Insider loan fraud: Regulation O violations

Is your financial institution Regulation O compliant? How transparent are transactions among insiders of your financial institution? Insider abuse can be difficult to detect and cannot only lead to substantial FDIC penalties but will increase the reputation risk of your financial institution.

Regulation O, issued by the Federal Reserve, governs the extension of credit by a member bank to an executive officer, director or principal shareholder (an Insider) of that bank. An insider who becomes indebted to the financial institution must, under most circumstances, report that indebtedness to the board of directors of the financial institution. In some instances, depending on the loan amount or total amount of loans outstanding, the insider must obtain proper approval by the board of directors before the loan is issued.

Nominee loan scheme

  • A violation of Regulation O may occur if an insider becomes involved in a nominee loan scheme. A nominee loan is a loan in which the borrower named in the loan documents is not the party receiving the use or benefit of the loan proceeds.
  • The scheme could be perpetrated by an insider soliciting a credit worthy individual to take out a loan and divert loan proceeds to the insider. Essentially, the insider is able to influence the credit worthy individual to obtain the proceeds without disclosing his or her indebtedness to the financial institutions’ board of directors.

Risks

In addition to the credit risk and FDIC imposed penalties, many other intangible consequences can surface from Regulation O violations. Insider abuse can impair the public’s confidence in the institution and damage the financial institution’s reputation beyond the dollar amount of any credit loss.

Prevention and detection

Prevention:

  • An overall internal control risk assessment of the lending process will help identity control gaps and weaknesses. Once a risk assessment is completed, recommendations will be provided for the design and implementation of strong controls to mitigate risks identified.
  • A Regulation O compliance officer should be appointed and a formal policy should be maintained that specifically defines Regulation O and its requirements.
  • There should be periodic training to educate employees and raise awareness.

Detection:

  • A detailed analysis of cash transactions between loan customers and insiders can assist in identifying the diversion of loan proceeds and insider activities.
  • Periodic Regulation O audits or compliance reviews may uncover noncompliance issues or insider loan fraud.

If at any time you suspect there may be illicit insider activities occurring within your financial institution, a forensic accountant can help identify the issue, quantify any damages and provide recommendations to mitigate the risk of such activities in the future.

For more information on this topic, or to learn how Baker Tilly banking specialists can help, contact our team.