CHEQUE FRAUD AND BANKING RESPONSE THE INCREASING USE OF CREDIT CARDS AND OTHER PLASTICS: THE CASE OF TRIMDAD AND TOBAGO Y 1 CHEQUE FRAUD AND BANKING RESPONSE - THE INCREASING USE OF CREDIT CARDS AND OTHER PLASTICS: THE CASE OF TRINIDAD AND TOBAGO KELVIN A SERGEANT' I. INTRODUCTION Cheque fraud and other unladl activities have plagued the banking sector all over the world since the 1980s. These unlawful checking activities against banks became pronounced in the 1990s and now exist in many forms. These include altered cheques, forged signatures, forged endorsements, counterfeit cheques, and cheque kiting. Today, technology and the technological revolution has made it increasingly easy for criminals to create realistic counterfeit cheques and false identification that can be used to defraud companies and banks. The FBI in 1994 reported in its Financial Institution Fraud and Failure Report that 60% of all criminal referrals relate to cheque fraud. A 1994 survey by the American Bankers Association found that 54% of community banks, 94% of mid-sized banks, and 88% of large banks sustained tremendous losses from cheque fraud in 1993. Between 1991- 1993, the number of fraudulent cheques submitted increased 136%, from 537,000 to 1,267,000. During the same period, annual losses from these frauds increased to reach US$8 15 million for 1993. Conservative estimates are that banks lost in excess of US$1 billion to cheque fraud in 1996. More than 1.2 million worthless cheques will enter the banking system each day in America in 2001. In the UK, counterfeit and altered cheques accounted for f 11.25 million of the total of £44 million that was lost by the financial services industry to cheque fraud during the last year. Retail merchants, government 1 The Author is an economist and Manager of Economic Research employed with the Royal Bank of Trinidad and Tobago (a member of RBTT Financial). The views expressed in this paper are those of the author and not necessarily that of RBTT. 1 =h +' urn: agencies, and companies of all sizes are now victims of cheque fraud. A recent survey of more than 2000 large U.S. corporations concluded that on average, they lost approximately US$360,000 a year to cheque fraud. Trinidad and Tobago has also been affected by this phenomenon in recent years. In fact, the problem was so severe that in 1999, the commercial banks in Trinidad and Tobago removed the cheque guarantee facility which existed before. The banks have also asked customers to make greater use of point of sale, Linx and other electronic means for doing business. Such developments have the potential to alter the payments system in Trinidad and Tobago. There are implications for the banking system and monetary policy. This paper seeks to address some of these concerns. In what follows, a history of the Cheque Guarantee Facility will be discussed followed by a section on Technology and Fraud. Issues related to the protection of customers and merchants are then discussed. A discussion on monetary policy and electronic money follow with conclusions. 11. History of Cheque and the Guarantee Facility Cheques have been used as a payment method in Trinidad and Tobago since the beginning of the century. While payment by cash remained the preferred payment option, the 1970s saw the beginning of a shift as there developed a greater demand for more widespread use of non-cash payment methods, both for security (in terms of carrying less cash) and convenience. At that time, cheques were one of the few alternatives available. To encourage acceptance of cheques by businesses, commercial banks in Trinidad and Tobago introduced the Cheque Guarantee Card. This card assured merchants that cheques would not be returned for insufficient funds up to a specified amount, so long as conditions were met. In most cases, the maximum guarantee on the card did not exceed TT$1,000. However, as most of the risks for cheques covered by the guarantee fell with banks, credit risk assessment was critical in determining who qualified for such a facility. Only approximately 10% of the Banks' customers actually had a Cheque Guarantee Card. With this guarantee facility, cheque acceptance and usage 2 I-Fr 1- grew significantly, until a few years ago when Electronic Banking was introduced in the country. 111. Technology and Cheque Fraud Since 1980, phenomenal advances in payments technology have occurred. New payments mechanisms and web sites about digital cash and other electronic payments systems have been proliferating wildly. Today there is LINK ABM services, LINX Debit Point of Sale, Smart Cards and many variants of Credit Cards. It is this electronic money revolution that has shifted so much economic power from the state to financial markets. This revolution has shaken financial markets worldwide. Additionally, worldwide liberalization of government controls on capital outflows, combined with new telecommunications and computing technologies, have enabled huge electronic "hot money" flows to flash around the globe in search of the highest returns. Today private sector financial capital outweighs Central Bank foreign exchange reserves and international trade-related flows in some countries, although this was not the case a few years ago. In embracing the opportunities that this technological revolution offered, Trinidad and Tobago banks introduced automated banking machines (ABM's) in 1986, Link ABM Service in 1994 and LINX Debit Point of Sale in 1996. This has enabled more customers access to non-cash payment methods. Parallel to these developments, there has been a continuous increase in cheque fraud costing banks, customers and merchants millions of dollars annually. Cheque fraud can take many forms. It can exist as: Forged signatures in which legitimate blank cheques exist with an imitation of the payor signature. Forged endorsements which usually involves the use of stolen cheques, that are then endorsed and cashed or deposited by someone other then the payee. Counterfeit cheques. With the advancement in colour copying and desktop publishing, this is the fastest growing source of fraudulent checks today. 3 =I, rf - Altered cheques in which the information on a legitimate check, such as payee or check amount is changed to benefit the perpetrator Cheque Kiting which is the process of depositing a cheque drawn on bank account B into bank account A, then writing a cheque on bank account A while bank account B has insufficient funds. Apart from the above forms of cheque fraud, there are other methods used which include: 1. Getting customer information from bank insiders 2. Stealing bank statements and cheques 3. Working with dishonest employees of merchants who accept payments by cheque, or 4. Rifling through trash for information about bank relationships. Although the exact figure for losses through cheque fraud is not available in Trinidad and Tobago, my information is that losses run into millions of dollars annually. As a benchmark, if we use the credit card business, where the environment is structured and priced to handle an anticipated level of fraud, theft and abuse, losses incurred for 1999 as per VISA International Statistics were 5.43% of the outstanding balances. The Caribbean and Latin American region reported a figure of 10.6%. The approximate percentage for Trinidad and Tobago for 1999 was 3%. It is estimated that cheque fraud losses exceed the credit card figure. Banks have also incurred increasing costs in recent years for training with respect to identifying and deterring cheque fraud. Attendance to specific Seminars and the introduction of more rigid system and audit trails had assisted in controlling losses associated with the incidence of cheque fraud. However, the sophistication of the perpetrators supported by reasonably priced cutting-edge technology created new challenges daily. The initiatives taken were designed to control or reduce the amount of fraud in the system. IV. The Need for the Protection of Customers and Merchants The increase cheque fraud posed increasing risks of loss to all stakeholders. The banking sector therefore saw it as their responsibility to reduce these risks as far as possible. In 1998, the Government passed the Negotiation Instruments (Dishonoured Cheques) Act, which protected merchants against persons who obtain property or services by use of dishonoured cheque. Additionally, there are now several alternative payment options that offer a higher level of security than previously existed. Two of the more popular are LINX Debit Point of Sale and telephone banking which are electronic payments systems that offer a Personalized Identification Number (PIN) Code Security to customers. The PIN is only known to the customer and, if compromised can be changed easily. Pin Code access offers a higher level of security to all parties, as it ensures that only the persons authorized to have access do so. On account of higher levels of security and on-line, real-time access to their accounts, all customers can now avail themselves of the Debit ABM Card facility. There are no strict qualifying criteria. In 2000, there was a substantial increase in Debit/ABM Cardholders with over 750,000 now in issue. There are now approximately 7,000 merchants on-line nationwide and this figure continues to grow. Reliability of the system currently stands at 99%. There are numerous benefits that accrue to customers and merchants with electronic banking. For the customer, the following benefits accrue: (a) Safety - PIN security versus signature security. (b) More buying power - card limit of $5,000 per day compared to the guarantee limit of $600-$1,000 per transactiodmerchant per day. (c) More accessible than cheques. (d) Cheaper - A Debit Point of Sale transaction cost approximately 50 cents versus 90 cents per cheque transaction. Additionally, some 5 =h - - dl L customers pay for their checkbooks, which could increase the cost of a cheque transaction.