How to Use Internal Controls to Prevent Fraud: Key Strategies

Fraud is a silent predator in financial institutions, quietly siphoning funds, damaging reputations, and eroding trust. Every day, new tactics emerge; some high-tech, others as old as money itself. Financial institutions create internal controls to prevent fraud, protect their assets (and their customers’), protect clients, and uphold their commitment to financial integrity.

In practice, internal controls have different types and each is used for a different purpose, one of which is preventing fraud (rather than just reacting to it)!

What are Internal Controls?

Internal controls are the rules, policies, procedures, and technologies that keep fraudsters at bay, ensure compliance with laws, and maintain operational integrity.

According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO), internal controls are a structured process led by a company’s management, employees, and board of directors. They are designed to ensure that operations run efficiently, financial reports are reliable, and the company follows all necessary rules and regulations.

A solid internal control to prevent fraud does three key things a) blocks unwanted access b) holds people accountable c) creates transparency.

These practical benefits are fraud controls which can be the difference between catching a fraudster early and discovering a financial disaster too late.

The Importance of Internal Controls to Prevent Fraud

The goal of fraud prevention controls is to stop fraud before it happens or make it as difficult as possible to commit.

Fraudsters take advantage of weaknesses in financial systems, so any gaps make it easier for them to commit fraud. That’s why regulators enforce laws like AMLD and SOX, which require institutions to have strong anti fraud measures (including fraud prevention controls) to prevent corporate malpractice, malfeasance and money laundering in response to high-profile fraud cases.

The Three Essential Types of Fraud Controls

Fraud doesn’t just happen in one way, so institutions need three layers of protection:

1. Preventive Controls

One example of preventative anti fraud control is the segregation of duties so no single person should have full control over financial transactions. This is as simple as one person processes, and another approves!

Let’s say a loan officer in a bank processes loan approvals. If they are also able to authorize those loans, they could approve fake loans and funnel the money elsewhere. Segregation of duties prevents this by requiring a second person to approve the transaction.

2. Detective Controls

Even the best preventive anti fraud measures aren’t foolproof, and some fraud will still get through. Detective controls help uncover fraud as soon as it happens before it spirals out of control. For example, if a fraudster tries to steal funds by making multiple small transfers, an AI-powered transaction monitoring system (assuming that the institution uses one) detects the irregular behavior and triggers an alert for further investigation.

3. Corrective Controls

When fraud is detected, the response must be swift and effective. Corrective anti fraud controls help financial institutions recover and improve their systems to prevent the same fraud from happening again. An example is freezing the account and filing a Suspicious Activity Report (SAR).

Common Types of Fraud in Financial Institutions

Fraud is not confined to cybercriminals, it can be committed by employees, customers, and third parties as well.

1. Employee Fraud

Employee fraud happens when staff members use their position to commit dishonest acts. Employees often have inside access to financial systems, making it easier for them to bypass security measures.

Common forms of employee fraud include:

• Embezzlement

• Unauthorized Transactions

• Falsification of Records

Several concerns could suggest potential financial irregularities 1) there have been unexplained shifts in lifestyle like sudden wealth or extravagant purchases, which may raise questions about the source of these funds 2) noticing discrepancies, such as missing or altered records, which could indicate an effort to obscure or manipulate information 3) there have been instances of unauthorized access to sensitive financial details, signaling a potential breach of security.

2. Customer Fraud

Customer fraud occurs when individuals outside the institution use its services to commit fraud.

Common forms include:

• Identity Theft (Read more about Synthetic Identity Theft)

• Account Takeover Attacks (Learn how to prevent ATOs)

• Loan Fraud (Explore the types, impact, and preventative strategies)

• Credit Card Fraud (Discover Credit Card Fraud Detection and Prevention Techniques in this weblog)

One warning sign to watch out for is when there are numerous loan or credit applications within a brief period, which may indicate financial strain or an attempt to overextend credit. Another concern is large withdrawals or transfers from an account that can’t be easily explained.

Also, any sudden changes in a customer's contact details, such as a new phone number or address, should raise caution, as this could point to efforts to conceal identity or avoid detection.

3. Third-Party and Vendor Fraud

Third-party fraud occurs when external parties, like vendors or contractors, exploit their relationship with the financial institution.

Common types of this type of fraud include: a) Fake Invoices b) Collusion c) Overbilling.

There are several red flags to be aware of:

• If there are unusual changes in billing practices, differing from the typical procedures

• If some payments lack the necessary documentation to support their legitimacy

• If certain vendors have been requesting payments outside the usual terms

4. Cyber Fraud and Financial Crimes

Cyber fraud is an increasing risk for financial institutions, as criminals use technology to steal information, money, or disrupt operations.

Common types of cyber fraud include phishing, hacking, ATM skimming, and money laundering.

One such security concern or indicator is when there are irregular login attempts or access from unfamiliar locations, which could signal unauthorized activity. It's also important to take seriously any reports from customers about transactions they didn’t authorize.

Key Fraud Indicators and Red Flags

In addition to recognizing specific types of fraud, financial institutions should look out for general fraud indicators.

For example, large transfers that don’t have a clear explanation, especially if they’re going to high-risk areas, or if account details are changing frequently. Another thing to watch for is sudden changes in spending like employees or customers making expensive purchases or taking lavish vacations.

It's also important to pay attention if there are repeated violations of internal policies or approval processes being ignored.

Essential Internal Controls to Prevent and Detect Fraud

We explain the key internal controls to prevent fraud and detect it.

1. Internal Controls to Prevent Fraud

Preventative internal controls stop fraud before it occurs!

2. Internal Controls to Detect Fraud  

These internal fraud controls are designed to identify fraud when it occurs or to spot fraud red flags.

How to Strengthen Internal Fraud Controls in Financial Institutions

To stay ahead of fraudsters you must be proactive, not reactive. Fraud and internal controls create a structured environment where risks are mitigated through systematic monitoring.

The effectiveness of fraud and internal controls lies in their proactive nature, early detection of fraud is often driven by:

1. Use Advanced Fraud Detection Technology

2. Tighten Access Controls

3. Conduct Routine Fraud Risk Assessments

4. Build a Culture of Ethics and Accountability

Prevent Fraud with FOCAL

FOCAL’s AI-powered fraud prevention solution analyzes data to generate accurate Fraud Scores. The system uses advanced device fingerprinting and behavior analysis to detect unusual user actions. It also blocks high-risk connections, including VPNs and hosting services, to prevent fraud.

FOCAL automatically creates action labels for responses, allowing for customized actions when needed. It integrates global IP databases to block risky IPs and prevent fraud. The system can also map event locations and customer activities on an interactive map, making it easier to make quick, informed decisions. FOCAL detects unusual device behavior, such as changes in device use, multiple accounts on one device, or inconsistent geolocations, helping to stop fraud before it happens.

If you'd like to learn more about FOCAL Fraud Prevention solution or have specific questions, please schedule a free one-on-one meeting with our experts.