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Friday, May 25, 2012

The cost of banking fraud and the butterfly effect

Let's talk about shooting yourself in the foot, or rather, avoiding that uncomfortable limp.  Please open your mind to the impossible. Let's talk about how "always" and "never" almost always have exceptions.  For example, we might think that catching a burglar is "always" a good thing, right?  Well, let's consider the possibility that allowing a crook to rob a bank might be good for us all in the long run.

To understand the concept that is about to be presented, as it applies to the banking industry, please first consider the value of the internet and the value of our recent digital revolution to the banking industry.  Computers and online banking systems save banks from needing as many tellers, agents, and other staff.  Depending on the size of the bank, their Information Technology department (IT) might save them 50 million dollars per year in employee costs.  Also, that same infrastructure might drive new profit for the bank, possibly another 50 million per year.  Out of this windfall profit/savings of 100 million, the bank might spend 40 million per year on IT services and hardware.  That leaves the bank 60 million ahead thanks to their IT department.

Every year, the bank evaluates the performance of their IT department and the profitability of their online banking services.  They might discover that they can spend 50 million on IT and make an extra 100 million dollars as a result.  Now the bank is 150 million ahead.
Now let us consider cyber fraud.  With no security, the online banking system could not function at all.  Crooks would steal all the money, duh.  Cyber-security is just as important to the operation of online banking as the computer systems that process all the financial transactions.  No security system is perfect however, and losses due to fraud will continue at some rate.  A bank might spend 10 million per year on cyber security and still lose 50 million per year on fraud.  That still leaves the bank 90 million ahead vs. if computers and the internet did not exist.

Are you following this?  

If not, here is a chart of what we have described so far:

Profitability from internet   +200 million
IT costs                                 -  50 million
Security costs                        - 10 million
Fraud costs                           -  50 million
Net profitability                      90 million

Now suppose that the bank spent 1 million more on IT security and only lost 30 million from fraud as a result.  The bank would do this because it leaves them 19 million better off at the end of the year, getting their total back up to 109 million per year.  This is their net benefit from Information Technology (IT / "the internet").

To summarize the free market approach:

Profitability from internet   +200 million
IT costs                                -  50 million
Security costs                       - 11 million
Fraud costs                          -  30 million
Net profitability                    109 million

Easy as pie, right?

The same bank might try to spend 2 million more the next year on security, and find that they are still losing 30 million to fraud.  That would leave them with a profitability of only 108 million now, so they decide it is best to stay at 11 million on security spending for now.

The point of this whole example is simple:  A bank plus computers and the internet is way more profitable than a bank without these.  Keep in mind that when all businesses in an industry profit more, as long as there is healthy competition, those profits eventually find their way back to you and I in the form of better services and lower costs.  Of course the numbers are relative to the size of the bank and other factors; so please think about the logic here rather than the actual numbers.
Now let us look at a regulatory approach.  We often focus on the negatives in a situation, like that 30 million those nasty thieves are stealing from the bank.  After all, those costs are being passed on to we customers in the form of higher fees and lower interest payouts.  We forget that we are still many times better off than before IT, even with the rampant robbery.  So, we decide that we need the government to lock down the internet, make it "secure", and catch all the bad guys.  It sounds like the fair and just thing to do, but it ends up making the world a worse place for all of us.  Here is how:

The government passes regulations that were lobbied by IT security firms and the law says that our bank must have top notch IT security spending of 15 million per year.  We already know that the bank has figured out that the extra spending won't benefit them much, so now their profitability is down to 105 million.  There's just an extra 4 million padding the pockets of the lobbyists and executives at the IT security firms now.
Also in the new regulations, the government is required to form an agency to enforce bank compliance, and that might cost another 5 million for that bank.  There goes another 5 million of profitability in the form of tax increases and so we are down to 100 million.   The train wreck of regulation does not end there.  The bank must form a department to ensure compliance and communicate proof of compliance to the government agency.  That might cost another 5 million annually, and so now our bank is down to 95 million in profitability.
Of course, the government will also form a task force to investigate and arrest the criminals.  that might reduce fraud costs (proportionately for the bank in our example) by 10 million per year, but cost we the people 20 million for the task force.  So, now we the people are out millions to subsidize the bank's security whether we bank there or not.  That's money out of our pockets directly, but let's just charge that cost against the bank's profitability for now.  The net effect here is a decrease of another 10 million in profitability.

Now we have to jail the criminals, another 5 million loss to we the people in the form of taxes, and we're down to 80 million.  And consider the losses of freedom of all internet users because of the extra security.  There's no way to begin to figure that out, but just say it's another 10 million and that leads us down to 70.

So, to summarize the regulatory course of action:

Profitability from internet              +200 million
IT costs                                           -  50 million
Security costs                                -   15 million
Fraud costs                                     -  20 million
Compliance costs                            -   5 million
Govt. enforcement (bank facing)    -   5 million
Govt. enforcement (people facing) - 20 million
Incarceration                                   -   5 million
Loss of opportunity on internet       - 10 million

Net profitability                                 70 million

Well that sucks, especially when you consider that some of the costs above come out of our pockets whether we us a bank or not.  We were better off letting the banks decide how much the crooks were costing them and subsequently how much they should spend to counteract the thievery.

Let's not forget where the butterfly effect comes in.  Consider the chance that we arrest a teenage prodigy who might have otherwise grown up and revolutionized security or the banking industry itself by developing Bitcoin II.  We might just accidentally prevent technology that was scalable, secure, and capable to handle worldwide transactions for free.  Please see that freedom can be invaluable and it might have tripled the profitability of the bank in our example to 600 million.  When we promote creativity and motivation, there will be benefits for all in the long run.  The alternative is to choose government regulation, security, justice, and mediocrity for all.

The information technology industry and the internet are shining examples of why freedom works best.  The growth, opportunity, job creation, and improvement to everyone's standard of living all occurred without government regulation.  People were free to be creative, productive, and to profit mightily for their efforts.  That environment proved that freedom generates more benefit for us all than does regulation.  The last great example before that was the rise of American prominence in the world.  We went from nothing to the greatest nation on earth because of a void in regulation and government intimidation, rather than because of it.  

We should focus on information rather than regulation.  When information becomes available that there is a better way of doing something, the people and businesses who adapt to the new information will succeed.  Regulations merely force everyone to follow a particular course of action whether it is the best action or not.  Regulations hinder progress; only freedom and creativity advance progress.  The only time regulations contribute to progress is when they drive people to be creative about how they get around the regulations.

Disclaimer:  The numbers above are completely fictional.  There is no way to project reality.  For example, there is no way for a bank to determine how much they would have made one year without the use of computers.  Suffice it to say, they would not have to because they would not be competitive enough to stay in business without computers.  While my numbers are fake, please agree: values and projections made by those who advocate more government regulation are equally fallible.  I'm merely offering a picture of the costs and benefits of two particular courses of action: freedom vs. regulation.

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