Lender beware

When inflation skyrockets, central banks increase interest rates to slow spending. Here, the author details why periods of high inflation might lead to high rates of fraud in the lending industry and what lenders can do about it.

In the past year, inflation has dominated news headlines around the world, and you’ve probably felt some of its effects in your wallet as prices on everything from food and fuel to cars and houses shot up. Because inflation means higher prices, the usual remedy from central banks is to slow spending by hiking up interest rates. And while higher interest rates might ease inflation, those higher rates can mean trouble for lenders and consumers.

My organization, Point Predictive, operates an auto-lending consortium with data that suggests there’s a correlation between periods of high inflation and first-party fraud. First-party fraud, also known as “fraud for purchase,” is when fraudsters give false information about themselves such as fabricating their income. This is different from third-party fraud, which is essentially identity theft. (See “The different types of fraud and how they’re changing,” Experian.) In this column, I’ll detail why our data shows that lenders must be vigilant when interest rates are high, and some steps they can take to prevent and detect potential fraud in loan applications.

Inflation and fraud risk in lending

The consortium has data on more than 120 million auto loan applications from 65 million consumers throughout the U.S. Within that data is information about demographics, credit histories, income and employment. Lenders often use this data to gauge their applicants’ credit risk, but it can also be used to identify fraud trends across industries as the consortium comprises all loan applications no matter the approval status.

Our Auto Fraud Manager tool allows automotive lenders to assess an applicant’s risk of fraud based on information in their applications, past and present. The greater number of red flags we see in an applicant’s data, the higher their overall risk. The overall fraud scores across the data consortium show, as demonstrated in the graph below, there’s a high correlation between those risk scores and the inflation rate in the U.S. As prices increase, people have less money to spend on everything, and considering that reliable transportation is a necessity, securing a loan at a good rate might spur some to misrepresent income or employment information. Indeed, as interest rates increase so have fraud risk scores.

Source: Point Predictive

Inflation rate vs. fraud risks

As the graph above showing the relationship between inflation rate to average fraud scores indicates, the average fraud score for loan applicants has been trending upward since early 2021. We think this is heavily influenced by the harsher economic conditions brought on by higher inflation with both career criminals and the average consumer perpetrating this kind of fraud.

Why inflation might create the conditions for fraud

Lenders and financial institutions often focus on third-party fraud because the red flags are much more obvious, and most fraud detection tools are built for this type of fraud. However, the red flags of first-party fraud are much more subtle. But, as fraud examiners know, when there’s a downturn in the economy, there’s generally an uptick in fraud, especially first-party fraud. (See Occupational Fraud: A Study of the Impact of an Economic Recession, ACFE, 2009.) Because of this, it’s necessary to consider what this period of inflation might mean for fraud in the lending industry as people must spend more money on everyday necessities, leaving little room to afford anything else. We can look to the Fraud Triangle to conceptualize why fraud might increase during periods of inflation.

• Financial pressure: First, to make the conditions right for fraud, people need to perceive they have an unshareable financial need. Consider the price of cars, which are at an all-time high, and combine that with high interest rates for car loans and that most people need reliable transportation, and it’s not inconceivable that someone might be willing to misrepresent their income to secure the best rate they can get on a car loan. (See “New Car Prices Nearing All-Time High Again,” by Sean Tucker, Kelley Blue Book, Nov. 9, 2022.)
• Opportunity: But a potential fraudster can’t commit fraud with motivation alone. They also need the opportunity. In the lending industry, speedy approvals on loan applications and the ease of applying with minimal friction — anything that slows down the process — are a lender’s competitive advantage. But a simple, speedy application process might also mean that lenders aren’t closely scrutinizing applicants, providing the perfect opportunity for false information to fly under the radar with little consequence for loan seekers.
• Rationalization: Fraudsters need to rationalize their crimes and justify their behavior. For many consumers, they might not think of a large bank or other lender as a victim and see a misrepresentation of their income or a lie about employment as a “little white lie” that won’t hurt anyone.

What drives “fraud for purchase”

Income misrepresentation

Before a lender decides to underwrite a loan, they must first review the applicant’s ability to pay it off. The two key measurements lenders use to determine an applicant’s suitability for a loan are their payment-to-income (PTI) and debt-to-income (DTI) ratios. PTI measures how much of a person’s monthly income would be used toward a car payment, and DTI is the ratio of how much they owe per month versus how much they earn. The higher these ratios are, the riskier it is to extend a loan to an applicant. The result of inflation is increased prices on goods, which will affect the applicant’s ability to make payments on their debt. And increased interest rates can affect how much an applicant will be able to pay on their loan every month. If a consumer’s income hasn’t kept up with inflation, their DTI and PTI won’t look good to a lender.

In our research comparing stated incomes on applications to applicants’ verified incomes, we’ve found that on average, 20% of loan applicants have overstated their incomes by at least 15%. We consider this material misrepresentation that would cause lenders to make decisions about applicants they wouldn’t necessarily make if they knew the truth. This trend of mispresenting income continues to rise alongside an increase in inflation.

Source: Point Predictive

Employment misrepresentation

Another growing trend we’ve identified in our data is applicants using fictitious employers in their employment history. With further investigation, we discovered that many of these fake employers were credit repair companies that created fake businesses for their customers and acted as employment verification services. These “employers” all had a limited online presence with websites built from templates and offered services to verify employment.

Extraordinary growth in application submissions with these fake employers appears to correlate with high inflation. Of course, these fictitious employers serve the purpose of making a loan applicant seem like a good bet to lenders during a time of high inflation. Whether the applicant wants to show they have a higher income to keep up with inflation or a person is unemployed, these companies provide cover to anyone seeking a loan. In 2022 alone, we alerted lenders to more than $710 million in attempted fraud from applications using fraudulent employers and, we saw a 380% increase in the number of applications submitted using fake employers since the start of the pandemic. This trend is consistent, and we’ve identified more than 8,500 fake employers to date. What has been most eye-opening to us is that it appears as though these 8,500 fake employers have been used over and over again by applicants. The table below shows the top 10 fake employers that applicants used in 2022. These top 10 fake employers were found in more than 2,000 submitted loan applications with a potential of over $60 million in fraud losses had these applicants been approved.

Source: Point Predictive

How to prevent inflation-related fraud

The following are steps lenders can take to protect their organizations from inflation-related fraud.

• Train employees on fraud. Arguably the most important thing any organization can do to protect itself is educating employees about fraud. It doesn’t matter how sophisticated your fraud prevention technologies or strategies are, fraud will continue to occur if the people using those tools aren’t properly trained. A strong fraud awareness training program can be the best deterrent and one of the best investments you can make in your organization. A strong anti-fraud training program will include education on the schemes and the methods fraudsters generally use to carry out fraud. Your program should also include information on how employees can spot red flags and the steps they should take if they do spot something that appears suspicious. When conducting trainings with employees, it helps to include examples of common fraud scenarios they might encounter.
• Invest in AI. As previously mentioned, a lender’s ability to quickly grant credit and the ease of the application process are the biggest competitive advantages for lenders. But as lenders automate their credit checks, they aren’t always keeping up with necessary controls that can prevent fraud. The faster an application is approved, the faster it is for someone to commit fraud, and lenders need to stay apace. Leveraging artificial intelligence (AI) can help keep lenders safe while allowing them to keep up with the shift in automation. There is no one-size-fits-all approach to implementing AI, so lenders should consider the types of fraud they often see and what their risk appetite might be for implementing it. Looking for fraud is a little like trying to find a needle in a haystack, but AI can help cut down that stack. (For a list of different AI tools and what they provide, see “2023 Solution Providers Infographic,” About Fraud.)
• Use income and employment verification services. In a recent survey Point Predictive conducted, lenders told us that roughly 10% of pay stubs are doctored or forged in some way. (See “2020 Annual Auto Fraud Report,” Point Predictive.) This means relying on a paystub for income verification is highly unreliable, and many lenders require these reviews on 100% of their applications, thus underwriting teams are tasked with a massive amount of work. By leveraging as much alternative data as possible from multiple sources, such as open-source government data or salary data from aggregators, it becomes easier to spot inconsistencies and stop the fraud before it’s too late.

Source: Point Predictive

In early 2023, there’s been some encouraging news about inflation, with rates falling for the first time in three years and consumer prices decreasing by 0.1% in the U.S. (See “Prices fell in December as inflation continues to moderate,” by Alicia Wallace, CNN, Jan. 12, 2023 and “Wall Street rises on optimism before key inflation report,” by Caroline Valetkevitch, Reuters, Jan. 11, 2023.) But there’s still plenty of uncertainty to go around as the pandemic and war in Ukraine continue and fears of recession grow, so lenders will need to stay tuned to inflation rates and know that difficult times might nudge some of their applicants to commit fraud.

Justin Davis, CFE, is vice president of product delivery at Point Predictive, where he has also worked as a fraud consultant. Contact him at jdavis@pointpredictive.com.