FROST, PLLC Shows How Lack of Internal Controls Leads To Fraud With Investment Portfolios

Oct. 19, 2009 - PRLog -- Many banks unknowingly fail to utilize proper segregation of duties for their investment portfolio balances even though they represent a significant portion of their balance sheets. Investment portfolios are often managed by key officers so there is a significant amount of trust placed in those individuals by bank boards and audit committees, but reliance on key individuals for significant balances can be dangerous. When a bank incurs losses related to material fraud, the investment portfolio represents a material risk as an area that could be affected – a direct consequence of too much reliance on a few individuals with a wide range of access and control over the financial reporting process.

Internal controls in place to protect an average bank’s assets related to cash funds at the teller level are often significant, cumbersome, and are outlined in great detail in written form. A significant percentage of an institution’s personnel are usually dedicated to processing in this area as well.  Looking at a typical bank’s balance sheet from a financial reporting perspective, assets at the teller level are often not significant to the overall financial condition of the bank.  Typical thefts at this level are generally charged off and although they are often reviewed by the board of directors, they are not central to the overall financial health of the institution.

The controls in place over the loan portfolios at most financial institution also include several steps and reviews. A significant number of personnel are involved in order to provide proper segregations of duties and controls to prevent and detect fraud.

“You might assume that there would be an equal level of controls associated with the bank’s investment portfolio process but this is often not the case – even though investment portfolios can be as large or larger than the loan portfolio balances at many conservative financial institutions,” says Brent Currey, an audit manager for accounting firm FROST, PLLC. “Investment portfolios of most financial institutions are often managed by a single individual with little or no oversight by another party, often due to a lack of available personnel.”

Investment portfolios are generally managed by a key officer within the institution and that individual’s investment decisions are rarely challenged due to the complexity of today’s investment options. Monitoring controls may be established for oversight by the board of directors but more often than not, the committees are more focused on areas such as loan losses, other real estate owned or employee expenses.  

Thefts and fraud within this area of the balance sheet, while infrequent, are often significant and can be catastrophic to the institution causing significant losses of capital and destabilization in the local community due to unwanted negative media coverage.  In fact, negative media coverage is often so potentially damaging that when these thefts are detected they may be settled by the institution with the individual to prevent the public from learning of the deception.  Depositors that do not trust a financial institution to manage their assets because they cannot control internal assets might move their investments to banks they consider to be trustworthy.

“Proper segregation of duties for investment portfolios requires institutions to separate the purchasing, disbursement, and reconciliation processes within the investment cycle,” Currey says.  “In addition, risk analysis of the investment portfolio should be monitored closely by the institution’s oversight group to ensure the risk profile of the investment portfolio matches the risk goals for the institution. The key control to separate is the reconciliation of the investment portfolio from the management function.  Not only should the reconciliation process be performed by a separate individual, but the reconciling individual needs to be familiar with the investment process and must follow up timely on any significant reconciling items.”  

Another key control available for larger institutions is the use of internal audit teams to perform reviews of the controls in place related to the investment portfolio management and assessment of the adequacy of implementation of those controls.  

“To ensure an accurate assessment, these reviews should be conducted at various and multiple times throughout the year and should be as spontaneous as possible,” adds Currey.

In cases where financial institutions do not have adequate personnel to complete these segregations of duties or audits of the investment portfolio there are often outside third parties available to manage the portfolio, conduct the transactions, audit the investment portfolio, or reconcile the investment balances.  Although these third parties will charge a nominal fee, the expenses related to conducting these activities should be weighed against the potential cost of material fraud in terms of capital loss and tarnished reputation in the community.
 
“By improving controls over investment portfolios, banks can not only improve their chances of detecting material fraud before it occurs, but they can also improve the monitoring process of their investments to protect against potential loss of principal,” Currey says. “Wouldn’t you expect that level of accountability with your own investment portfolio?”

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