploiting the float time. The fraudster typically attempts to siphon the funds before the check is presented for payment. This differs from 2nd or 3rd-party check fraud, where external entities forge or tamper with checks. 
  2. Paper hanging: Paper hanging is when fraudsters write checks on known closed accounts, relying on institutional inefficiencies to cash in. 
  3. Application fraud: Application fraud happens when an accountholder misrepresents their personal or identifiable credentials or uses false information or supporting documentation to get more favorable terms on a loan or line of credit.  
  4. Government loan fraud: First-party fraudsters may misrepresent information about themselves to benefit from government loans or stimulus programs. This abuse was frequent with the Paycheck Protection Program (PPP) set up during the Covid-19 pandemic. 
  5. 1st-party debit or credit card fraud: Card fraud causes financial institutions significant monetary losses. Several types of card fraud should be understood:
    • Chargeback fraud: A customer buys something with a credit or debit card and then claims to their card company that the payment was fraudulent to get back the funds fraudulently. Chargeback misuse costs both financial institutions and their clients significantly.  

    • Cyber shoplifting: This type of 1st-party fraud involves a cardholder filing an invalid dispute against a credit card transaction, usually after a significant purchase. The transaction is effectively valid until the cardholder initiates a dispute. 

    • Friendly fraud: When a cardholder initiates a chargeback on a purchase without a legitimate basis. Unlike cyber shoplifting, which is usually intentional, friendly fraud may not be malicious and is usually inadvertent. Regardless of the motive, the outcome is the same: the cardholder has merchandise they haven't paid for. 
    • Goods Lost in Transit Fraud (GLIT): GLIT occurs when a person orders goods online and falsely claims they were never delivered or damaged on arrival. Sometimes, fraudsters return empty boxes to get a refund and vanish before the refund can be reversed. 

Two-pronged approach

Prevention and detection of 1st-party fraud

Confronting 1st-party fraud requires a dual approach: prevention and detection. Below are a few best practices financial institutions can use to curb hard dollar losses while protecting clients: 

  • Leverage fraud detection software: Relying on fraud detection software integrated within an AML program can be a game-changer. Robust software can swiftly analyze vast amounts of data, detecting anomalies and flagging potential check fraud instances. 
  • Embrace real-time monitoring: Modern banking needs to champion real-time oversight. This vigilance can flag suspicious activities instantaneously rather than during end-of-day processing.  
  • Enhance KYC and due diligence practices: By implementing thorough new account protocols, conducting background checks, and maintaining consistent monitoring, you can identify individuals who might pose a fraud risk to your financial institution. Establish a consumer risk assessment procedure that factors in the likelihood of first-party fraud in consumer accounts. 
  • Data analytics: Machine learning can discern patterns often overlooked by human oversight. Regular, seemingly routine transactions can be flagged for closer inspection. Banking intelligence solutions can assist with data analysis so financial institutions can better see activity patterns.  
  • Augment float time management: Minimizing float time can effectively curtail fraud opportunities, particularly kiting, leaving little to no window for exploitation. 

Banks and credit unions can proactively counter these threats by leveraging advanced technologies like fraud detection software and adhering to KYC initiatives. As with any challenge, vigilance and preparedness are the keys to ensuring the safety of institutional assets and their clients' trust. 

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About the Author

Terri Luttrell, CAMS-Audit, CFCS

Compliance and Engagement Director
Terri Luttrell is a seasoned AML professional and former director and AML/OFAC officer with over 20 years in the banking industry, working both in medium and large community and commercial banks ranging from $2 billion to $330 billion in asset size.

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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