by
Michael J. McAteer
September 2008
UNIVERSITY OF PHOENIX
September 2008
ii
Focus of the quantitative correlational study was the relationship between occurrence of
management fraud in community banks in United States and financial ratios the Federal
Community Banks, and that financial statements using financial ratios provide a lens to
view the actions of management. Using logistical regression, three groups of financial
ratios (i.e., performance, growth, and capital) were tested in the model for a period of
three years prior to the occurrence of management fraud. The performance ratio logistical
regression model provided strong and consistent predictive results over multiple
management fraud into the Analytic Model of Management Fraud in Community Banks.
provide leaders and stakeholders a tool for the detection and prevention of management
fraud.
v
DEDICATION
ACKNOWLEDGMENTS
Verma, Dr. Toni Greif, and Dr. Steve Seteroff. At the first year residency, Dr. Seteroff
provided encouragement and insight that this was within my grasp. Dr. Toni Greif
the first big idea. Dr. Kewal Verma has been an anchor to keep me focused and on task
I would also like to acknowledge the Mindbenders, my first learning team, and all
the other members of the cohort. Your friendship made the journey worthwhile and most
pleasant.
v
TABLE OF CONTENTS
LIST OF TABLES....................................................................................................xi
Research Questions..................................................................................................13
Hypotheses............................................................................................................... 16
Conceptual Framework............................................................................................ 17
Definition of Terms..................................................................................................21
Assumptions.............................................................................................................28
Limitations ...............................................................................................................29
Delimitations............................................................................................................ 30
Summary .................................................................................................................. 30
Documentation.........................................................................................................32
Banking Failures............................................................................................... 50
Overview...........................................................................................................52
Conclusion ............................................................................................................... 63
Summary .................................................................................................................. 64
Research Design....................................................................................................... 66
Research Questions..................................................................................................75
Hypotheses............................................................................................................... 77
Population ................................................................................................................78
vii
Geographic Location................................................................................................81
Instrument Validity........................................................................................... 86
Objectivity................................................................................................................87
Reliability .........................................................................................................87
Internal Validity................................................................................................88
External Validity...............................................................................................88
Performance Ratios...........................................................................................89
Growth Ratios...................................................................................................90
Capital Ratios....................................................................................................91
Summary .................................................................................................................. 94
CHAPTER 4: RESULTS.........................................................................................96
Descriptive Statistics................................................................................................99
Findings..................................................................................................................103
Performance Ratios................................................................................................110
Conclusions............................................................................................................ 132
Limitations .............................................................................................................136
Implications............................................................................................................136
Recommendations..................................................................................................141
REFERENCES ......................................................................................................144
MODEL .................................................................................................................228
MODEL .................................................................................................................235
LIST OF TABLES
LIST OF FIGURES
to 2006. ...................................................................................................................... 6
CHAPTER 1: INTRODUCTION
stakeholders for the managers’ own purposes (Zahra, Priem, & Rasheed, 2005). Despite
efforts to improve corporate governance and align management and shareholder interests,
the incidence of management fraud has increased since the 1980s. The promulgation of
codes of conduct has not mitigated fraud increases. The study of management fraud
applies to many disciplines, yet the literature includes only a few empirical studies on its
In the regular course of business, leaders face ethical dilemmas that require the
use of moral values, judgments, codes of conduct, and fundamental concepts of right and
wrong (Kavali, Tzokas, & Saren, 1999). The ethical and legal consequences of business
leaders’ decisions can be far reaching. The ethical dilemmas of leaders have common
unethical, fraudulent, or criminal behavior, the effects are far reaching and damaging to
the business organization and the community. When managers of banks are involved in
(Samolyk, 2004). The banking system and its regulation are built upon a bond of trust
between the depositors and the bank. Federal regulators protect such trust by monitoring
the safety and soundness of the banking system (Federal Deposit Insurance Corporation
2
[FDIC], 2007c). Management fraud in a bank affects the viability of the bank as a
financial intermediary and an ongoing business. Management fraud in a bank breaks the
Community banks are small banks with less than $1 billion in assets that provide
a significant and disproportionate share of banking services to small businesses and rural
particularly damaging to the local community and the market segments it serves.
the trust between stakeholders in local economies and can enhance economic
development.
Management fraud has increased since the 1980s and has become a worldwide
problem (Zahra et al., 2005). Management fraud is a widely accepted topic for research in
many fields and disciplines. Despite evidence of the debilitating effects of management
fraud and the interest in the phenomenon, there have been few empirical studies on the
cause, detection, and prevention of management fraud. The purpose of the current study
was to examine with a quantitative correlational design the financial ratios federal
regulators use in monitoring banks for safety and soundness as a method of detecting
Chapter 1 begins with an introduction to the specific problem the research has
addressed, statements of purpose and significance of the study, and a overview of the
conceptual framework that represents the theoretical foundation of the research endeavor.
Sections subsequent to the introductory paragraphs include the research questions and
details of the nature of the study with an outline of the chosen methodology. The current
3
study findings add to the literature and body of knowledge with implications for
leadership. The focus of the quantitative correlational study was the examination of the
United States and financial ratios used by the FDIC to monitor the banks’ safety and
soundness.
and increasing problem (Zahra et al., 2005). Most of the literature concerning
management fraud covers multiple areas that include (a) issues of ethical behavior
(Anand, Ashforth, & Joshi, 2004; Cullen, Parboteeah, & Hoegl, 2004; Ludwig &
(Beasley, Carcello, Hermanson, & Lapides, 2000; Crutchley, Jensen, & Marshall, 2007;
Griffith, Fogelberg, & Weeks, 2002), and (c) the use of auditing controls in stopping
the issuing of misleading financial statements (Elliot & Willingham, 1980). Management
consists of the individuals who control or are beyond the control of internal safeguards
within organizations.
organization ultimately control the mechanisms used to ensure compliance and safeguard
the organization. Managers can override internal controls that block their personal
objectives. In the case of the Enron fraud, the company board of directors voted twice to
override its own code of ethics in order to setup the financial partnerships that were the
4
fraudulent vehicle in their collapse (Tipgos, 2002). The changing business environment
presents new challenges associated with management behavior. New methods and
The banking industry has traditionally occupied a unique position within the
economy of the United States because of the special economic role banks perform in
2004). Bank regulators such as the FDIC, the Office of the Comptroller of the Currency
(OCC), the Board of Governors of the Federal Reserve (FRS), and the Office of Thrift
Supervision (OTS) monitor the banking industry to ensure its continuing financial
viability (FDIC, 2006). The special economic role that banks perform brings together the
interests of stakeholders that include the public, depositors, and government regulators
(Simpson & Gleason, 1999). The occurrence of management fraud at community banks
An analysis of failed national banks under the regulatory oversight of the OCC
(1988) indicated that 90% of bank failures resulted from poor management and that
almost one third of the 90% included fraud by the bank’s management. Researchers for
the U.S. General Accounting Office [USGAO] (1994) studied 286 banks that failed in
1990 and 1991 and reported insider abuse, insider fraud, or loan losses to insiders in 61%
of the failed banks. A study by the FDIC (1997) of banks during the years 1980 to 1994
indicated a large percentage of bank failures where incidents of management fraud and
that management fraud was a significant contributing factor to the banks’ failure.
5
Community banks have less than $1 billion in assets and represent 94% of all
institutions within the banking industry (Critchfield et al., 2004). In the years 1998 to
During the same years, community banks represented 63% of failed bank deposits
Federal regulators have produced onsite and offsite monitoring systems to identify
and monitor banks whose safety and soundness might be in question (Curry, O’Keefe,
quarterly basis, using offsite reviews of mandated financial statements. Part of the review
includes an analysis of financial ratios from the banks’ financial statement. The analysis
includes over 30 financial ratios such as performance, growth, and capital ratios to
The FDIC Improvement Act of 1991 (FDICIA) required the FDIC to act quickly and
infuse new or additional capital into financially distressed banks. The FDIC often infuses
new or additional capital into financially distressed banks by merging the distressed bank
with a healthier institution (Elsas, 2007). Since the time of the OCC, USGAO, and FDIC
studies, the number of bank failures has decreased, but the incidence of management
fraud, as defined in the current study, has increased since 2002 (FDIC, 2007a). Earlier
researchers have suggested a relationship between management fraud and failure (FDIC,
1997), but the results of studies attempting to predict the onset and mitigate the
current study and bank failure. The historical relationship between management fraud and
bank failure suggested in previous studies (OCC, 1988) appears to be taking opposite
prohibition fell from over 70 in 1996 to 13 in 2001. During the same period, there were
six bank failures in 1996 and four in 2001, averaging 4.8 failures per year. The number of
termination or prohibition enforcement orders has increased since 2001 while the number
of bank failures has decreased (FDIC, 2007b). Since 2001, the number of enforcement
orders has risen from 13 in 2001 to 90 in 2006. During the same period, the number of
bank failures has decreased from 11 in 2002 to none in 2005 and 2006.
100
90
80
Number of Institutions
70
60
Failures
50
Prohibition/terminations
40
30
20
10
0
06
03
04
05
96
97
98
99
00
01
02
20
20
20
20
19
19
19
19
20
20
20
Year
Figure 1. Comparison of failure and prohibition enforcement actions from 1996 to 2006.
Adapted from FDIC Enforcement Decisions and Orders by FDIC (2007b). Retrieved March 17,
Billions of dollars are lost each year from the failure of all types of organizations,
Sukhtankar, 2002). Failures in the banking industry have similar consequences (FDIC,
1997). In many cases, management has concealed the true condition of the organization
in failure. Since 2002, the number of bank failures has decreased, but the incidence of
management fraud as defined in the current study has increased (FDIC, 2007b). A FDIC
(1997) study of banks during the years 1980 to 1994 indicated that a large percentage of
bank failures had incidents of management fraud. Management fraud was a significant
The banking industry has traditionally occupied a unique position within the
economy because of its special role in facilitating payments and channeling credit to
threatens the viability of the institution and causes disruption to the bank’s role as
financial intermediary. Management fraud at a community bank creates distrust with the
community of bank stakeholders and causes significant damage to the local community
design, the current study produced findings regarding the predictive value of financial
ratios the FDIC uses in monitoring banks as a method of detecting management fraud.
8
United States and financial ratios the FDIC uses to monitor the banks’ safety and
soundness. Earlier studies by the OCC (1988), USGAO (1994), and the FDIC (1997)
indicated there might be a link between the occurrence of management fraud and
financial failure. The dependent variable in the study was the occurrence of management
fraud. Performance, growth, and capital ratios were the three groups of financial ratios
that represented the independent variables. The FDIC has used performance, growth, and
capital ratios as determinants of a community bank’s financial condition during the years
1996 to 2003. The examination of these groups of financial ratios facilitated drawing
inferences regarding the ratios’ ability to predict the dependent variable, occurrence of
management fraud.
The control variables for the study were asset size, location, and the time of the
conditions as influencing the occurrence of financial failure. By matching the control and
experimental groups within the study by size and location during the same period, the
Studies of bank failures have indicated a significant portion of failed banks have
high incidents of management fraud (FDIC, 1997; OCC, 1988; USGAO, 1994). Small
banks with assets under $1 billion, also known as community banks, provide services to
9
small businesses and the agricultural industry. Community banks are increasingly
important to both market segments (Critchfield et al., 2004; Samolyk, 2004). The
Financial failures cause the loss of billions of dollars each year and the economic
dislocations of thousands of workers (Graham et al., 2002). Central banks around the
world recognize that bank failures exacerbate cyclical economic downturns and can
aggravate a financial crisis (BCBS, 2004). Banks are primary channels of credit, and their
failure can have widespread economic impacts. While not all bank failures are caused by
fraud, the root cause of many collapses has been the fraudulent conduct of senior
Managers and business leaders are as ethical and hardworking as any other
segment of the workforce but are also a product of the workplace environment
(Sutherland, 1973; Trevino & Brown, 2004). Managers and leaders recognize that the
underpinning of leadership is trust (Reina & Reina, 2006). The misbehavior of managers
and leaders within an organization undermines the trust that supports leadership and
and the agricultural industry. Such services are based on relationships with the customers,
creating trust amongst customer stakeholders (Critchfield et al., 2004). The importance of
community bank lending to the economic sectors small businesses and the agricultural
of the local economy, and their performance is a local economic catalyst (Critchfield et
al., 2004).
transformational leadership. While research about leaders and their qualities is abundant,
(Feeley, 2006). The definition of management fraud used in the current study was a FDIC
individual employed by the bank, declaring the individual to have engaged in personal
dishonesty against the bank (FDIC, 2005b). Management fraud in a bank affects the
viability of the bank as a financial intermediary and an ongoing business (BCBS, 2004).
Management fraud in a bank is an attack on the trust developed with bank stakeholders
building trust with a community of stakeholders (Burns, 1978). The pursuit of higher
(Burns, 1978). Transformational leaders are concerned with end values, “Leaders ‘raise’
their followers up through levels of morality” (Burns, 1978, p. 426). The focus of the
current study was the dysfunction that management fraud brings to community banks and
and quantitative components. The basis for choosing a research approach should be
matching the research approach to the research problem (Karami, Rowley, & Analoui,
11
2006). The quantitative approach to the current study was appropriate because the
variables” (Creswell, 2003, p. 50). The purpose of the quantitative correlational study
community banks in the United States and the financial ratios the FDIC uses to monitor
Quantitative research problems involve showing the influence that one or several
sets of variables have on other variables. The following four criteria determine the
possible, (b) assessing the impact of the variables is possible, (c) the results can be used
to test theories or provide broad explanations, and (d) the results can apply to a large set
of people (Creswell, 2003). In the current study, the independent variables were
condition. The dependent variable was the occurrence of management fraud in United
States community banks. The goal of the research was to determine the ability of the
association between the variables (Creswell, 2003). Correlation research designs are
appropriate where the study attempts “to explain an association between two or more
the current study was the relationship between the occurrence of management fraud and
the financial condition of a community bank in the United States as measured by the
management fraud at community banks led to the creation of an experimental group and a
control group. In the matched pairs design, each member of the control group is matched
Earlier researchers of management fraud have used a matched pairs design in testing
fraud and the effects of boards of director composition, accounting procedures, and senior
management demographics (Beasley et al., 2000; Crutchley et al., 2007; Saksena, 2001;
The matched pairs design allows for the accounting of extraneous factors that
might influence the dependent variable (Eachus, 2006). In the current study, the matching
process allowed the control of local and macroeconomic conditions that can affect a
bank’s overall financial condition (Altman, 1983; BCBS, 2004; Cebula, 1999). The
matching factors were asset size, location, and year of occurrence of management fraud.
The matched pairs design ensured that the matched community banks had similar
operating conditions.
The population of the study was community banks in the United States.
Community banks are institutions that take deposits and focus on lending to a specific
local economy (Anonymous, 2003; Hein, Koch, & MacDonald, 2005). Community banks
tend to be small in terms of asset structure. A total asset base of $1 billion or less is a
13
common level of differentiation. For the current study, the definition of a community
bank was any bank monitored by the FDIC with assets below $1 billion.
basis for transparency and trust between management of an organization and stakeholders
within the financial reporting structures (O’Gara, 2004). Ratio analysis of financial
In the case of community banks in the United States, the primary regulator is the
FDIC (2007a). The FDIC administers depository insurance for member banks to support
confidence and trust in the banking system of the United States. The FDIC monitors its
member banks for safety and soundness and for risks affecting operations and the impact
of an institution’s failure on the banking system (FDIC). The current study was an
community banks in the United States and the financial ratios the FDIC uses to monitor
Research Questions
the study (Creswell, 2003). Research questions synthesize the purpose of the study in
order to focus and craft the relationship to be studied (Cone & Foster, 2003). The
following research question guided the current study: “How does the financial condition
14
of a community bank, as measured by financial ratios used by the FDIC, relate to the
Banks in the United States operate within a highly regulated environment. The
FDIC, as primary regulator of community banks in the U.S., is charged with monitoring
and maintaining the safety and soundness of community banks (FDIC, 2007a). Previous
(Johnson & Rudesill, 2001; Lemke & Schminke, 1991). Financial ratios can be predictive
of future financial condition of an organization and federal regulators use financial ratios
in the monitoring process (Altman, 1983; King, Nuxoll, & Yeager, 2005).
Performance ratios are one type of financial ratios used to measure the relative
equity, return on assets, net interest margin) are indicators of the relative financial
models of organizational failure and decline in banks (Dabos & Escudero, 2004). The
FDIC has used the 20 performance ratios listed in Table 1 as indicators of the financial
condition of a community bank. The ratios became independent variables in the current
study.
management fraud. A rapidly expanding small business has an increasing risk factor of
fraud, including management fraud (Johnson & Rudesill, 2001). In 1988, the OCC found
overly aggressive growth before a bank’s failure in 42% of the cases examined.
15
Growth ratios are a type of financial ratio the FDIC and other regulators use to
monitor the safety and soundness of banks (King et al., 2005). Four different growth
ratios used by the FDIC as indicators of the financial condition of a community bank are
assets per employee, equity capital to assets, loans and leases plus long-term securities to
assets, and volatile liabilities to assets. Capital ratios are a class of financial ratios used in
Table 1
Performance Ratios
Performance Ratios
Estrella, Park, and Peristiani (2000) noted that capital ratios were predictors of
bank failure. Regulators use different types of capital ratios to manage the risk-taking
behavior of bank managers. Capital ratios have shown a propensity to predict failures at
differing time intervals. Among capital ratios used by the FDIC as indicators of the
16
financial condition of a community bank, the capital ratios of (a) equity capital to assets,
(b) core capital (leverage) ratio, (c) tier 1 risk-based capital ratio, and (d) total risk-based
Hypotheses
(Creswell, 2003). The study hypotheses incorporated financial ratios used by the FDIC as
ratios (i.e., performance ratios, growth ratios, and capital ratios) became sets of
performance for conditions that affect the solvency of the bank. The inclusion of FDIC
performance ratios in the study led to the formulation of the following hypothesis to be
banks:
H10: Community banks with poor performance ratios do not incur an increased
Johnson and Rudesill (2001) and the OCC (1988) suggested that rapidly growing
banks created conditions conducive to the occurrence of management fraud. The FDIC
uses growth ratios to monitor conditions that can affect a community bank’s financial
condition. The inclusion of FDIC growth ratios in the study led to the formulation of the
17
H20: Community banks with high growth ratios do not incur an increased
H21: Community banks with high growth ratios have an increased occurrence of
Estrella et al. (2000) and the OCC (1988) suggested that poor capitalization of
banks created conditions conducive to financial failure. The FDIC uses capital ratios to
gauge the safety and soundness of banks under its regulatory review. The inclusion of
FDIC capital ratios in the study led to the formulation of the following hypothesis to be
tested in order to establish the likelihood of management fraud occurring at a bank with
H30: Community banks with low capital ratios do not incur an increased
H31: Community banks with poor capital ratios have an increased occurrence of
Conceptual Framework
Improper, illegal, and fraudulent behaviors on the part of managers and leaders
disciplines has generated different perspectives and labels (Zahra et al., 2005). Corporate
crime, corporate wrongdoing, and management fraud are some of the labels used to
18
define illegal behavior in different fields of study. The definition of each label is subject
behavior (Saunders, 1980) and usually requires a deliberate act of financial manipulation
The fraudulent act can be the direct manipulation of the accounting records such as
inflating sales or concealing the fraudulent act by false accounting entries as in the theft
of assets (Elliot & Willingham, 1980). The financial reporting system provides
criminal manners. Sutherland (1973) first coined the phrase white-collar crime in the
1940s. The differentiation the term white-collar crime implies is not in the nature of the
crime but in a demographic of the criminal. Sutherland believed the same basic variables
that prompted ordinary criminal behavior also prompted white-collar crime and defined
acceptable without the balancing influences of legal or good behavior. In one of the
fraud contained the three elements of (a) an unsharable financial problem, (b) the
accessibility and control of assets or accounting records, and (c) the ability to rationalize
19
the actions the fraudster takes. Cressey’s contention was that viewing management fraud
purely from the perspective of control and regulation was incorrect and that research of
The focus of management behavior studies has been the relationship between
owners and employee managers. Agency theorists posited that, when the goals of
occurred (Jensen, 2004). Meckling and Jensen (1976) first described agency theory as the
Managers have their own interests that can conflict with those of shareholders and
stakeholders. The management of conflicting interests generates costs that include the
cost of oversight, compliance, and enforcement and are referred to as agency costs
interests with those of shareholders. The misalignment of goals and interests in terms of
misuse, abuse, and diversion of resources and assets because of conflicting interests are
agency costs. Management fraud is an agency cost because of the inherent abuse of
position and authority of managers as evidenced by the fraudulent behavior with agency
costs at its roots that caused the failure of firms such as WorldCom and Enron (Jensen,
2004).
misleading financial statements” (p. 4). Within Elliot and Willingham’s definition, a
manager is a person who controls or is beyond the control of internal safeguards within
20
an organization. Cressey (1971) and Elliot and Willingham identified accounting records
organization controls the procedures and processes of the organization, including the
accountants and auditors to use red flags as indicators of possible fraud within a
company. According to the AICPA, the use of financial ratios as an analytical tool to
assist auditors in the detection of financial reporting fraud can produce red flag indicators
because accountants and auditors interpret the context of red flags differently. Many
accountants do not appreciate the effectiveness of red flags as a predictive tool because of
The analysis of financial ratios allows the analyst to compare a relative change in
an organization over time against (a) other organizations, (b) an industry, or (c) preset
identify underlying factors affecting the organization (Palepu, Healy, & Bernard, 2003).
Financial ratios have produced accurate results in predicting financial decline (Altman,
1983). Financial ratios form the basis of the modern predictive models used in credit
decision making. The FDIC uses financial ratios as part of their responsibilities in the
surveillance and monitoring activities of banks to ensure the banks’ safety and soundness
institutions are subject to increased regulatory scrutiny. The mission of the FDIC is to
21
soundness of the banking system. The FDIC attempts to detect unsafe and unsound
financial data. The purpose of enforcement actions the FDIC takes after examinations and
reviews of financial data is to modify or change practices deemed unsafe (Curry et al.,
1999).
Findings from studies of banks and nonbanking organizations have shown that
ownership and agency theory increase the risk-taking behavior of managers (Barnes,
2004; Demsetz, Saidenberg, & Strahan, 1997; Lee, 2002). Excessive risk taking is
associated with failure and unethical behavior (Lemke & Schminke, 1991). The premise
of the current study was that the financial ratios used by the FDIC in monitoring the
Definition of Terms
Assets per employee (ASTEMPM). Assets per employee are the ratio of total
assets to employees, a growth and performance ratio. Total assets are in the millions of
dollars, and the employee count is the number of full-time employees (FDIC, 2005a).
Average assets (ASSET5). Average assets are a control variable used in the
matching process in the current study. Average assets mean the average assets held by the
Average earning assets (ERNAST5). The phrase is commonly used and means the
average loans, leases, and investments that are earning interest, payments, or dividends
and are held by the bank during the reporting period (FDIC, 2005a).
Cash dividends to net income (IDDIVNIR). Cash dividends to net income are
annual cash dividends declared divided by net income, a performance ratio (FDIC,
2005a).
Community banks. Community banks are institutions that take deposits with a
focus on lending to a specific local economy (Anonymous, 2003; Hein et al., 2005).
Because of the limitation of local economies, community banks tend to be small in terms
differentiation. While many researchers use a threshold limit as a defining factor, the
scale of operations conducted by the bank also influences the definition of a community
bank (DeYoung, Hunter, & Udell, 2004). In 1999, the Federal Reserve developed a basic
framework for monitoring all complex banking organizations over $1 billion in assets
(DeFerrari & Palmer, 2001). The FDIC monitors most banks that do not fall within the
2003). For the current study, the definition of a community bank was any bank monitored
Core capital (leverage) ratio (RBC1AAJ). Core capital (leverage) ratio is core
(Tier 1) capital divided by average assets less ineligible intangible assets, a capital ratio.
Within the definition, core or tier 1 capital is common equity, preferred perpetual non-
2005a).
annualized total interest expense on deposits and borrowed funds divided by the average
Credit loss provision to net charge-offs (ELNANTR). Credit loss provision to net
charge-offs is the credit loss provisions divided by net charge-offs, a performance ratio
(FDIC, 2005a).
amortized intangible asset expenses divided by net interest income and non-interest
Equity capital to assets (EQV). Equity capital to assets is the total equity capital
Financial ratios. The financial ratios used in the current study were financial
ratios calculated by the FDIC or used by the FDIC. The ratios belong to the three groups
of performance, growth, and capital ratios. Performance ratios are 20 ratios consistently
calculated by the FDIC during the period 1992 through 2006. Growth ratios are four
ratios calculated from FDIC data collected during the period 1992 through 2006. The
growth ratios used in the study are from the FDIC Growth Monitoring System [GMS].
Capital ratios are four ratios consistently calculated by the FDIC during the period 1992
through 2006. Two of the ratios are used in multiple categories. The equity capital to
assets (EQV) ratio is used in both the capitalization and performance groups. The assets
per employee (ASTEMPM) ratio is used in the performance and growth groups.
24
Growth ratio 1 (ROLLPS5TA). Growth ratio 1 is loans and leases plus securities
with a maturity of greater than 5 years divided by total assets, a growth ratio (Sahajwala
divided by total assets, a growth ratio (Sahajwala & Van den Bergh, 2000). Volatile
foreign offices, federal funds purchased and repurchased, demand notes to the U.S.
non-current loans is the allowance for loan and leases divided by non-current loans and
for loan and lease losses divided by total loan and leases less unearned income, a
different studies (Zahra et al., 2005). The breadth of usage of the phrase management
fraud can make the collection of consistent data on occurrence problematic. Since
management fraud in many instances is a criminal activity, earlier researchers have used
al., 2000; Cressey, 1971; Saksena, 2001; Williams et al., 2000). The definition of
bank, declaring the individual to have engaged in personal dishonesty against the bank
(FDIC, 2005b).
Net charge-offs to loans (NTLNLSR). Net charge-offs to loans is loans and leases
less recoveries divided by average total loans and leases loans, a performance ratio
(FDIC, 2005a).
Noncurrent assets plus other real estate owned to assets (NPERFV). Noncurrent
assets plus other real estate owned to assets is noncurrent assets divided by total assets, a
performance ratio. Included in the definition of noncurrent assets are nonaccrual assets,
assets 90 days past due, and real estate owned (OREO) (FDIC, 2005a).
loans and leases divided by total loans and leases, a performance ratio. Included in the
definition are noncurrent loans and leases are nonaccrual loans and loans and leases 90
asset is expenses other than from interest bearing assets divided by average earning
assets is income other than from interest bearing assets divided by average earning assets,
Net interest margin (NIMY). Net interest margin is the total interest income less
total interest expense divided by average earning assets, a performance ratio (FDIC,
2005a).
26
Net loans and leases to core deposits (IDLNCORR). Net loans and leases to core
deposits is total loans and leases less unearned income, allowances for loan and lease
losses, and provisions for loan and lease loss divided by core deposits, a performance
ratio. Included in the definition of core deposits are domestic deposits less than $100,000
Net loans and leases to deposit (INLSDEPR). Net loans and leases to deposit is
total loans and leases less unearned income, allowances for loan and lease losses, and
provisions for loan and lease loss divided by total deposits, a performance ratio (FDIC,
2005a).
Net operating income to assets (NOIJY). Net operating income to assets is net
equity mean net income less cash dividends divided by average equity, a performance
Return on asset (ROA). Return on asset is net income after taxes and
Return on equity (ROE). Return on equity is net income after taxes and
Tier 1 risk-based capital ratio (RBC1RWAJ). Tier 1 risk-based capital ratio is Tier
1 (core) capital divided by the risk-weighted assets. Within this definition, the appropriate
regulator that is subject to market conditions defines risk-weighted assets a capital ratio
(FDIC, 2005a).
27
Total risk-based capital ratio (RBCRWAJ). Total risk-based capital ratio is total
risk-based capital divided by the risk-weighted assets, a capital ratio. Within this
definition, the appropriate regulator that is subject to market conditions defines risk-
Yield on earning assets (INTINCY). Yield on earning assets is the annualized total
interest income divided by the average earning assets of the bank, a performance ratio
(FDIC, 2005a).
variable (Hair, Black, Babin, Anderson, & Tatham, 2006). Logistic regression analysis
has unique terms that will be used in subsequent chapters and are defined as follows:
model estimation fit and is measured as -2 times the log likelihood (-2LL) (Hair et al.,
2006). The log likelihood ratio test is a test of model fitness. The test measures the level
of difference between the -2LL for the study model and the -2LL for a reduced model
(Garson, 2006).
Log likelihood (LL). The log likelihood in logistical regression is the probability
of the value of dependent variable that is predictable from the value of an independent
coefficients of the independent variables are estimated using an iterate algorithm. Instead
to maximize the likelihood of an event occurring (Hair et al., 2006). The MLE maximizes
the log likelihood (LL), which is the likelihood that the dependent variable may be
Assumptions
Several assumptions applied to the current study. It was assumed that the financial
data collected by the FDIC and the individual community banks’ independent auditors
were accurate and a true reflection of the financial condition of the banks. It was assumed
order issued by the FDIC was true and factual. While the FDIC makes efforts to ensure
accuracy of the data it collects, the agency issues a disclaimer that it cannot guarantee the
Matching banks by geography, size, and time assumes that they operate in similar
employ differing operating strategies and serve nonlocal customers. Such a situation
would negate the control variables and the attempt to match economic operating
Logistical regression analysis assumes all relevant variables are included in the
model and all irrelevant variables are excluded of the model (Garson, 2006). Error terms,
29
(i.e., false positive and false negative results) were assumed independent. Cases that were
A linear relationship was assumed between the independent variable and the log
odds of the dependent variable. The log odds were defined as the natural log of the odds
of the dependent variable occurring (Garson, 2006). Logistical regression assumes that
assumes no outliers are in the data and that the expected dispersion of the variance of the
Limitations
All studies have limitations or weaknesses that affect the degree of generalization
behavior is that only discovered frauds can be the subject of research. When selecting a
matching no fraud bank, the selection can include a bank where a fraud has occurred that
was not discovered. The selection of a matching community bank for the study involved
scrutiny of the matching bank for 3 years subsequent to the matching date to determine
A second limitation was that the study population did not include all community
banks but only banks insured by the FDIC. Credit Unions, not insured by the FDIC,
provide many of the same services to a local community as community banks insured by
the FDIC. Institutions such as mortgage bankers and finance companies also provide a
limited number of services that FDIC-insured community banks provide and were not
included in the study. No claim is made about the generalization of the results to banking
likelihood estimate (MLE) decreases as the sample size decreases, and the reliability of
the MLE increases as the sample size increases. The convergence process of the MLE is
dependent on an adequate sample size (Garson, 2006). The adequacy of the sample can
Delimitations
Only community banks insured and regulated by the FDIC participated in the
study. The focus was limited to three groups of financial ratios (i.e., performance,
growth, and capital) as indicators used by the FDIC in assessing the financial condition of
community banks. Data collected by the FDIC provided the ratios. Only a limited form of
fraudulent behavior as detected by the FDIC was the selection criterion for the fraud
participants. The fraud participants were matched to no fraud participants of similar asset
Summary
The purpose of the quantitative correlation study was to examine the relationship
between the occurrence of management fraud in community banks in the United States
and financial ratios the FDIC uses to monitor the banks’ safety and soundness. Earlier
research by the OCC (1988), USGAO (1994), and the FDIC (1997) indicated a potential
link between the occurrence of management fraud and financial failure. When managers
and leaders defraud stakeholders who trust them with managing and leading an
organization, the potential damage is grave. Management fraud in a bank undermines the
provide banking services to small businesses as well as rural and agricultural economies
(Critchfield et al., 2004). The FDIC administers the depository insurance fund
guaranteeing the public’s deposits with insured banks and acts as the regulator for the
safety and soundness of most community banks (FDIC, 2005b). The FDIC collects
financial statement data, including financial ratios, and monitors community banks to
detect distress and possible failure. Financial ratios created from financial statements are
organizations (Altman, 1983; FDIC, 2007a). The current study was the examination of
financial ratios used by the FDIC as indicators of the financial condition of a community
bank and the potential relationship of financial ratios to the occurrence of management
fraud.
of management fraud, its causes, detection, and prevention. A discussion of the predictive
attributes of financial ratios and the banking industry follows the sections on management
fraud. The review follows an organizational pattern with sections on (a) management
leadership address various aspects of management fraud. Few researchers have directly
studied the underlying causes of fraudulent acts by management (Smith et al., 2006).
misstating the assets or obligations of an organization (Elliot & Willingham, 1980). The
organization. The focus of the study was community banks, specific financial ratios used
by the FDIC as indicators of the financial condition of community banks, and the
Documentation
The study of improper, illegal, and fraudulent behavior on the part of managers,
leaders, and organizations has produced a variety of perspectives because of its relevance
sociology, ethics, economics, and law (Zahra et al., 2005). The topics of organizational
decline and the world of financial institutions are as interdisciplinary as the topic of fraud
by leadership. Management fraud, organizational decline, and banking have rarely been
studied together, requiring a review of far more literature than is incorporated in the
current study.
study includes 95 of the 100s of journal articles, dissertations, Web sites, books, and
reports reviewed. Eighty-four sources are incorporated into the literature review, and 10
33
of the 84 are related to research methods, designs, and analytical techniques. The
literature review consists of three theoretical concepts and search topics that are (a)
management fraud, (b) organizational decline, and (c) banking. Journal articles constitute
the largest segment of the literature with 30 articles on management fraud, 7 articles on
Table 2
Management fraud 30 1 2 11
Organizational decline 7 0 0 1
Banking 19 0 9 4
a multitude of constructs and definitions (Griffin & Lopez, 2005). Management fraud has
represented a small portion of research that is fragmented into the issues of corporate
governance, accounting and auditing, and criminology. The two germinal works of
Sutherland (1973) and Cressey (1971) have formed the foundations of thought in the
study of management fraud, but Smith et al. (2006) noted there have been few empirical
studies in the area of management fraud. The corporate governance literature focused on
management fraud (Schnatterly, 2003) produced conflicting results (Beasley et al., 2000;
The current study was an examination of financial ratios used by the FDIC as
predictors of occurrence of management fraud, the dependent variable in the study. The
34
AICPA (2005) recommended that auditors use analytical procedures such as financial
ratios to detect fraud. While auditors have and continue to follow the recommendation,
there is little empirical evidence that financial ratios can detect fraud (Kaminski et al.,
2004).
are far fewer studies in the banking industry (Griffith et al., 2002). The primary studies
concerning bank failures by the OCC (1988), USGAO (1994), and FDIC (1997) have
indicated a potential link between management fraud and failure. The U.S. banking crisis
in the 1980s and 1990s instigated research, and federal agencies conducted the studies.
An extensive search of all regulatory Internet sites, journals, and working papers for
recent scholarly works on bank failures or management fraud took place, and documents
Historical Overview
committing management fraud. Enron, WorldCom, Tyco, Adelphia, Cendent, Rite Aid,
Sunbeam, Waste Management, Health South, Anderson, Ernst & Young, KPMG
Lynch, Morgan Stanley, Bear Sterns, Salomon Smith Barney, Parmalat, Global Crossing,
and Credit Suisse First Boston have all been fined, implicated in, or convicted of criminal
behavior, or they have admitted guilt to unethical practices (Anand et al., 2004; Duska,
2004; Ivancevich, Duening, Gilbert, & Konopaske, 2003). The list is a current list of
companies with management misbehavior that the news media has reported. Each year,
Along with boards of directors, managers are responsible for fraud prevention and
detection and for promoting honest and ethical behavior in U.S. organizations (AICPA,
2005). Some types of fraud, particularly financial reporting fraud, start with executives
such as the chief executive officer (CEO) or the chief financial officer (CFO) (COSO,
1987). While the majority of financial and business people are as ethical and industrious
as in any other segment of the workforce, society faces the tragic occurrences of leaders
and managers committing unethical or possibly criminal acts. The recognition, detection,
and elimination of such behavior are essential because management fraud seriously
The banking industry has traditionally occupied a unique position within the
economy of the country because of the special role it plays in facilitating payments and
channeling credit to individuals and businesses (Samolyk, 2004), making poor financial
condition in the banking industry a major issue for owners, the public, and management
(Simpson & Gleason, 1999). The ultimate result of continued poor financial condition by
organization. Several studies of the banking crisis in the 1980s and 1990s have indicated
a relationship between fraud by insiders and financial failure of a bank (FDIC, 1997;
The banking crisis of the late 1980s and early 1990s illustrated the convergence of
management fraud (FDIC, 1997; OCC, 1988; USGAO, 1994). Historically, the topics of
within the theoretical frameworks of the appropriate disciplines. Multiple definitions for
36
the same terms within research of multidisciplinary topics makes direct comparison to
Sutherland first coined the phrase white-collar crime in the 1940s. White-collar
crime is a term that changes common and legal definitions by identifying a specific class
differentiate the term white-collar crime from other types. The position white-collar
criminals hold, not the act itself, defines the term (Sutherland, 1973). Sutherland believed
the same basic variables that prompted ordinary criminal behavior prompted white-collar
crime. According to diffusion theory (Sutherland, 1973), individuals who support or are
exposed to criminal activity and are not exposed to counterinfluences accept criminal
behavior.
133 convicted embezzlers who held management positions at the time they committed the
criminal acts. From the interview data, Cressey hypothesized that management fraud
occurred because of the presence of the following three elements: (a) an unsharable
financial problem, (b) the accessibility and control of assets or accounting records, and
(c) the ability to rationalize the actions the fraudster takes. Cressey’s contention was that
viewing management fraud purely from a point of control and regulation was incorrect
and that the study of management fraud needed a behavioral context (Cressey, 1971).
and many predictive models have been developed (Altman, 1983). According to Altman,
there can be many causes for financial distress, including microeconomic and
37
macroeconomic factors. Analysis of such factors can provide insight into the types and
The OCC (1988) conducted an analysis of failed national banks under its
regulatory oversight following the banking crisis of the 1980s. The OCC findings
revealed that 90% of bank failures resulted from poor management and almost one third
included fraud by the bank’s management. A study by the USGAO (1994) of 286 banks
that failed in 1990 and 1991 found insider abuse, insider fraud, or loan losses to insiders
in 61% of the failed banks. A study by the FDIC (1997) of banking institutions subject to
the FDIC supervision during the years 1980 to 1994 found management fraud was a
institutions.
Community banks are banks with less than $1 billion in assets and account for
94% of the number of institutions within the banking industry (Critchfield et al., 2004).
losses to the FDIC. During that time, community banks represented 63% of failed bank
deposits insured by the FDIC and 72% of the failure costs. The higher costs of the impact
of bank failure for community banks and the implied relationship between bank failure
Management Fraud
misleading financial statements” (p. 4). A manager is a person who controls or is beyond
occur within the business environment, business crime, misleading financial statements,
Business crime is all illegal business activity, internal and external to the
organization. Misleading financial statements are the conventions, intentional acts, and
activity refers to the actions managers take in the course of business. Elliot and
Willingham (1980) noted these activities combined to increase the risk severity to the
Corporate fraud is a view of fraud from the perspective of the object of the fraud
(O’Gara, 2004). In that context, it can be either for the organization (i.e., inflating sales)
or against the organization (i.e., hiding or diverting assets). Since all fraud by
financial reporting structures, O’Gara defined corporate fraud as the abuse for personal
The term occupational fraud refers to “the use of one’s occupation for personal
2004, p. 1). Within the ACFE definition is a subset of occupational fraud that includes
owners and executives. ACFE stated in their biannual report on occupational fraud that
owners and executives represented only 12.4% of all reported cases of occupational fraud
but with a median loss 14 times larger than losses from nonexecutives.
39
detect and prevent management fraud, the ACFE 2004 Report to the Nation on
Occupational Fraud showed only 6% of all cases of occupational fraud by owners and
those not involved with internal controls uncovered the majority of cases (51%).
Accountants and auditors view management fraud through the lens of their
from the organizations books and records. The AICPA (2005) provides guidance to
accountants and auditors regarding their duties in the detection and prevention of
Accounting Standards [SAS] 99 revised the standards and methods that auditors used to
provide management fraud detection to clients. The changes in SAS 99 required auditors
change was a departure from previous standards that focused on the detection of
that white-collar crime was a learned behavior from those who promoted it in the absence
of those who rejected it. Baker and Faulkner (2003) used the term intermediate fraud to
describe organizations created for a legitimate purpose that began, at some stage, to
engage in illegal activities. Using a case study of an oil and gas venture that began as a
40
legitimate business venture before adopting fraudulent behavior, Baker and Faulkner
enterprise. Baker and Faulkner concluded the factors that contributed to the success of the
fraudulent act can be direct manipulation of the accounting records or concealing by false
effective management behavior” (p. 108). The financial incentive compensation system
rewards those who aggressively exploit profitable opportunities (Jensen, 2004). The
system has, at times, the effect of encouraging managers to cross the line between ethical
Cressey’s (1971) original work in analyzing managers who embezzled from the
organizations that employed them found management fraud to include three elements: (a)
an unsharable problem, (b) accessibility and control of assets or accounting records, and
(c) the ability to rationalize the actions they took. Cressey described a triangular
2004). Opportunity refers to the ability to bypass or override controls meant to prevent
manipulation. Pressure is the motivation to commit the fraudulent act, and rationalization
refers to the moral and ethical argument used to justify the act (Wilson, 2004).
41
management fraud, other factors are present in many situations in which managers
they termed the Bathsheba syndrome. Managers and leaders who are increasingly
successful often acquire unrestrictive control over the organization and its resources.
The Bathsheba syndrome is described in the Book of Samuel in the Bible in which the
story of David and Bathsheba is an example of the corrupting influences of power and the
willful abuse of authority. As a successful leader and warrior, David is granted increasing
authority over the people of Israel. David abuses his authority in seducing Bathsheba and
his attempts to cover-up this indiscretion leads to the death of Bathsheba’s husband.
Ultimately, David’s abuses are discovered, he is disgraced, and performs public penance.
Ludwig and Longenecker (1993) suggested that a negative consequence of success is the
new ability of managers to rationalize actions they know are unethical. Several studies
conducted after large organizational failures have shown higher than anticipated
(COSO, 1987).
Managerial Discretion
Some theories of management behavior have been grouped under the general
Enron, Maxwell Communications, and Polly Peck (Barnes, 2004). The presence of
management fraud in such circumstances could be expected if explained with the concept
discretion in making decisions (Barnes, 2004). Meckling and Jensen (1976) suggested
42
that, rather than pursue shareholder goals, managers pursue their own interests. When a
to take steps that conflict with stakeholder interests to forestall the failure of the
hubris theory of management behavior predicts that success causes managers to believe
that their judgment is superior to that of all others with the effect of producing
to create a conflict of interest with stakeholder interests, it creates what Barnes called
organization for their own use. Managers often resort to diverting resources in order to
(Barnes, 2004).
Ethical Behavior
Underlying or deeply held beliefs and attitudes can affect ethical decision making.
Cynical beliefs and unethical behavior are related (Traynor, 2004). Traynor studied
graduate and undergraduate students and found those who held the belief that most
people cheat and steal were far more likely to cheat and steal. Through a series of studies
using ANOVA and logit regression to test cynical beliefs and differing unethical
behaviors, Traynor found that cynicism was a predictor of unethical behavior. Traynor
concluded the belief that others are acting unethically provides a rationalization for
such behavior. The cycle of rationalization and socialization spreads behavioral standards
The factors that influence managers’ unethical or fraudulent behavior are elusive.
experiences with corporate wrongdoing. Williams et al. examined the top management
teams and boards of directors from Fortune 500 firms for the period 1991 to 1994. The
In Williams et al.’s (2000) study, the violations served as the dependent variable,
and military service and graduate education of top management, firm size, and firm
strategy were independent variables. Firm strategy indicated no link with illegal activity.
Citations for illegal activity increased with firm size. As citations for illegal activity grew
with firm size, so did the level of military service of top management teams. Illegal
activity at large firms increased with the level of graduate education of the top
management team. The causal relationship between such factors is not evident. Williams
et al. (2000) speculated that military service and education might reflect yet unknown
variables.
factors influence decision making by changing the focus of attention from group or social
Cullen et al. used data the World Values Study Group (2005) had collected from 3,450
to justify ethically suspect behavior, and the independent variables were national culture
and social institutions. Cullen et al. found that conditions of institutional anomie affected
managerial personnel differently than the general population, based on results of previous
studies of the general population. Cullen et al. speculated that the social status attached to
the manager’s position changes the effects of cultural and institutional factors in the
Agency Theory
managers diverge from the goals of stockholders (Jensen, 2004). Jensen stated that the
failure of firms such as WorldCom and Enron had at its roots agency costs. An agency
2004).
According to agency theory, managers have their own interests at heart. Agency
costs are the costs associated with monitoring management’s activities and preventing
conflicts of interests. Agency costs are associated with attempts to control management
behavior (Ekanayake, 2004). The use of incentives, compensation schemes, and control
mechanisms affect management’s behavior and the alignment of their interests with
shareholders.
45
In October 2002, the AICPA auditing standards board released SAS 99 entitled
guidance to the auditing industry for detecting financial statement fraud (Thomas &
Programs and Controls. In the document, the AICPA outlined an approach to the
detection and prevention of material financial statement fraud that included (a) a culture
of honesty and high ethics, (b) antifraud controls, and (c) oversight (AICPA, 2005).
and reform the excesses of the recent past. Using Sutherland’s (1973) definition of white-
collar crime, Ivancevich et al. proposed (a) the elimination of accounting industry
conflicts of interest, (b) increased sentencing for white-collar crime, (c) administration
and civil sanctions, (d) financial penalties, (e) shaming offenders, (f) a national code of
conduct, (g) ethical behavior rewards, (h) independent board members, (i) a governance
While AICPA guidelines provide a basis for evaluation, the methodology used to
implement the guidelines can affect their effectiveness. Kaminski et al. (2004) studied a
technique called ratio analysis auditors use to determine whether financial statements
financial ratios that auditors commonly use in analyzing the possibility of financial
nonfraudulent companies, Kaminski et al. found ratio analysis had limited ability to
detect a fraudulent reporting firm from a nonfraudulent reporting firm. Sixteen of the
46
financial ratios were found to be significant, but few were significant over multiple
periods. A very high rate of misclassifications was evident, ranging from 58% to 98%.
The lack of theoretical backing for the financial ratios used in the analysis might explain
Smith et al. (2006) observed the effects of the threat of formal sanctions on the
ethical conduct of managers. After each wave of corporate wrongdoing, such as the
recent scandals of Enron and WorldCom, governmental and regulatory agencies enact
penalties and sanctions to act as deterrents for future misconduct. Criminologists employ
deterrence theory, the cost of being caught is weighted against the perceived benefits of
the unethical activities. Smith et al. found the formal sanctions were not directly
influencing behavior. Informal sanctions from society that affected the managers’ image
mechanisms between organizations that were guilty of financial reporting fraud and those
that were not. Unlike previous researchers, Beasley et al. segmented the organizations by
used allegations made by the Securities and Exchange Commission (SEC) during the
period 1987 to 1997 of fraudulent financial reporting to establish fraud organizations and
data from the National Association of Corporations (NACD) to match the fraud
findings indicated that organizations found guilty of financial reporting fraud (a) had less
47
independent boards, (b) had fewer audit committees, (c) the audit committees met less
often, (d) the audit committees were less independent, and (e) the boards and audit
in 100 bank holding companies during the period 1995 to 1999. Griffith et al. used the
financial indicators of economic value added, market value added, and Tobin’s q to
evaluate financial performance. The findings indicated that CEO ownership improved
performance when ownership was less than 12% or over 67%. When financial ownership
Griffith et al. (2002) posited there were points at which CEO ownership interacted
with personal wealth diversification leading to the choice of a less risk-tolerant position.
Griffith et al. found the combination of the positions of CEO and chairman of the board
of directors had no effect on financial performance. The finding differs from that of
Beasley et al.’s (2000) who had found board independence and the separation of the CEO
suffered accounting frauds during the period 1990 to 2003. Fraud firms were matched to
no fraud firms by Standard Industrial Classification (SIC) codes and markets values
determined by book value to market value ratios. Crutchley et al. found that certain
The characteristics included (a) high levels of growth, (b) engaging in earnings
management techniques, (c) audit committees composed of few outside directors, and (d)
Organizational Decline
organizational decline or failure, many proprietary models have been developed to assist
the increased likelihood of management fraud. Lemke and Schminke (1991) examined
the relationship between the two variables of unethical behavior and declining
Lemke and Schminke (1991) proposed two hypotheses. In the first hypothesis, a
declining organization will show a higher level of unethical behavior than an organization
not in decline, and the greater the decline, the greater the level of unethical behavior. In
the second hypothesis, the effects of decline will be independent of the initial level of
with managers placed in unethical dilemmas raises ethical concerns, so Lemke and
Schminke used scenario simulation. The simulation created industry-wide conditions that
placed the participating teams into stages of financial decline and provided options of
questionable ethical behavior at various points in time. The conclusions reached in the
study confirmed both hypotheses and suggested further study into potential other factors
(e.g., organizational environment, structure, leadership style, culture) that affect ethical
behavior.
Corporate Failures
financial distress and influenced the development of many of the predictive models in use
primary factors that cause financial distress lie within the organization itself (Altman,
1983). Analysis of such factors can provide insight into the types and levels of financial
pairs firms using financial ratios as dependent variables predictors of financial failure.
The subsequent testing of the z score model showed success for up to two reporting
periods before the failure. The accuracy of the model decreased quickly as the duration of
the period under study expanded. Subsequent models refined the accuracy of prediction.
The models are not publicly available since they are proprietary property of organizations
decline in organizations and how the patterns affected decision making. Three different
patterns of decline were identified that were (a) gradual decliners, (b) sudden decliners,
and (c) lingerers. Using a matched pairs study design, a total of 98 large firms were
selected and matched by environment and size, one being bankrupt and the other being
survivors, a term which was not defined. Four decision variables tested for a correlation
determinants for the variables were obtained from public information, such as merger
management.
time element. D’Aveni confirmed and expanded the concept of resource munificence by
including financial resources and managerial resources. D’Aveni concluded that strategic
50
more managers dealing with survival than with growth. One of the weaknesses in the
study was that it only included large firms. The factor of size might have an overall
liquidate and downsize operations. D’Aveni did not attempt to examine the
characteristics prevalent among firms that recovered from decline and what actions the
Banking Failures
Gupta and Lalatendu (1999) studied the large number of bank failures during the
1980s and 1990s through the examination of regulatory and academic studies focusing on
causes. From the analysis, Gupta and Lalatendu constructed recommendations for a new
regulatory structure for the banking industry. The study included five parts that explored
(a) the origins of the banking crisis, (b) how the Savings and Loan regulators originally
handled the crisis, (c) how the crisis was handled after the passage of the Financial
Institution Reform Recovery and Enforcement Act (FIRREA), (d) how the Federal
Deposit Insurance Company (FDIC) handled the crisis, and (e) changes in the regulatory
system since the passage of the Federal Deposit Insurance Company Improvement Act
(FDICIA).
Gupta and Lalatendu (1999) drew from other studies and concluded that
macroeconomic conditions were the root causes of the banking crisis (e.g., erratic public
capital, deposit insurance reform, and increased regulatory monitoring including limited
flexibility for regulatory interpretation. Most notably missing from the study was any
51
mention of three major studies and investigations by government sponsored agencies, one
by the OCC in 1988 and two by the USGAO in 1993 and 1994.
Wheelock and Wilson (2000) studied the question of U.S. banks disappearing
regulatory barriers and restrictions influence economic dynamics. Using a hazard model,
the likelihood of acquisition by another institution. Wheelock and Wilson found that the
lack of capitalization, high leverage, poor asset quality, and low profitability were key
determinants of whether a bank would fail. The same factors were key determinants of
Cebula (1999) studied bank failures from 1963 to 1991 and concluded that
deposit insurance had a major impact on failures. Cebula believed the impact was
particularly real when factoring economic trends such as interest rates and domestic
growth into the analysis. Cebula suggested that increasing the level deposit insurance
Simpson and Gleason (1999) examined the effect of ownership and board
structure within banks in financial distress. The type of oversight of management is the
Simpson and Gleason used information from publicly traded companies that financial
the closer management was involved within the board, the less likely the bank would be
Beasley et al.’s (2000) contention that greater board independence decreased financial
distress.
bank managers, the size of the institution, and management ownership in the institution.
In the study of 65 bank holding companies during the period of 1987 to 1996, Lee found
greater risk takers. Lee posited the probability of organizational failure was lower in
Curry, Elmer, and Fissel (2001) studied the effects of market data as predictor of
financial distress in banks. Curry et al. found that measures of stock prices and returns on
downgrades were official. The trends did not hold true for improving banks and other
types of market data such as trading volume, and turnover of shares were not predictive.
Overview
banks have common products in loans, deposits, and checking accounts, and they have
readily collectable data provided by regulators. The data are standardized, available over
a long time horizon, and comparable. The banking industry in the United States has four
federal regulators, the FDIC, the FRS, the OCC, and the OTS.
institutions. The FRS supervises bank holding companies such as state chartered banks
53
that are members of the Federal Reserve System, Edge Act banks, and branches,
agencies, and offices of foreign banks in the U.S. (FRS, 2007). The OCC supervises
national chartered banks, the FDIC supervises state chartered banks not in the Federal
Reserve System, and the OTS supervises Savings Associations insured by the FDIC
(OTS, 2007).
The U.S. banking system is a bifurcated system consisting of very large complex
acting on a banking relationship basis. While such descriptions are broad, they represent
generalizations of the activities of the U.S. banking industry (Anonymous, 2003). The
Federal Reserve has scrutinized large complex banking organizations since the early
1990s. Large institutions grow beyond the traditional banking products of deposits and
comprehensive manner than other institutions. Unlike the smaller community or regional
banking organizations, the failure of one of the large complex banking organizations
poses a systemic danger to the banking system. The Federal Reserve, in conjunction with
emphasizing internal systems and controls within the organizations. In 1999, the Federal
Reserve developed a basic framework for all complex banking organizations with over $1
State and federal regulators monitor banks that do not fall within the definition of
complex banking organization through a series of onsite and offsite examinations (Collier
et al., 2003). The FDIC, in conjunction with other regulators, monitors institutions
54
covered by deposit insurance. As the insurer protecting deposits at member banks, the
FDIC has a regulatory responsibility for most banks in the United States.
and taking enforcement actions when deemed necessary. Part of the examination is the
assignment of a safety-and-soundness rating based upon the areas of (a) capital adequacy,
(b) asset quality, (c) management, (d) earnings, (e) liquidity, and (f) sensitivity to market
risk (Curry et al., 1999). The FDIC uses such ratings in its regulatory duties, and the
Report. The Call Report contains detailed financial and demographic information (FDIC,
2005a) and is the basic regulatory information collection method for banks. In addition to
the role of collecting and monitoring financial data from all insured depository
institutions, the FDIC is the primary federal regulatory for state chartered institutions that
In the role of primary federal regulator, the FDIC can take both formal and
informal enforcement action against the institutions it supervises. Informal actions take
the form of board resolutions and memoranda of understanding to make changes in the
operations and management of the institution. In more serious situations for which
informal actions are ineffective, the FDIC takes formal enforcement actions including
written agreements, cease and desist orders, termination or prohibition orders against
individuals, the removal of officers and directors of the institution, and monetary
As shown in Table 3, the FDIC was the primary regulator for over 60% of
banking institutions in 2006. The OCC was the primary regulator of 19.8% of FDIC
insured institutions and a majority of the insured assets. While the majority of insured
assets are regulated by the OCC, the FDIC regulates substantially more banking
institutions.
Table 3
Note: Adapted from FDIC (2007a). Statistics on Depository Institutions. Retrieved March 17, 2007, from
http://www2.fdic.gov/sdi/main.asp
Over the period 1996 to 2006, the FDIC was the primary regulator of 58.6% of all
FDIC insured banks and thrifts. FDIC is the primary regulator for state chartered banks
not in the Federal Reserve System. As shown in Table 4, of the four federal regulators,
the FDIC is the majority regulator for banks under $1 billion in assets. While the number
billion in assets.
56
Table 4
Note: Adapted from FDIC (2007a). Statistics on Depository Institutions. Retrieved March 17, 2007, from
http://www2.fdic.gov/sdi/main.asp
Community Banks
Two primary characteristics of a community bank are the relative smaller size of
the institution and the concentration of its activities in a single community (Anonymous,
specific local economy and are small in terms of their asset structure (Hein et al., 2005).
57
The small size is an identifier for community banks. A total asset base of $1 billion or
limit does not address all the complexities associated with a community bank. The scale
of operations conducted by the bank influences its behavior in the marketplace (DeYoung
that included a threshold of $1 billion in assets, a majority of its deposits locally raised,
al. (2004) used a similar definition of a bank or thrift below $1 billion in assets that
confines its business activities to a geographically limited location. For the current study,
the definition of a community bank was any bank monitored by the FDIC with assets
below $1 billion.
The FDIC, as the primary federal regulator of banks with less than $1 billion in
assets, requires quarterly standardized financial statements that measure the financial
performance of a bank. The financial statements called Call Reports are required of all
insured banks. The FDIC is responsible for monitoring the safety and soundness of banks
it insures (FDIC, 2005c). A part of such responsibility, the FDIC monitors the financial
The number of community banks has fallen by nearly half since the beginning of
1985, from 15,084 to 7,842 at the end of 2003, reflecting the changing banking
environment. The reduction in the number of community banks occurred largely from
failure and unassisted mergers. During the period 1985 through 2003, 8,122 banks were
merged, purchased, or acquired by other banking organizations, 2,698 failed, and 3,097
58
new banking organizations were formed (Jones & Critchfield, 2004). The successes of
the newly formed banking organizations suggest the viability of the community bank
model. Between 1992 and 2003, approximately 1,250 new community banks formed,
over 1,100 still exist independently, approximately 100 have been merged, 17 closed
While the aggregate number of banking institutions has been declining since
1985, the more recent trend is toward stabilization at present levels or a slight decline in
future years (Jones & Critchfield, 2004). For community banks, the shift has been away
from the very small institutions of $100 million or less. The reduction is mostly from
growth into the segment above $100 million rather than from failure or mergers and
acquisitions. Failure, mergers, and growth have all had an effect in changing the
in fraud detection analysis. Apostolou, Hassell, Webber, and Summers (2001) examined
the fraud risk factors that auditors use in making a determination during an external audit.
Using the risk factors identified in SAS 88, Apostolou et al. surveyed 93 auditors from
characteristics and control procedures as more important than operational and financial
characteristics. Apostolou et al. found that economic characteristics were the least
effective method of evaluating the risk factors of fraudulent activities. The conclusions
are the practitioners’ views rather than the results of a statistical study.
59
heterogeneous environment, and industry membership and how such factors might relate
to management fraud. The foundational basis for using such factors is agency theory and
illegal corporate activity literature. The definition of management fraud used was a
formal complaint issued by the Securities and Exchange Commission for violating Rule
regression of 152 matched paired, fraud and no fraud companies, for the period 1982 to
1993. Of the internal factors tested, financial performance, insolvency, slack, and size, all
results with the coefficients indicating the predicted direction but only a heterogeneous
Dabos and Escudero (2004) explored the predictive properties of several financial
devaluation of the Mexican peso in 1994, financial instability swept through the
economies of Central and South America. Dabos and Escudero examined public, private,
and mutual financial institutions in Argentina with a duration model. Using financial
ratios modeled after the indicators used by regulators in Argentina and the United States,
Dabos and Escudero found several indicators that were predictive of the ability of a
60
Curry et al. (1999) studied the effect of enforcement actions by the FDIC on
distressed banks. The FDIC regulates and enforces the use of safe-and-sound
management practices at institutions they insure. Using onsite examinations and offsite
analysis of quarterly financial data, the FDIC attempts to detect unsafe and unsound
practices at the institutions they insure. Using several formal and informal enforcement
financial performance occurred. Curry et al. found that changes occurred in areas where
the management of the institution had control of the action. In areas where management
did not have control (i.e., raising outside capital), the enforcement actions did not assist
financial performance.
Wheelock and Wilson (2000) examined the factors that determine whether an
individual bank will fail or will be acquired. Wheelock and Wilson tested the hypothesis
that another bank will acquire a bank in financial distress because of management
deficiency rather than the bank’s failing. The premise in such decisions is that the
acquiring bank recognizes deficiencies and corrects them. Wheelock and Wilson built
upon previous studies and improved them by increasing the sample size, looking at
additional ways to evaluate management quality, and using a competing risk model to
evaluate the probability of acquiring and of failing. The model included the same
The results of Wheelock and Wilson’s (2000) study confirmed many of the earlier
results that banks with poor capitalization are at greater risk of failure, and banks with
higher leverage and loan quality issues are at a higher risk of failure. Wheelock and
Wilson’s findings further confirmed that states permitting branch banking had a lower
risk of failure. The test of whether recognition of managerial inefficiencies would lead to
banks acquiring the deficient banks showed the opposite. Banks with managerial
deficiencies were more likely to fail. Wheelock and Wilson concluded the cost of
banking institutions. There have been many methodologies used in calculating the ratios
from complex risk-based calculations to simpler methods. Estrella et al. found that
were the level of capital as the numerator, and a factor used to represent the relative risk
that the capital is exposed as the denominator. Estrella et al. (2000) discovered that
simpler constructs of capital ratios were as predictive as the more complex constructs
over short time frames of 1 to 2 years. The more complex constructs were more
Shunway (2001) used a hazard model to develop a predictive model for organizational
failure. The results of Shunway’s studies indicated that many financial ratios used in
static models were poor predictors within the Shunway’s model. Market size, stock
returns, and the standard deviation of stock returns were predictive of failure. When
62
combined with the two financial ratios of (a) net income to total assets and (b) total
liabilities to total assets, an accurate predictive model was developed (Shunway, 2001).
expanding small business had an increased risk factor of fraud, including management
Johnson and Rudesill concluded the lack of internal control systems in small businesses
was a contributing factor in the increased risk of fraud at small firms. The overall lack of
resources to staff and maintain sophisticated controls systems within small businesses
results from the inability to segregate duties as can be done in larger organizations. The
An OCC (1988) study found overly aggressive growth occurred before a bank’s
failure in 42% of the cases examined. Aggressive business behavior on the part of
rapidly increasing loan growth. The OCC concluded that overly aggressive behavior by
Rapid asset growth combined with falling capital ratios is an indicator of concern
for developing moral hazard within a banking institution (King et al., 2005). Reflecting
concerns of the consequences of high-risk strategies, the FDIC developed the Growth
agencies use growth rates and growth ratios as indicators of a bank requiring closer
examination.
63
operation 5 years or less) and the long-term probability of failure within this group.
Comparing de novo banks to small established banks in similar communities, the findings
indicated the failure rate for de novo banks was higher for systemic causes such as
business cycles. The failure rates were the same regarding improper business practices
and lax management. Rapid asset growth was associated with lax business practice and
excessive risk taking and was a long-term predictor of failure. DeYoung found failure to
grow at a sufficient rate to be a cause of failure in de novo banks but not in established
small banks.
Conclusion
There are many definitions for management fraud, but the definitions have in
common the fact that a person in a position of responsibility and authority abuses both
the responsibility and the authority (ACFE, 2004; Elliot & Willingham, 1980; O’Gara,
extend beyond the guilty individual to the organization and can cause far reaching
economics, ethics, accounting, and law are fields of study in which researchers have
studied the causes of management fraud (Zahra et al., 2005). While researchers have
attempted to explain management fraud (Cressey, 1971; Elliot & Willingham, 1980;
Jensen, 2004; Ludwig & Longenecker, 1993; Sutherland, 1973), each has built models
64
from the perspective of a single discipline. The factors that affect the occurrence of
organization or the cause of the collapse (COSO, 1987; FDIC, 1997). Because of the
unique characteristics of the banking industry (Samolyk, 2004), the ability to identify
management fraud in the early stages affects regulators, individuals, and business. The
Summary
Since the banking crisis of the 1980s, the community banking industry has shrunk
because of failure and unassisted mergers and acquisitions (Jones & Critchfield, 2004). A
frequently mentioned factor for failed banks is the presence of improper or fraudulent
behavior by insiders (OCC, 1988). The community banking segment of the banking
industry represents 94% of all banking companies within the United States (Critchfield et
al., 2004). Organizational decline is a major concern within the community banking
(Curry et al., 1999; Dabos & Escudero, 2004; Estrella et al., 2000).
65
organizational decline (Altman, 1983). Findings from several studies conducted after
(COSO, 1987). While studies have indicated that the risk of unethical and possibly
fraudulent behavior increased in organizational decline (Lemke & Schminke, 1991), not
all frauds by management result in financial failure nor are all organizations in decline
organizational decline in community banks with financial ratios as they relate to the
description of types of financial ratios and the rationalization for their use. The chapter
includes the model for the study and the statistical tests used. Chapter 3 concludes with a
The purpose of the quantitative correlation study was to examine the relationship
between the occurrence of management fraud in community banks in the United States
and financial ratios the FDIC use to monitor the banks’ safety and soundness. The
research question for the study and the purpose and significance of the research were
topics in Chapter 1. Chapter 2 was a detailed review of literature within categories of (a)
historical perspectives of management fraud, (b) organizational decline, and (c) the
banking industry.
Chapter 3 begins with the rationale for the choice of research design and its
appropriateness. In research, the design flows from the research problem, the purpose of
the study, and the conceptual framework underpinning the study (Creswell, 2003). In the
current study, the research topic was management fraud, and its significance derived from
the research problem, the purpose statement, and the conceptual framework. Fraud by
managers and leaders is associated with economic failures that cause the loss of billions
of dollars each year and the economic dislocations of thousands of workers (Graham et
al., 2002).
Research Design
and quantitative components. The basis for choosing a research approach should be
matching the research approach to the research problem (Karami, Rowley, & Analoui,
2006). The quantitative approach to the current study was appropriate because the
variables” (Creswell, 2003, p. 50). The purpose of the quantitative correlational study
community banks in the United States and financial ratios the FDIC uses to monitor the
for an experimental group and comparing scores with the scores of a control group. In the
experimental group to perform illegal or unethical acts would itself be unethical (Lemke
group to determine the degree of similarity or difference. The control and experimental
groups are determined with historical data. A researcher can examine the variables, as
they are, not subject to imposed behaviors. Correlational measures show the association
or lack of association between variables and do not indicate a causal relationship between
lack of association between a dependent variable and two or more independent variables,
a regression analysis is appropriate (Creswell, 2003). When the dependent variable in the
logistic regression analysis is appropriate when questions exist concerning the underlying
variables. When two or more dependent variables exist within a study, multiple
discriminate analysis is more appropriate (Hair et al., 2006). Logistic regression models
are applicable when the single dependent variable is categorical (i.e., nonmetric) and the
independent variables are either metric or nonmetric (Hair et al., 2006). Logistic
likelihood of the independent variables influencing the dependent variable (Hair et al.,
2006). Logistic regression analysis was most appropriate for the current study.
The study involved examining the ability of financial ratios used by the FDIC to
nonmetric variable was the occurrence of management fraud, and the metric independent
variables were performance, growth, and capital ratios used by the FDIC. Data analysis
growth, and capital characteristics of community banks. Control variables denoting size,
location of the community bank, and time were used in the matched pairs design.
community banks used in the current research. In the model, the financial ratios of
performance, growth, and capital depict the data found in financial statements used to
69
determine the comparative condition of the community banks. Financial statements are a
transparency into the operations of community banks and management’s behavior. The
financial statements from banks contain financial ratios of performance, growth, and
statements. The focus of data analysis in the study was testing the ability of financial
bank failure and management fraud (FDIC, 1997; OCC, 1988), they have produced
70
conflicting conclusions regarding the ability to predict the onset and mitigate the
management fraud in the study was a FDIC enforcement decision or order, specifically a
the individual to have engaged in personal dishonesty against the bank (FDIC, 2005b).
The analysis involved testing three groups of financial ratios for the level of
correlation at time intervals of 1 year, 2 years, and 3 years before the year of discovery of
the management fraud incident. The performance ratios used as independent variables are
listed in Table 5. The FDIC calculates and publishes the performance ratios found in
Table 5 as part of the Call Report data. The table consists of all performance ratios
Table 5
Variable Name
Table 5 (Continued)
Table 6 lists the growth ratios used in the study. The growth ratios listed in Table
6 are part of the Growth Monitoring System [GMS] used by the FDIC and are all derived
from the Call Report data (King et al., 2005). The growth ratios are calculated using data
Table 6
Variable Name
Table 7 lists the capital ratios used as independent variables in the current study.
The FDIC calculated and published the capital ratios found in Table 7 as part of the Call
Report data. The table consists of all capital ratios consistently published from 1992 to
2006.
Table 7
Variable Name
Gupta and Lalatendu (1999) and the BCBS (2004) have shown that
a method used to control factors that might influence the outcome of the study (Creswell,
2003). The variables used in the present study to control macroeconomic and
microeconomic activities are listed in Table 8. The control of extraneous factors occurred
recorded, based on the same relative size, in the same local economic conditions, and at
Table 8
Control Variables
Variable Name
LOC Location
From 1996 to 2003, the FDIC issued 295 enforcement orders prohibiting
individuals from working at banking institutions (FDIC, 2007b). Not all enforcement
the current study. The matching banks came from FDIC regulated banks with no
matching asset size, location, and time interval. The total sample size of the study was
The purpose of the quantitative correlation study was to examine the relationship between
the occurrence of management fraud in community banks in the United States and the
financial ratios the FDIC uses to monitor the safety and soundness of banks. In earlier
research, the OCC (1988), USGAP (1994), and the FDIC (1997) have suggested a link
74
between the occurrence of management fraud and financial failure. The focus of the study
was the ability of financial ratios used by the FDIC to explain and describe the conditions
The independent variables comprised the three groups of financial ratios of (a)
performance, (b) growth, and (c) capital ratios used by the FDIC during the years 1996 to
size, location, and the time of occurrence of management fraud controlled extraneous
economic conditions identified in previous studies (Altman, 1983; BCBS, 2004; Cebula,
1999). The control of extraneous economic conditions influences both the occurrence of
Logistic regression is a specialized and predictive model used in cases where the
categorical variables are female/male, live/dead, and win/lose in which the variable must
be one or the other (Hair et al., 2006). In logistic regression, continuous and categorical
independents variables can predict the dependent variable. Logistic regression involves
the percent of variance in the dependent variable explained by the independent variables
interaction effects of the variables and understand the impact of covariate control
Logistic regression transforms the dependent variable into the natural log of the
regression calculates the likelihood of an event occurring. Unlike ordinary least squares
75
(OLS) regression, logistic regression does not involve calculating changes in the
dependent variable; it involves calculating changes in the log odds of the dependent
variable.
Like OLS regression, logistic regression uses coefficients in the regression model
but uses logit coefficients. The logit coefficients correspond to beta weights, and a
pseudo R2 statistic is available to summarize the strength of the relationship. Unlike OLS
regression, linearity between the independent variables and the dependent variable is not
assumed, normal distribution of the variables is not required, and homoscedasticity is not
techniques such as analysis of variance (ANOVA) and logistical regression. The key
difference is that, in logistical regression, the dependent variable is categorical, not metric
(Hair et al., 2006). ANOVA requires the dependent variable to be continuous. Logistical
regression has the advantage of being less affected by a lack of normality in the
Research Questions
The purpose of the quantitative correlation study was to examine the relationship
between the occurrence of management fraud in community banks in the United States
and financial ratios the FDIC uses to monitor the safety and soundness of banks. In
quantitative studies, research questions narrow the purpose of the study (Creswell, 2003).
Research questions synthesize the purpose of the study in order to focus and craft the
76
relationship to be studied (Cone & Foster, 2003). The research question guiding this
study was, “How does the financial condition of a community bank, as measured by
financial ratios used by the FDIC, relate to the occurrence of management fraud in the
bank?”
Performance ratios are one type of financial ratio used to measure the relative
the relative financial condition of an organization and have been used successfully in
models of organizational failure and decline in banks (Dabos & Escudero, 2004). The
FDIC used the 20 different performance ratios listed in Table 1 as indicators of the
financial condition of a community bank. The ratios were the independent variables of
the study.
Growth ratios are another type of financial ratio the FDIC and other regulators
used to monitor the safety and soundness of banks (King et al., 2005). Four different
growth ratios used by the FDIC as indicators of the financial condition of a community
bank became independent variables in the study. The four growth ratios were (a) assets
per employee, (b) equity capital to assets, (c) loans and leases plus long-term securities to
Capital ratios are a class of financial ratios used in predicting credit worthiness
(Altman, 1983). Estrella et al. (2000) found capital ratios to be predictors of bank failure.
Regulators use different types of capital ratios to manage the risk-taking behavior of bank
leaders. Capital ratios have shown a propensity to predict failure at differing time
intervals. Four different capital ratios used by the FDIC as indicators of the financial
condition of a community bank became independent variables in the study. The capital
77
ratios were (a) equity capital to assets, (b) core capital (leverage) ratio, (c) tier 1 risk-
Hypotheses
(Creswell, 2003). The study hypotheses identified financial ratios used by the FDIC as
ratios (i.e., performance ratios, growth ratios, and capital ratios) were used as sets of
independent variables in the study. The three categories of financial ratios produced null
H10: Community banks with poor performance ratios do not incur an increased
H11: Community banks with poor performance ratios have an increased occurrence of
H20: Community banks with high growth ratios do not incur an increased occurrence
of management fraud.
H21: Community banks with high growth ratios have an increased occurrence of
H30: Community banks with low capital ratios do not incur an increased occurrence
of management fraud.
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H31: Community banks with poor capital ratios have an increased occurrence of
The information used in the study was public data collected by the FDIC in the
course of its regulatory duties and published on the FDIC Web site. Determination of
the bank declaring the individual to have engaged in personal dishonesty against the bank
(FDIC, 2005b).
Population
The target population for the research was community banks in the United States.
The definition of a community bank was any bank monitored by the FDIC with assets
below $1 billion. The primary source of data was the FDIC as regulator of the banking
industry. The banking industry has four federal regulators that are the FDIC, the FRS, the
OCC, and the OTS. Each regulator has a supervisory responsibility for specific classes of
banking institutions. In the case of community banks in the United States, the primary
regulator is the FDIC. During the period 1996 to 2006, there were between 4,959 and
6,202 community banks whose primary regulator was the FDIC (FDIC, 2007a).
confidence in the banking system of the United States. As part of its charter, the FDIC
monitors its members for risks affecting their insurability and the impact of a failure on
the banking system (FDIC, 2005c). As part of the FDIC duties to monitor the safety and
soundness of insured banks, the agency collects financial and demographic data on a
quarterly basis. Over time, the FDIC has modified the data elements collected to reflect
the changing banking environment. The study data came from the financial and
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community banks.
Sampling Frame
management fraud group and of the control group consisting of no fraud banks. The
matched pairs design produced measurements of the value of the dependent variable,
which was the occurrence of management fraud, by controlling for extraneous facts that
can influence the independent variables. Altman (1983), BCBS (2004), and Cebula
(1999) found that macroeconomic and microeconomic conditions were extraneous factors
affecting management fraud and financial decline. Previous researchers used the matched
pairs design successfully to study the occurrence of management fraud (Beasley et al.,
2000; Crutchley et al., 2007; Saksena, 2001; Williams et al., 2000) and organizational
Under the definition of community bank used in the study, the number of
community banks in the United States has varied from 10,906 in 1996 to 8,064 in 2006
(FDIC, 2007a). The number of community banks with the FDIC as the primary
regulatory agency was 56% to 61% of all community banks during the same period. This
subset of community banks generated the sample for the study. Termination or
prohibition orders issued by the FDIC as primary regulator formed the basis for selecting
experimental group was matched with community banks of the same asset size, from the
same geographic location, and in the same time interval with the FDIC as the primary
regulator that did not have a termination or prohibition order issued by the FDIC
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To ensure the matching community banks did not have an unreported occurrence
of management fraud, records of the matching bank were searched for any termination or
prohibition orders issued against the bank’s employees for 3 years subsequent to the
matching date. The performance, growth, and capital ratios for matched community
banks were drawn from the same time intervals based upon the year of occurrence of
management fraud of the experimental group of community banks. The data drawn from
statistical significance with the logistical regression analysis. From 1996 to 2003, the
FDIC issued 295 enforcement orders prohibiting individuals from working at banking
banks where there has been an occurrence of management fraud. While not all
indicated that all 37 enforcement orders mentioned personal dishonesty (FDIC, 2007b).
All qualifying community banks with fraud occurrence matched with an equal number of
no fraud banks became participants in the study for a total sample size of 266 community
banks.
81
Geographic Location
The purpose of the quantitative correlation study was to examine the relationship
between the occurrence of management fraud in community banks in the United States
and financial ratios the FDIC uses to monitor the safety and soundness of banks.
Between1996 and 2003, the FDIC (2007b) issued 295 termination or prohibition orders.
Not all the termination or prohibition orders were for officers or employees of
community banks and not all included an incident of personal dishonesty as required by
the study definition of management fraud. To ensure a large enough sample was available
for the study, the geographic location was the United States. To ensure the control of
regional differences in economic operating conditions, the geographic location within the
United States was a control variable in the matched pairs design of the study.
because the information needed was in the public domain. The data for the study were
obtained through the FDIC Web site. The FDIC provides an extensive publicly available
database of bank financial performance. The publicly available information includes the
name, addresses, holding company affiliation, and extensive financial information of all
The FDIC accumulates these data from a standardized report, referred to as a Call
Report. All member banks file the Call Report quarterly. The termination or prohibition
orders used to define the occurrence of management fraud also came from public
The raw data available from a public domain were reorganized, coded, and
analyzed to test the hypotheses. During and after the data organization and analysis
process, the coded data were stored in a locked cabinet and were accessible only by the
researcher. All data will be secured for a period of 3 years after completion of the
Data Collection
Evidence from the data collected provided answers to the research question and
hypotheses of the study. According to Creswell (2003), the manner of data collection
influences the ability to draw conclusions. The ability to analyze data and to generalize
findings is a function of the methods and procedures used in collecting the data.
Banks have common products in loans, deposits, checking accounts, and they have
readily collectable data provided by regulators such as the FDIC. The data are
In the banking industry, the need to provide accurate, timely, and meaningful data
forthcoming (Creswell, 2003). The use of historic data in the current quantitative
83
approach increased the validity of the results but did not eliminate the possibility of an
A primary source of data on the banking industry is the FDIC. The FDIC
possesses the authority to take several types of enforcement actions against member
banks and their officers and directors. The FDIC can take formal and informal
enforcement actions against the institutions the agency supervises. Informal actions are
and management of the institution. In situations that are more serious or where informal
actions are ineffective, the FDIC takes formal enforcement actions including written
agreements, cease and desist orders, termination or prohibition orders against individuals,
the removal of officers and directors of the institution, and monetary penalties (FDIC,
2005c).
that are causing problems at an institution, to stop detrimental actions, and to prevent
losses to the deposit insurance fund. Some of the actions are informal and not disclosed
placement in receivership are formal and public actions (Curry et al., 1999).
prohibition order against an individual employed by the bank, declaring the individual to
management fraud. The FDIC enforcement orders are available for download from the
prohibition order against an individual employed by the bank, declaring the individual to
have engaged in personal dishonesty against the bank, is provided in Appendix B. During
the processing phase of data collection, the raw data obtained from the public domain
were reorganized and coded in preparation for analysis to test the hypotheses.
Call Reports
publicly available. The FDIC accumulates these data from a standardized report, referred
to as a Call Report, filed quarterly by all member banks. The Call Report captures
level. The reports are available to the public approximately 8 weeks after the end of the
The independent variables of the study were the performance ratios and capital
ratios provided in the FDIC data and the FDIC data to calculate the growth ratios. The
financial ratio data provided by the FDIC represent metric data of the sample community
banks as appropriate for independent variables when using logistic regression analysis
(Hair et al., 2006). The control variables of asset size, location, and time interval were
data captured by the Call Reports published by the FDIC. The data for the period 1992 to
the present account for the preceding time intervals and post intervals and matched the
Year-end Call Report data are available to the public for the years 1992 to 2006
from the FDIC Web site. The FDIC data are in the form of Microsoft Office Excel
Comma Separated Values Files. FDIC enforcement actions are available from the FDIC
85
Web site with individual documents on each action available for downloading. The
documents include a copy of the actual enforcement order in html or pdf file format. All
enforcement actions were reviewed and entered into a MS Excel spreadsheet and were
sorted by category, type of action, and year. Individual documents on each action were
The data for the matched-pairs of community banks were collected and sorted in
an MS Excel spreadsheet and entered into the analysis software. The logistic regression
analysis of the collected data was conducted using SPSS Graduate Pack 15.0 for
Windows®. Logistic regression analysis is suited for the dichotomous dependent variable
Research Instruments
The research instruments used in the study consisted of the FDIC statistical Web
site, the FDIC enforcement orders, SPSS Graduate Pack 15.0 for Windows® software,
and the logistical regression model. The logistic regression model was modified to reflect
the time intervals observed. A logistical regression analysis was conducted using the
SPSS Graduate Pack 15.0 for Windows® software with the data from the three groups of
financial ratios, drawn from the FDIC statistical Web site at intervals of 1, 2, and 3 years,
and with the data regarding occurrence of management fraud drawn from the FDIC
enforcement orders. The intent was to measure the predictability of the independent
The logistic regression model formula computes the probability of the selected
response as a function of the values of the independent variables. In the study, the
86
independent variables were segmented into the three groups representing performance,
growth, and capital ratios. Logistic regression predicts or explains a binary nonmetric
variable (Hair et al., 2006). In the study, the dependent nonmetric variable was the
Since the goal of the study was to provide guidance in predicting the occurrence
of management fraud before its occurrence at different intervals, the amended model was
predictor variables, Xi are the independent variables, t is the year of occurrence, and y is
Instrument Validity
sample sets, a holdout set and an analysis set (Hair et al., 2006). The study sample is
randomly divided into two sets. The analysis set is used to estimate the logistic regression
model and the holdout set is used to validate the estimation. Test of the validity and
significance of the logistical regression model occurs through examining the hit ratio,
which is the percentage of correct classification of the dependent variable by the model of
87
the holdout set to the analysis set (Hair et al., 2006). In the study, the sample size of 266
produced a sample large enough to divide into the two sample sets required to test for
The study involved the use of historic data collected by the FDIC in the analysis
regularity of the data maintained by the FDIC encourage stable reliability of the data
(Colorado State University, 2007). As primary regulatory for community banks, the
FDIC provides a consistent basis for the treatment of termination or prohibition orders,
the definition of management fraud in the study. The activities conducted to maximize
data validity are correlated to the reliability and validity standards such as objectivity,
Objectivity
Because the data used in the study were drawn from existing sources such as the
FDIC, biases and prejudices from the originating source could have affected the study
findings. The results could be subject to participant biases and prejudices of the person
who updates the FDIC Web site daily, quarterly, and annually. It was assumed that the
FDIC employees collect and classify the data objectively. Neutrality was maintained in
the study when collecting, coding, and analyzing the FDIC data.
Reliability
2004; Cebula, 1999). By matching the experimental banks with banks of the same size, in
88
the same location, and in the same period, both sets of community banks were subject to
the same economic conditions. Accounting for extraneous factors increases the reliability
of the collected data (Creswell, 2003). The data collected by the FDIC are subject to
increasing standardization and reliability of the data. An assumption of the study was that
Internal Validity
Standardization of the data collected in the Call Reports strengthened the internal
validity of the findings. Previous researchers (e.g., Cebula, 1999; Collier et al., 2003;
Curry et al., 1999, 2001; DeFerrari & Palmer, 2001) have used FDIC data effectively.
Differing applications of enforcement actions over time could have threatened internal
validity. The large size of the matched pairs sample with the same time intervals lessened
such possibility.
External Validity
(Creswell, 2003). Community banks are less complex institutions than larger banks
(DeFerrari & Palmer, 2001), precluding the generalization of the findings about small
banks to larger banks. The highly regulated nature of the banking industry makes
operating rules, and reporting requirements imposed by the FDIC can affect the
Data Analysis
The logistic regression analysis of the collected data was conducted using SPSS
Graduate Pack 15.0 for Windows®. Logistic regression analysis has been used
2001). Logistic regression analysis is suited for the dichotomous dependent variable and
metric independent variables (SPSS, 2006) of the study. The logistical regression formula
instrument was run on each hypothesis expression, H1, H2, and H3, of the logistical
regression model. The model analyzed data from intervals of 1, 2, and 3 years from the
model.
The analysis tested the financial ratios for the level of correlation at time intervals
of 1 year, 2 years, and 3 years preceding the year of discovery of the management fraud
incident. The logistic regression analyzed the data for each participating community bank
three times, 1 year before the occurrence of management fraud, 2 years before the
fraud. The financial ratios variables as shown in Tables 5 and 7 were the performance and
capital ratios calculated and published by the FDIC as part of the Call Report data. The
growth ratios as shown in Table 6 were part of the Growth Monitoring System [GMS]
Performance Ratios
H10: Community banks with poor performance ratios do not incur an increased
To test Hypothesis H10, the logistic regression model formula was applied to the
hypothesis. H10 tested the effects of performance ratios in predicting the occurrence of
management fraud. The performance ratios were from quarterly reports by the FDIC
(FDIC, 2005a). The performance ratios were from year-end intervals. Using the logistical
regression formula instrument and substituting the performance ratio variables listed in
Table 4 as X1(t-y) . . . Xk(t-y), H10 expressed itself in the logistic regression model as
B19*(ROE)(t-y) + B20*(ROEEINJR)(t-y))
predictor variables, Xi are the performance ratio independent variables, t is the year of
Growth Ratios
H20: Community banks with high growth ratios do not incur an increased occurrence
of management fraud.
To test Hypothesis H20, the logistic regression model formula was applied to the
hypothesis. H20 tested the effects of the growth ratios in predicting the occurrence of
management fraud. The FDIC uses growth ratios as part of a forward-looking model of
possible financial distress (King et al., 2005). The growth ratios were from year-end
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intervals. Using the logistical regression formula instrument and substituting the growth
ratio variables listed in Table 5 as X1(t-y) . . . Xk(t-y), H20 expressed itself in the logistic
regression model as
B3*(ROLLPS5TA)(t-y) + B4*(ROVLTA)(t-y)
predictor variables, Xi are the growth ratio independent variables, t is the year of
Capital Ratios
H30: Community Banks with low capital ratios do not incur an increased occurrence
of management fraud.
To test the Hypothesis H30, the logistic regression model formula was applied to
the hypothesis. H30 tested the effects of the capital ratios in predicting the occurrence of
management fraud. Capital ratios are one of the more effective tools used by regulators in
determining the risk of failure in banks (Estrella et al., 2000). Using the logistical
regression formula instrument and substituting the capital ratio variables listed in Table 6
B3*(RBC1RWAJ)(t-y) + B4*(RBCRWAJ)(t-y)
predictor variables, Xi are the capital ratio independent variables, t is the year of
The use of logistic regression rather than OLS regression was based on the fact
that logistic regression does not have many of the restrictive assumptions of OLS
regression (Garson, 2006). In logistic regression, the relationship between dependent and
independent variables is not assumed linear. The distribution of the dependent variable
and the distribution of error terms need not be normal. The dependent variable is not
In logistic regression, all relevant variables are assumed included in the model.
Failure to include all relevant variables would misallocate any common variance of other
variables or inflate the error term. Excluding all irrelevant variables is also assumed.
Inclusion of irrelevant variables in the model would cause any shared common variances
increase with the correlation of the irrelevant variables and the independent variables
(Garson, 2006).
this assumption has serious consequences. Violations occur when participants provide
observations at multiple points in time. Logistic regression assumes there are no missing
independent variable and the log odds of the dependent variable. The logistic regression
variable when the assumption of linearity is violated and generates Type II errors.
Interaction effects known as additivity are not accounted for in logistic regression. The
exception occurs when interaction terms are added as additional variables in the analysis
(Garson, 2006).
increase. Multicollinearity does not change the estimates of the coefficients as the
likelihood estimate (MLE) decreases as the sample size decreases. Conversely, the
reliability of the MLE increases as the sample size increases. The convergence process of
the MLE is dependent on an adequate sample size. Hair et al. (2006) recommended there
be at least five events for each parameter in the logistic regression model. The adequacy
regression, it is assumed that the expected dispersion of the variance of the dependent
variable and the actual dispersion are small. Large discrepancies between the expected
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variance of the dependent variable and the observed variance signify problems with the
randomness of the sample. The sample size of the study, 266 events, exceeded the
Summary
The purpose of the study was to examine the relationship between the occurrence
of management fraud in community banks in the United States and financial ratios the
FDIC uses to monitor the safety and soundness of banks. The dependent nonmetric
variable was the occurrence of management fraud, and the metric independent variables
were performance, growth, and capital ratios used by the FDIC (2005a). The study tested
banks (FDIC, 2005a) were the independent variables. The variables denoting size,
location of the community bank, and time controlled extraneous variables in the matched
The model for the study was financial statements as numerical interpretations of
the financial condition of the bank (Altman, 1983). The financial statements from banks
contain the financial ratios of performance, growth, and capital. The financial ratios are
three of many potential perspectives when reviewing the financial statements from banks.
prohibition and termination orders against bank officers and directors, and the
information is available to the public (FDIC, 2007a). Logistic regression was used in the
analysis of the collected data, using SPSS Graduate Pack 15.0 for Windows®. The
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logistical regression formula instrument was run on each hypothesis expression, H1, H2,
discussion of the findings includes the validity and reliability of the model and instrument
and the generalizations applicable to the general population of community banks and the
CHAPTER 4: RESULTS
United States and financial ratios the FDIC uses to monitor the banks’ safety and
soundness. Earlier studies by the OCC (1988), USGAO (1994), and the FDIC (1997)
indicated a possible link between the occurrence of management fraud and financial
failure. The current study was an examination of the ability of financial ratios used by the
fraud.
A total of 133 matched pairs of community banks of similar size and location was
the sample for the study. Banks where management fraud occurred were matched with
banks where no management fraud was discovered. The definition of management fraud
in the study was a termination or prohibition order by the FDIC, specifically against an
The logistical regression model instrument was applied to three sets of financial
ratios (i.e., performance, growth, and capital) for the sample group of community banks
at three time intervals. The three sets of financial ratios are shown in Tables 5, 6, and 7.
The time intervals were 1, 2, and 3 years before the initiation of the termination or
prohibition order. The 26 dependent variables, and the three time-interval iterations
generated a large and complex number of statistics. The analysis of the logistic regression
model instrument begins with a review of the data collection procedures, a discussion of
the logistic regression instrument model by hypotheses and time interval iteration, and a
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model.
The selection of the experimental or management fraud group and the control
group occurred through the use of a matched pairs design. The matched pairs design
permits the measurement of the value of the dependent variable (i.e., occurrence of
management fraud) by controlling for extraneous facts that might influence the
independent variables (i.e. the three sets of financial ratios). Earlier researchers used the
matched pairs design successfully to study the occurrence of management fraud (Beasley
et al., 2000; Crutchley et al., 2007; Saksena, 2001; Williams et al., 2000) and
prohibition orders issued by the FDIC as primary regulatory agency formed the basis for
the selection of community banks where management fraud occurred. The experimental
group was matched with community banks in the same time interval, from the same
geographic location, and of similar asset size where the FDIC was the primary regulator
The community banks where management fraud had occurred were first matched
for location by state and county. The no fraud community banks were selected as the
community banks closest in asset size within the same county with the FDIC as primary
regulator. If no matching community bank was found in the same county, the search was
To ensure the matching community banks did not have an unreported occurrence
of management fraud, 3 years of data subsequent to the matching date for any termination
or prohibition orders issued against the matching bank employees were examined. The
performance, growth, and capital ratios for matched community banks were from the
same time intervals based upon the year of occurrence of management fraud. The year of
occurrence of management fraud was determined from the docket number assigned by
the FDIC. The FDIC assigns a unique reference to every action it takes against member
banks. The first two digits of the reference indicate the year the action was initiated
(FDIC, 2007b).
The total sample size was 266 community banks forming 133 matched pairs of
community banks. The sample exceeded the recommended minimum sample size of five
observations for each independent variable or 130 (Hair et al., 2006). All data were from
year-end intervals. The data drawn from the FDIC were matched and sorted using MS
Excel software. The logistic regression analysis of the collected data was conducted using
Performance, growth, and capital ratios were the independent variables. The
FDIC used these three groups of ratios during the years 1996 to 2003 as determinants of a
community bank’s financial condition. The three groups of financial ratios were
examined for their ability to predict the dependent variable, occurrence of management
fraud. The control variables were asset size, location, and the time of the occurrence of
management fraud. The control variables were used to control any extraneous economic
Descriptive Statistics
Descriptive statistical tests were conducted between the fraud and no fraud groups
of community banks within the sample to determine differences between the two groups.
Means, standard deviations, the standard error means, and the number of observations
were determined and histograms drawn. The t tests were performed comparing the
differences between the independent variables of the fraud and no fraud community
banks. The t tests were performed for each group of financial ratios, performance,
includes the means, standard deviations, standard error means, and the number of
observations for all performance, growth, and capital ratios models at all three time
intervals. Appendix E includes the t tests of the performance, growth, and capital models
at all three intervals. Appendix F includes the histograms of all 26 financial ratio
independent variables separated into fraud and no fraud groups for all three time
intervals.
Analysis of the means, standard deviation, standard error means, and histograms
indicated similar distribution patterns in the fraud and no fraud groups among the
independent variables. The t tests assumed both equal variance and not equal variance.
There was no difference in the significance levels of the independent variable in either
assumption. To avoid confusion in presenting the data of the t test for independence,
test for independence showed a larger percentage of variables in the performance ratio
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model H1 were significant as the time interval was closer to the occurrence of
management fraud. One variable in the performance ratio model, ELNANTR credit loss
provision to net charge-offs, were not significant in all time intervals. The growth ratio
model showed a narrow rise and fall because of the lower number of variables in the
model. The capital ratio model showed a consistent pattern of all variables being
Table 9
Number of significant
variables
Variables
An analysis of any missing data was conducted. The reported missing data were a
result of the use of ratios as the dependent variable. In all cases of missing data, the
denominator of the ratio was zero. This ratio represents a value that cannot be calculated
rather than an absence of data, producing a result noted as N/A (i.e., not applicable) in the
FDIC data and is represented as a blank cell in the FDIC data download (FDIC, 2007a).
The two performance ratios in the performance ratio model, ELNANTR and
performance ratios ELNANTR credit loss provision to net charge-offs, and LNRESNCR
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loan loss allowance to noncurrent loans, represented 79.5% of all missing data. The
logistic regression analysis software eliminated cases where data were missing from the
analysis.
In the performance ratio model H1, 91% to 89.5% of all cases were included in
the logistic regression analysis. The growth ratio model H2 showed only a few instances
of missing data with no ratio having more than two cases of missing data. In the growth
ratio model H2, 99.6% of all cases were included in the logistical regression analysis.
The capital ratio model H3 had no missing data, and 100% of all data were included in
Descriptive statistics for the performance ratio model H1 consisted of the means,
standard deviation, standard error means, and number of observations (see Appendix D).
All t test results for the performance ratio model H1 are included in Appendix E. The t
test performed on the performance ratio model H1t-1 showed four ratios out of 20 that
were not significant. The performance ratios that did not have significance between the
fraud and no fraud groups were NIMY net interest margin, fraud (M = 4.53, SD = 1.09),
no fraud (M = 4.37, SD = 1.03), t(264) = -1.20, p = .23 (two-tailed); ELNANTR credit loss
= 2775.83), t(250) = -.20, p = .84 (two-tailed), IDDIVNIR cash dividends to net income,
(two-tailed), and LNLSDEPR net loans and leases to deposits, fraud (M = 71.60, SD =
The t tests performed on the performance ratio model H1t-2 showed two
performance ratios that were not significant when the fraud and no fraud groups were
compared. The two variables showing no significance were NIMY net interest margin,
(two-tailed) and ELNANTR credit loss provision to net charge-off, fraud (M = 113.50, SD
variables were shown to be not significant in H1t-1. The other 18 performance ratios
showed significance.
performance ratios were not significant when the fraud and no fraud groups were
compared. Of the two variables found not to be significant in both H1t-1 and H1t-2,
ELNANTR was found not significant in H1t-3, fraud (M = 344.08, SD = 1101.61), no fraud
(M = 133.64, SD = 734.17), t(245) = -1.76, p = .08 (two-tailed), and NIMY was found
= .04 (two-tailed). The variable IDDIVNR that was not significant in H1t-1 was also not
t(263) = .43, p = .67 (two-tailed). The performance ratio variable LNLSDEPR that was
not significant in H1t-1, was also not significant at H1t-3, fraud (M = 71.85, SD = 15.75),
Descriptive statistics for the growth ratio model H2 consisted of the means,
standard deviation, standard error means, and number of observations (see Appendix D).
All t test results for the growth ratio model H2 are included in Appendix E. The t tests
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performed on the growth ratio model H2t-1 showed two out of four growth ratios were not
significant. The two other growth ratios showed significance. The growth ratios that did
not have significance between the fraud and no fraud groups were ROLLS5TA growth
ratio 1, fraud (M = .77, SD = .15), no fraud (M = .73, SD = .20), t(264) = -1.42, p = .16
(two-tailed) and ROVLTA growth ratio 2, fraud (M = .13, SD = .09), no fraud (M = .12,
The t tests performed on the growth ratio model H2t-2 showed that the four growth
ratios were significant when the fraud and no fraud groups were compared. The t tests
performed on the growth model H2t-3 showed that three growth ratios were significant
when the fraud and no fraud groups were compared. The two variables found not to be
significant in H2t-1, ROLLS5TA growth ratio 1 and ROVLTA growth ratio 2 were found
significant in H2t-2. The only growth ratio to show no significance in H2t-3 was
Descriptive statistics for the capital ratio model H3 includes the means, standard
deviation, standard error means, and number of observations (see Appendix D). All t test
results for the capital ratio model H3 are included in Appendix E. The t tests performed
on the independent variables in the capital ratio model H3 showed all capital ratios were
Findings
The null hypotheses were tested within the logistic regression model formula by
setting the logit coefficient (Bk) equal to zero, providing a benchmark for the alternative
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hypotheses to be tested. The logistic regression model sample was split evenly between
fraud and no fraud community banks. Randomness dictates that the null hypotheses
predict a correct outcome 50% of the time. As shown in Table 10, the logistic regression
The number of missing cases in each data set accounts for the variation within the
Hypothesis H10(t-1), there were 114 no fraud community banks and 128 fraud community
banks. In the performance ratio Null Hypothesis H10(t-2), there were 113 no fraud
community banks and 125 fraud community banks. In the performance ratio Null
Hypothesis H10(t-3), there were 116 no fraud community banks and 122 fraud community
banks. In the growth ratio Null Hypotheses H20(t-i), there were 132 no fraud community
banks and 133 fraud community banks. In the capital ratio Null Hypotheses H30(t-i), there
were 133 no fraud community banks and 133 fraud community banks.
The SPSS logistic regression software tested the significance of each alternative
value (p < 0.05) as shown in Table 11. At all time intervals, the alternative hypotheses
were found significant at the level of p < 0.0005. The result means that the logistic
regression formula instrument for all hypotheses was better at predicting the likely
outcome than the null hypotheses had significance. At each time interval, the
performance ratio model H11 produced a higher chi-square statistic. The performance
ratio model H11 indicated a better overall goodness-of-fit than either the growth ratio
Table 10
Table 11
Table 11 (Continued)
Cox & Snell R2 and Nagelkerke R2 tests were performed at all time intervals for
the alternative hypotheses (see Table 12). The Cox & Snell R2 and Nagelkerke R2 tests
time interval. An additional goodness-of-fit test, the Homer and Lemeshow goodness-of-
fit test, was performed to test how well the logistic regression model performed relative
measured as p > .05 (Pallant, 2007). In logistic regression analysis, multiple measures of
model fit are used to find a convergence of indicators of model fit to support the research
In all time intervals, the performance ratio model H11 showed an increased ability
in explaining the variations in the dependent variable. Two time intervals of the growth
ratio model, H21(t-1) and H21(t-3), showed an increased ability in explaining the variations
in the dependent variable than the null hypothesis but to a lesser degree than found in the
performance ratio model H11. The H21(t-2) hypothesis produced a Homer and Lemeshow
goodness-of-fit score of 0.03 where p > .05. This indicated that the H21(t-2) model
All time intervals of the capital ratio models, H31(t-1), H31(t-2), and H31(t-3), showed
ability in explaining some of the variations in the dependent variable but only to a smaller
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degree than H11 and H21. Table 12 shows the results for Cox & Snell R2, the Nagelkerke
R2, and the Homer and Lemeshow tests, for all the hypotheses. The performance ratio
model H11(t-2) showed the greatest explanation of between 29.7% and 39.7% of the
Table 12
R2
The percentage of accuracy classification table (see Table 13) shows the ability of
each logistic regression model to predict accurately the correct outcome. The percentage
performance ratio models had a higher overall accuracy classification than either the
The capital ratio model all showed a poor ability to predict correctly a no fraud
community bank at .52 for all time intervals. This result is only slightly better than the
.50 for the null hypothesis. The performance ratio model for H11(t-2) had the highest
percentage of accuracy classification at 74% with both the ability to predict accurately
Table 13
The performance ratio model H11 showed the best overall fit of the three
performance ratio models H11 showed the highest chi-square value. This result was
confirmed by the performance ratio models H11 having the highest percentage accuracy
hypothesis, H11, H21, and H31, of the logistical regression model. The model analyzed
data from a 1, 2, and 3-year intervals from the occurrence of management fraud on all
three hypothesis of the logistical model. The procedure produced nine iterations of the
logistical regression formula instrument, H11(t-1), H11(t-2), H11(t-3), H21(t-1), H21(t-2), H21(t-3),
H31(t-1), H31(t-2), H31(t-3). Within each logistic regression iteration, the independent
variables were examined for significance in predicting the outcome of the dependent
variable.
of the independent variables (Hair et al., 2006). The high level of nonsignificant variables
Many financial ratios used in the study have common or derivative denominators,
does not affect the significance or validity of the model (Hair et al., 2006).
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the variables and the ability to draw conclusions concerning individual variables.
statistics, tolerance and the variance inflation factor [VIF]. Tolerance factors of .10 or
Appendix H provides the levels of tolerance and VIF for each iteration of H11. All
logistic regression models were tested for the degree of collinearity. Where high degrees
of collinearity existed, additional testing was conducted to examine and resolve the
collinearity effects. In cases of collinearity, one of the correlated variables are deleted
from the model, and the model is rerun (Hair et al., 2006).
Performance Ratios
To test the Hypothesis H11, the logistic regression model formula was applied to
the hypothesis. This was accomplished by using the logistical regression formula
instrument and substituting the performance ratio variables listed in Table 4 as X1(t-y) . . .
Xk(t-y). H11 then tested the effects of performance ratios in predicting the occurrence of
management fraud.
All three time intervals for H11 were significant at p < .001, as stated in Table 11.
outcome. The three independent variables identified in H11(t-2) were found significant in
The SPSS software in the logistical regression calculations excluded the variable
NIMY net interest margin as redundant. NIMY is the difference between variables
INTINCY yield on earning assets and INTEXPY cost of funding assets (NIMY = INTNCY
– INTEXPY). All other variables were incorporated into the logistic regression model.
The first test of the performance ratio model was for H11(t-1). The findings showed
that the model containing all performance ratio variables was statistically significant
χ2(20, N = 242) = 71.08, p > .001 where χ2 is the computed chi-square value, N is total
sample size, and p is the probability. The tests indicated that the performance ratio model
H11(t-1) could distinguish the difference between community banks where fraud occurred.
The Cox & Snell R2 and the Nagelkerke R2 estimated that the performance ratio
model H11(t-1) explains 25.4% to 34% of the change in the dependent variable in a
significant manner. The prediction accuracy classification for the performance ratio
model for H11(t-1) was 73.1%. The result indicates a strong model fit for performance
The details of the logistic regression analysis for H11(t-1) are included in Appendix
performance ratio model H11(t-1), no independent variables were significant at p < .05.
The result indicates that, while the model has improved accuracy in classifying which
community banks had an occurrence of fraud, it cannot be stated that any independent
The tolerance and VIF for all three time intervals of H1 are in Appendix H.
variables in the performance ratio logistic regression model H11(t-1). The result is an
The second test of the performance ratio model was at H11(t-2). The findings show
that model containing all performance ratio variables was statistically significant, χ2(20,
N = 238) = 83.98, p > .001, indicating that the performance ratio model for H11(t-2) could
distinguish the difference between community banks where fraud occurred. The Cox &
Snell R2 and the Nagelkerke R2 estimated that the performance ratio model H11(t-2)
explains 29.7% to 39% of the change in the dependent variable in a significant manner.
The prediction accuracy classification of performance ratio model H11(t-2) was 74.4%.
The result indicates a stronger model fit for the performance ratio model H11(t-2) than was
The details of the logistic regression coefficients for H11(t-2) are detailed in
performance ratio model H11(t-2), three independent variable were significant, NTLNLSR
net charge-offs to loans, ASTEMPM assets per employee, and IDLNCORR net loans and
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leases to core deposits. The independent variables NTLNLSR and IDLNCORR had odds
For every unit of increase in the independent variable, the odds ratios indicate the
ASTEMPM had an odds ratio of .48 and a B value of -.74. When the odds ratios are less
than 1 and the B value is negative, the odds are inverted in interpretation (Pallant, 2007).
In the case of ASTEMPM, a 1-unit increase in the independent variable decreases the
The tolerance and VIF for all three time intervals of H1 are in Appendix H.
variables in the performance ratio logistic regression model H11(t-1). The result is an
The third test of the performance ratio model was for H11(t-3). The findings show
that the model containing all performance ratio variables was statistically significant,
χ2(20, N = 238) = 57.89, p > .001, indicating that the performance ratio model for H11(t-3)
could distinguish the difference between community banks where fraud occurred. The
Cox & Snell R2 and the Nagelkerke R2 measures estimated that the performance ratio
model for H11(t-3) explains 21.6% to 28.8% of the change in the dependent variable in a
significant manner. The prediction accuracy classification for the performance ratio
model H11(t-3) was 69.3%. The performance ratio model H11(t-3) showed strong model fit,
The details of the logistic regression coefficients for H11(t-3) are included in
performance ratio model H11(t-3), four independent variables are significant to p < .05.
They are ROA return on assets, NTLNLSR net charge-offs to loans, ASTEMPM assets per
employee, and IDLNCORR net loans and leases to core deposits contributed. The
independent variables ROA, NTLNLSR, and IDLNCORR had odds ratio of 20.24, 2.83,
and 1.09.
For every unit of increase in the independent variable, the odds ratios indicate the
ASTEMPM had an odds ratio of .51 and a B value of -.68. When the odds ratios are less
than 1, the odds are inverted in interpretation (Pallant, 2007). In the case of ASTEMPM, a
1-unit increase in the independent variable decreases the likelihood of a 1-unit change in
The tolerance and VIF for all three time intervals of H1 are in Appendix H.
variables in the performance ratio logistic regression model H11(t-3). The result is an
of the significance found in analysis of the regression coefficients. Testing was conducted
to determine the extent of the collinearity between coefficients. The SPSS software
provided collinearity diagnostics of tolerance and VIF levels for the variables in the
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performance ratio model (Appendix H). Correlation matrices for all performance ratios
The correlation matrices indicate five pairs or groups of variables that exhibited
high levels of correlation. Four of the groupings consisted of a pair of variables, each
earning assets. Using a trial and error approach, one variable from each correlated set of
variables was selected to represent the correlated financial statement relationship and the
performance ratio logistic regression model was rerun. A new performance ratio model,
H12, was developed. The new performance ratio model contained nine performance ratio
Table 14
Variable Name
The tolerance and VIF for the three time intervals of H12 are in Table 15.
Tolerance factors of .1 or less and VIFs of 10 or greater were not found in any of the
variables in the new performance ratio logistic regression model H12. The result is an
Table 15
The findings for H12 show that model was statistically significant at H12(t-1),
χ2(10, N = 242) = 61.26, p > .001, at H12(t-2), χ2(10, N = 238) = 67.10, p > .001, and χ2(10,
N = 238) = 41.84, p > .001, at H12(t-3). The result indicates that the new performance ratio
model could distinguish the difference between community banks where fraud occurred
at all time intervals. The Cox & Snell R2 and the Nagelkerke R2 estimated that the new
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performance ratio model H12 explains 22.4% to 29.9% of the change in the dependent
21.5% at H12(t-3). The prediction accuracy classification for the new performance ratio
model for H12 was 70.7% at H12(t-1), 73.1% at H12(t-2), and 68.5% at H12(t-3). The result
indicates a strong model fit for the new performance ratio model H12. Table 16 provides
Table 16
performance ratio model H12, variables IDLNCORR and ASTEMPM were significant at p
< .05 in the three time intervals. Variable NTLNLSR was significant, p < .05, in time
interval H12(t-1) and H12(t-2). NTLNLSR was significant, p < .10, in time interval H12(t-3).
The three variables found significant in H12 were found significant in H11(t-2) and H11(t-3).
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The B values and odds ratios for NTLNLSR net charge-offs to loans, ASTEMPM assets
per employee, and IDLNCORR net loans and leases to core deposits are in Table 17.
For every unit of increase in the independent variable, the odds ratios indicate the
likelihood of a 1-unit increase in the dependent variable. When the odds ratios are less
than 1, the odds are inverted in interpretation (Pallant, 2007). A 1-unit increase in the
Table 17
Ratio
Growth Ratios
H21: Community banks with high growth ratios have an increased occurrence of
To test Hypothesis H21, the logistic regression model formula was applied to the
hypothesis. This was accomplished by using the logistical regression formula instrument
and substituting the growth ratio variables listed in Table 5 as X1(t-y) . . . Xk(t-y). H21 then
tested the effects of the growth ratios in predicting the occurrence of management fraud.
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In the growth ratio model, all three models were significant in the overall
goodness-of-fit test as stated in Table 11. The growth ratio model H21(t-2) was found not
significant in the additional Homer and Lemeshow goodness-of-fit test. In the logistical
regression analysis of the growth ratio model H21(t-1), three independent variables were
model H21(t-3), the three independent variables identified in growth ratio model H21(t-1)
The findings show that model H21(t-1) containing all growth ratio variables was
statistically significant χ2(4, N = 265) = 32.65, p > .001, indicating that the growth ratio
model for H21(t-1) could distinguish the difference between community banks where fraud
occurred. The Cox & Snell R2 and the Nagelkerke R2 estimated that the growth ratio
model for H21(t-1) explains 11.6% to 15.5% of the change in the dependent variable in a
significant manner. The prediction accuracy classification showed that the growth ratio
model for H21(t-1) was 61.9%. The result indicates that growth ratio model H21(t-1) showed
model fit and the ability to explain the variations of the dependent variable but to a lesser
growth ratio model H21(t-1) in Table 18, three independent variables are significant to p <
.05, ROVLTA ratio of volatile liabilities to assets, ASTEMPM assets per employee, and
EQV equity capital to assets. The independent variables ROVLTA had an odds ratio of
42.86. The independent variable ASTEMPM and EQV had an odds ratio of .53 and .90,
and B values of -.63 and -.10. When the odds ratios are less than 1 and the B values are
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negative, the odds are inverted in interpretation (Pallant, 2007). In the case of ASTEMPM
and EQV, a 1-unit increase in the independent variable decreases the likelihood of a 1-
Table 18
Odds Ratio
Odds
The tolerance and VIF for H2(t-1) are in Table 19. Tolerance factors of .1 or less
and VIFs of 10 or greater were not found in any variables in the growth ratio logistic
Table 19
The second test of the growth ratio model was for H21(t-2). The findings show that
model containing all growth ratio variables was statistically significant χ2 (4, N = 265) =
42.39, p > .001, indicating that the growth ratio model for H21(t-2) could distinguish the
difference between community banks where fraud occurred. The Cox & Snell R2 and the
Nagelkerke R2 estimated that the growth ratio model for H21(t-2) explains 14.8% to 19.7%
of the change in the dependent variable in a significant manner. The prediction accuracy
classification showed that the growth ratio model for H21(t-2) was 65.3%. There were
contradictory statistics for the growth ratio model for H21(t-2). A second goodness-of-fit
measure, the Homer and Lemeshow test, indicated a level of significance of .03, p > .05,
The third test of the growth ratio model was for H21(t-3). The findings show that
the model containing all growth ratio variables was statistically significant χ2(4, N = 265)
= 33.98, p > .001, indicating that the growth ratio model for H21(t-3) could distinguish the
difference between community banks where fraud occurred. The Cox & Snell R2 and the
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Nagelkerke R2 estimated that the growth ratio model for H21(t-3) explains 12% to 16% of
the change in the dependent variable in a significant manner. The prediction accuracy
classification showed that the growth ratio model for H21(t-3) was 64.2%. While this
indicates a model fit, the model has a lesser fit relative to the performance ratio models
growth ratio model H21(t-3) in Table 20, three independent variable are significant to p <
.05, ROVLTA ratio of volatile liabilities to assets, ASTEMPM assets per employee, and
EQV equity capital to assets. The independent variables ROVLTA had an odds ratio of
542.69. For every unit of increase in the independent variable, the odds ratios indicate the
ASTEMPM and EQV had an odds ratio of .59 and .88, and B values of -.53 and -.13.
When the odds ratios are less than 1, the odds are inverted in interpretation (Pallant,
2007). In the case of ASTEMPM and EQV, a 1-unit increase in the independent variable
decreases the likelihood of a 1-unit change in the dependent variable, likelihood of fraud.
The tolerance and VIF for H21(t-3) are in Table 21. Tolerance factors of .1 or less
and VIFs of 10 or greater were not found in any variables in the growth ratio logistic
regression model H21(t-3). The result is an indication of little multicollinearity between the
Table 20
Odds Ratio
Odds
Table 21
H31: Community banks with poor capital ratios have an increased occurrence of
The H31 logistic regression model formula was applied to the hypothesis by using
the logistical regression formula instrument and substituting the capital ratio variables
listed in Table 6 as X1(t-y) . . . Xk(t-y). H31 then tested the effects of the capital ratios in
predicting the occurrence of management fraud. All three capital ratios models were
significant in the overall goodness-of-fit test as stated in Table 10. In logistical regression
analysis of the capital ratio model H31, no independent variables in any time intervals
were significant in predicting the outcome of fraud or no fraud. All capital ratio models
The first test of the capital ratio model was for H31(t-1). The findings show that
model containing all capital ratio variables were statistically significant χ2(20, N = 266) =
24.58, p > .001, indicating that the capital ratio model for H31(t-1) could distinguish the
difference between community banks where fraud occurred. The Cox & Snell R2 and the
Nagelkerke R2 measures estimated that the capital ratio model for H31(t-1) explains 8.8%
The prediction accuracy classification for the capital ratio model H31(t-1) was
63.5%. The capital ratio model H31(t-1) provided improved model fit than the null
hypotheses, but it is weaker than the model fit shown by the performance ratio model H11
H22. The contributions of individual independent variables in the capital ratio model
H31(t-1) in Table 22 show no independent variables that are significant to p < .05.
125
Table 22
Odds Ratio
Odds
The tolerance and VIF for H31(t-1) are in Table 23. Tolerance factors of .1 or less
and VIFs of 10 or greater were found in all variables in the capital ratio logistic
variables that leads to questioning the reliability of the levels of significance of the
Table 23
The findings for capital ratio model H31(t-2) show that the model containing all
capital ratio variables was statistically significant χ2(20, N = 266) = 26.84, p > .001,
indicating that the capital ratio model H31(t-2) could distinguish the difference between
community banks where fraud occurred. The Cox & Snell R2 and the Nagelkerke R2
measures estimated that the capital ratio model for H31(t-2) explains 9.6% to 12.8% of the
classification for the capital model H31(t-2) was 63.5%. The contribution of individual
independent variables in the capital ratio model H31(t-2) in Table 24 shows that no
Table 24
Odds Ratio
Odds
The tolerance and VIF for H31(t-2) are in Table 25. Tolerance factors of .1 or less
and VIFs of 10 or greater were found in all variables in the capital ratio logistic
variables that leads to questioning the reliability of the levels of significance of the
Table 25
The third test of the capital ratio model was for H31(t-3). The findings show that
the model containing all capital ratio variables was statistically significant χ2(20, N =
266) = 26.84, p > .001, indicating that the capital ratio model for H31(t-3) could distinguish
the difference between community where fraud occurred. The Cox & Snell R2 and the
Nagelkerke R2 measures estimated that the capital ratio model for H31(t-3) explains 9.6%
to 12.8% of the change in the dependent variable in a significant manner. The prediction
accuracy classification for the capital ratio model H31(t-3) was 63.5%. When looking at the
Table 26, there are no independent variables that are significant to p < 0.05.
128
Table 26
Odds Ratio
Odds
The tolerance and VIF for H31(t-3) are in Table 27. Tolerance factors of .1 or less
and VIFs of 10 or greater were found in all variables in the capital ratio logistic
variables that leads to questioning the reliability of the levels of significance of the
Table 27
Validity of the data is central to the ability to infer results and generalize
sample into two groups of matched pairs and comparing the results of different measures.
Two measures were used in testing validity. The first measure entailed separating the
sample into two subsamples and comparing the percentage of accuracy classification. The
comparison was conducted of all alternative hypotheses at the different time intervals.
The second test of validity conducted was validation lift. In validation lift, the
logistical regression model results of each case are in percentile formats of a positive
result. In validation lift, the higher percentiles should represent a greater proportion of the
positive outcomes. Appendix M provides details of the validation lift measures of the
alternative hypotheses in all time intervals. All alternative hypotheses showed acceptable
levels of lift. The performance ratio model H1 showed the highest level of validation
Each of the alternative hypotheses, in each of the time interval, showed cases
outside of two standard deviations beyond the mean as shown in Table 28. The
performance ratio model H1 had the most outliers with five at H11(t-1), three at H11(t-2),
and three at H11(t-3). As detailed in Appendix N, the outliers in the model produced high
residuals or errors in predicting the observed and predicted outcome (Hair et al., 2006).
130
Table 28
Number of
outliers
All outlier cases were examined for anomalous data or unusual case histories, and
none was observed. The growth ratio model H2 had one outlier at each of the time
intervals. The capital ratio model had 1 outlier at H31(t-1), 2 at H31(t-2), and 1 at H31(t-3). As
detailed in Appendix O, the method of determining the effect of outliers on the logistical
regression model is to compare the results of the logistical regression with the outlier in
the model and without the outliers in the model. In all alternative hypotheses, in all time
intervals, the outliers had no material impact upon the logistical regression model.
Summary
Comparisons of the variances between the groups of fraud and no fraud community
banks indicated the significant differences for most variables. The logistic regression
model formulas tested the null hypotheses and provided a benchmark for the alternative
hypotheses. The logistic regression formula instrument for all alternative hypotheses was
better at predicting the likely outcome than the null hypotheses in a significant manner.
131
The performance ratio model H11 of the logistical regression formula instrument
showed the highest level of model fit and predictive accuracy. The performance ratio
multicollinearity from the performance ratio model, producing a new performance ratio
model, H12.
The new performance ratio model H12 showed high levels of model fit and
predictive accuracy and found three out of nine independent variables significant. The
growth ratio model H21 of the logistical regression formula instrument produced
inconsistent results. The capital ratio model H31 of the logistical regression formula
Chapter 5 includes a discussion of the logistical regression model and the findings
with a review of the research problem, purpose, and research methods in light of the
findings. The discussion addresses the limitations of the study, inferences, and the
significance of the study to the field of leadership. The discussions lead to conclusions,
trust that supports leadership and impairs the stakeholder community (Elliot &
Willingham, 1980). While researchers have written extensively about leadership and
leaders’ qualities, the area of why a leader or manager behaves in an unethical manner is
underresearched (Feeley, 2006). Community banks are increasingly important for local
economies and their performance is a local economic catalyst (Critchfield et al., 2004).
Management fraud in a bank affects the viability of the bank as a financial intermediary
The purpose of the quantitative correlation study was to examine the relationship
between the occurrence of management fraud in community banks in the United States
and financial ratios the FDIC uses to monitor the safety and soundness of banks. Earlier
studies by the OCC (1988), USGAO (1994), and the FDIC (1997) indicated there might
be a link between the occurrence of management fraud and financial failure. The study
was an examination of the ability of financial ratios used by the FDIC to predict the
Conclusions
A matched pairs design facilitated the selection of the experimental and control
groups. The management fraud group was the experimental group. The sample of
community banks was drawn from FDIC financial data. A termination or prohibition
order issued by the FDIC was the criterion for the selection of community banks where
management fraud occurred. The total sample size was 266, forming 133 matched pairs
of community banks.
133
Three groups of financial ratios (i.e., performance, growth, and capital) were the
independent variables examined for the ability to predict the occurrence of management
fraud, the dependent variable. The independent variables were tested for the ability to
predict the occurrence of management fraud at intervals of 1, 2, and 3 years before the
Accountants use financial ratios to detect and prevent management fraud. AICPA
auditing standards board released SAS 99 that outlined an approach to the detection and
prevention of material financial statement fraud that included (a) a culture of honesty and
high ethics, (b) antifraud controls, and (c) oversight (AICPA, 2005). While AICPA
guidelines provide a basis for evaluation, the methodology used to implement the
guidelines might have affected their effectiveness (Kaminski et al., 2004). Previous
researchers found that ratio analysis had a limited ability to detect a fraudulent reporting
firm from a nonfraudulent reporting firm. While the current study did not include the
same set of ratios as used in earlier studies, 16 of the 26 financial ratios were significant
in at least one time interval. Only one variable was not significant in all time intervals. In
all, eight financial ratios were significant in all time intervals. Unlike findings from
earlier studies, 31% of the financial ratios used by the FDIC were significant in multiple
time intervals.
The performance ratio model H11 had superior results in predicting the likelihood
of management fraud occurring in all three time intervals. The findings indicate that
financial ratios and performance ratios in particular are highly successful in predicting
conditions that increase the likelihood of management fraud. The alternative Hypothesis
Earlier studies have shown mixed results. D’Aveni’s (1989) and Wheelock and
Apostolou et al. (2001) examined the fraud risk factors that auditors use in
making a determination during an external audit. Apostolou et al. found that auditors
economic characteristics to be the least effective method of evaluating the risk factors of
fraudulent activities.
H21: Community banks with high growth ratios have an increased occurrence of
In two time intervals of the growth ratio model, H21(t-1) and H21(t-3), showed an
increased ability in explaining the variations in the dependent variable than the null
hypothesis. Both H21(t-1) and H21(t-3) showed a lesser degree of explanation than the
135
performance ratio models H11 and H12. The H21(t-2), alternative hypothesis produced poor
Rapid growth has been previously identified as a risk factor for the occurrence of
management fraud. Rapid asset growth combined with falling capital ratios is an
indicator of concern for developing moral hazard within a banking institution (King et al.,
2005). The current study findings confirm the relationship between growth and
management fraud. The H21(t-1) and H21(t-3) growth ratio models showed better predictive
abilities than the null hypothesis. The lack of model fit for H21(t-2) suggests that more
work is needed to refine the connection between growth and the occurrence of
management fraud.
H31: Community banks with poor capital ratios have an increased occurrence of
In the capital ratio model H31, all three models were significant in the overall
model fit, but all capital ratio models H31 showed only marginal ability to predict a no
fraud community bank outcome. This result is contrary to the concept that measures of
Cebula (1999), Wheelock and Wilson (2000), and Estrella et al. (2000) used
positions as illustrated by capital ratios are all strong predictors of organizational decline.
In the current study, capital ratios showed only a marginally better ability to predict
Three independent variables in the performance ratio model H12 were significant
in the three time intervals. The three variables were NTLNLSR net charge-offs to loans,
ASTEMPM assets per employee, and IDLNCORR net loans and leases to core deposits.
NTLNLSR and IDLNCORR both focus on loans, their quality, and how they are
supported. Findings in previous studies have supported the relationship between loans
and management fraud at banks (FDIC, 1997; OCC, 1988; USGAO, 1994).
The significance of ASTEMPM was not expected nor was the negative direction
of the B-value. ASTEMPM was also significant in the growth ratio models H21(t-1) and
H21(t-3). Assets per employee are a measure of efficiency in the use of resources rather
Limitations
definition of management fraud in the study was measurable and involved a single
regulator, the FDIC. There are different methods of defining management fraud in other
industry settings that might not be measurable or consistently applied. The focus of the
study was limited to community banks that are small by definition and represent a less
complex business model than other banks. Generalizing the conclusions of the study to
Implications
intermediary and as an ongoing business and attacks the trust developed with bank
137
stakeholders (BCBS, 2004; Elliot & Willingham, 1980). The results of the current study
suggest that performance ratios used by the FDIC in monitoring community banks’ safety
occurrences. Other methods of measuring financial soundness such as growth and capital
consistently.
banks as well as many publicly traded organizations (Altman, 1983; Kaminski et al.,
2004). The evaluation methods include financial ratio analysis (Kaminski et al., 2004).
The ability to use performance ratios in the analytic model of management fraud to
building trust with the community of stakeholders (Burns, 1978). The focus of the study
was the dysfunction that management fraud brings to community banks and the possible
methods of early detection of its presence. Leadership is concerned with end values.
Burns stated, “Leaders ‘raise’ their followers up through levels of morality” (p. 426).
Cressey (1971) stated that certain elements were present when individuals
create conditions in organizations that increase the likelihood of management fraud. The
financial ratios used in the performance ratio model H11 and H12 show a strong
significant variables in H12, a case can be made that the variables represent Cressey’s
conditions.
delinquent loans made by the bank. As the percentage of delinquent loans rises, the
likelihood of management fraud increases. As stated in Table 17, at time interval H12(t-1),
the likelihood of management fraud rises 2.05 fold, in time interval H12(t-2), 3.50 fold, and
The loans a bank makes can become delinquent for various reasons including
poor economic conditions. A rising nonpayment rate can also represent inferior lending
practices or controls at the bank. Cressey’s (1971) fraud triangle suggests that inferior
The variable IDLNCORR net loans and leases to core deposits represents the
percentage of loans supported by core deposits. The FDIC (2007a) defines core deposits
as local checking, savings, or time deposits that are smaller than $100,000. Core deposits
are more stable deposits, considered less sensitive to interest rate variations, and represent
a less volatile source of funding for a bank. As the percentage of loans supported by core
deposits increases, the likelihood of management fraud increases. As stated in Table 17,
at time interval H12(t-1), the likelihood of management fraud rises 1.02 fold, in time
interval H12(t-2), 1.03 fold, and in time interval H12(t-3), 1.03 fold.
All banks in the United States are required to hold a portion of deposits as a
reserve against losses. The greater the percentage of loans to core deposits, the greater the
reliance on more volatile noncore deposits to meet the reserve requirements (Mishkin,
139
2007). An increasing level of loans supported by core deposits can be caused by different
Reliance on more volatile deposits represents increased risk taking and can be an
The significance of variable ASTEMPM assets per employee was not expected.
The negative sign of the B-value indicates an inverse relationship with the occurrence of
management fraud. As the amount of assets per employee increases, the likelihood of
As stated in Table 17, at time interval H12(t-1), the likelihood of management fraud
falls 1.66 (the inverse of .60) fold. In time interval H12(t-2), the likelihood of management
fraud falls 1.92 (the inverse of .52) fold, and in time interval H12(t-3), 1.81 (the inverse of
.55) fold. Assets per employee can represent efficiency. The more efficient the bank’s
operations, the less likely conditions for management fraud will exist.
inefficient use of the resources (Meckling & Jensen, 1976). Inefficient use of a
shareholders. The same principle applies to human resources. The inefficient use of
fraud would also measure management’s attitude to those conditions. Sutherland (1973)
proposed that white-collar crime was a learned behavior prompted by the absence of
individuals who reject it. The acceptance of conditions that increase the likelihood of
management fraud occurs over time and spreads in an organization (Baker & Faulkner,
2003).
ratios of performance, growth, and capital depict the data found in financial statements
that determine the comparative condition of community banks. Financial statements are a
condition of the bank. Financial statements are a lens providing transparency into the
The findings of the current study indicate the analytic model of management fraud
in community banks can be refined. The logistical regression model instrument provides
predictive values based upon the performance ratios used by the FDIC. The performance
(1971).
Viewed over time, the predictive values from the model indicate the degree of
revised model provides theoretical foundations for the use of financial ratios as indicators
Recommendations
The recommendations for future action are comprised of two parts. The first
organizations and how to apply the lessons learned from the study to organizations. The
fraud allows leaders, managers, and stakeholders to consider preventive and corrective
actions to maintain the necessary levels of trust between stakeholders. Leaders should
review the implications of measuring the conditions that make fraud more likely. Leaders
should consider methods of advancing the practical application of the analytical model of
management fraud within their organization. Leaders and stakeholders can use the model
142
management fraud.
the linkage between management fraud and financial analysis. Exploring growth and
capital ratios beyond ratios used in financial decline or by the FDIC is an additional area
of potential research. Other measures of growth and capital such as long- and short-term
growth rates and different capital formations might provide different results.
Additional areas of study include using different populations of different sizes and
industries. The study was limited to a narrow subset of financial institutions in a highly
regulated industry. Expansion of the concepts in the analytic model of management fraud
additional area of potential research. Different standards for defining fraudulent activities
or deceptive practices or legal actions alleging fraud could form the basis for additional
studies. Expanding the timeframe to include a larger sample size or additional time
The focus of the quantitative correlational study was the relationship between the
occurrence of management fraud in community banks in the United States and financial
ratios the FDIC uses to monitor the safety and soundness of banks. The theoretical
143
framework reflected the concept that financial statements provide a lens to view the
when certain conditions were present. In Figure 3, the foundational concepts of Cressey
(1971) and Sutherland (1973) are incorporated into the analytic model of management
The logistical regression model tested three groups of financial ratios (i.e.,
performance, growth, and capital). The performance ratio logistical regression model
provided strong and consistent predictive results over multiple timeframes. The
performance ratio logistical regression model provided strong and consistent predictive
results over multiple timeframes. The results of the performance ratio logistical
regression model (Appendices G, I, and J) support the conceptual framework of the study
as illustrated in the revised analytic model of management fraud (Figure 3). The revised
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Smith, N. C., Simpson, S., & Huang, C. (2006). Why managers fail to do the right thing:
Centre for Marketing Working Paper No. 06-201. Retrieved May 2, 2007, from
http://www.london.edu/Marketing
StatSoft, Inc. (2006). Electronic statistics textbook. Retrieved March 16, 2007, from
http://www.statsoft.com/textbook/stathome.html
Sutherland, E. H. (1973). White collar crime. New York: Holt, Rinehart, and Winston.
database.
Tipgos, M. A. (2002). Why management fraud is unstoppable. CPA Journal, 72(12), 34-
Traynor, W. F. C. (2004). Are the most mistrustful the least trustworthy? Studies of
No. 3137949)
Trevino, L. K., & Brown, M. E. (2004). Managing to be ethical: Debunking five business
United States General Accounting Office. (1994). Bank insider activities: Insider
Wells, J. T. (2001). Why employees commit fraud. Journal of Accountancy, 191(2), 89-
Wheelock, D. C., & Wilson, P. W. (2000). Why do banks disappear? The determinants of
U.S. bank failures and acquisitions. The Review of Economics and Statistics
Williams, R. J., Barrett, J. D., & Brabston, M. (2000). Manager’s business school
Human Relations, 53(5), 691-712. Retrieved November 15, 2005, from ProQuest
database.
World Values Study Group. (2005). World values survey. Retrieved January 10, 2006,
from http://www.worldvaluessurvey.org/
Zahra, S. A., Priem, R. L., & Rasheed, A. A. (2005). The antecedents and consequences
All the data that will be used in the study is in the public domain and as such does
not require obtaining permission or informed consent. The financial data will be drawn
issued by the FDIC will be drawn from a publicly available database maintained by the
http://www.fdic.gov/bank/individual/enforcement/index.html.
Although the raw data are available from a public domain, these data will be
reorganized, coded, and analyzed to test the Hypotheses. During and after the data
organization and analysis process, the coded data will be stored in a locked cabinet and
will be accessible only by the researcher. All data will be secured for a period of three
http://www.fdic.gov/bank/individual/enforcement/index.html
162
DOWNLOAD
163
164
MODELS
166
Table D1
Variables Fraud N M SD SE
Table D1 (continued).
Fraud N M SD SE
Table D2
Variable Fraud N M SD SE
Table D2 (continued).
Variable Fraud N M SD SE
Table D3
Variables Fraud N M SD SE
Table D3 (continued).
Variables Fraud N M SD SE
Table D4
Variables Fraud N M SD SE
Table D5
Variables Fraud N M SD SE
Table D6
Variables Fraud N M SD SE
Table D7
Variables Fraud N M SD SE
Table D8
Variables Fraud N M SD SE
Table D9
Variables Fraud N M SD SE
Table E1
p 95% C.I.
Table E1 (continued).
p 95% C.I.
Table E2
p 95% C.I.
Table E2 (continued).
p 95% C.I.
Table E3
p 95% C.I.
Table E3 (continued).
p 95% C.I.
Table E4
p 95% C.I.
Table E5
p 95% C.I.
Table E6
p 95% C.I.
Table E7
p 95% C.I.
Table E8
p 95% C.I.
Table E9
p 95% C.I.
APPENDIX F: HISTOGRAMS
186
0.00 1.00
20
15
Count
10
0
1.00 2.00 3.00 4.00 5.00 6.00 1.00 2.00 3.00 4.00 5.00 6.00
ASTEM PM ASTEM PM
0.00 1.00
40
30
Count
20
10
0.00 1.00
100
75
Count
50
25
0
-20000.00 -10000.00 0.00 10000.00 -20000.00 -10000.00 0.00 10000.00
ELNANTR ELNANTR
0.00 1.00
75
50
Count
25
0
0.00 250.00 500.00 750.00 0.00 250.00 500.00 750.00
IDDIVNIR IDDIVNIR
0.00 1.00
20
15
Count
10
0
0.00 50.00 100.00 150.000.00 50.00 100.00 150.00
IDINCORR IDINCORR
0.00 1.00
20
15
Count
10
0
1.00 2.00 3.00 4.00 5.00 1.00 2.00 3.00 4.00 5.00
INTEXPY INTEXPY
0.00 1.00
30
20
Count
10
0
4.00 6.00 8.00 10.00 12.00 4.00 6.00 8.00 10.00 12.00
INTINCY INTINCY
0.00 1.00
30
Count
20
10
0
2.00 4.00 6.00 8.00 2.00 4.00 6.00 8.00
LNATESR LNATESR
0.00 1.00
30
Count 20
10
0
25.00 50.00 75.00 100.00 125.00 25.00 50.00 75.00 100.00 125.00
LNLSDEPR LNLSDEPR
0.00 1.00
125
100
Count
75
50
25
0.00 1.00
75
50
Count
25
0
0.00 5.00 10.00 15.00 0.00 5.00 10.00 15.00
NCLNLSR NCLNLSR
0.00 1.00
20
15
Count
10
0
2.00 4.00 6.00 8.00 2.00 4.00 6.00 8.00
NIMY NIMY
0.00 1.00
50
40
Count
30
20
10
0.00 1.00
40
30
Count
20
10
0.00 1.00
40
30
Count
20
10
0.00 1.00
75
50
Count
25
0
0.00 4.00 8.00 12.00 0.00 4.00 8.00 12.00
NPERFV NPERFV
0.00 1.00
Count 60
40
20
0
0.00 5.00 10.00 15.00 0.00 5.00 10.00 15.00
NTLNLSR NTLNLSR
0.00 1.00
50
40
Count
30
20
10
0.00 1.00
Count 60
40
20
0
-150.00 -100.00 -50.00 0.00 -150.00 -100.00 -50.00 0.00
ROE ROE
0.00 1.00
75
Count
50
25
0
-150.00 -100.00 -50.00 0.00 -150.00 -100.00 -50.00 0.00
ROEINJR ROEINJR
0.00 1.00
20
15
Count
10
0
1.00 2.00 3.00 4.00 5.00 6.00 1.00 2.00 3.00 4.00 5.00 6.00
ASTEMPM ASTEMPM
0.00 1.00
40
30
Count
20
10
0.00 1.00
100
75
Count
50
25
0
0.00 4000.00 8000.00 12000.00 0.00 4000.00 8000.00 12000.00
ELNANTR ELNANTR
0.00 1.00
75
50
Count
25
0
-400.00 0.00 400.00 800.00 -400.00 0.00 400.00 800.00
IDDIVNIR IDDIVNIR
0.00 1.00
20
15
Count
10
0
25.00 50.00 75.00 100.00125.00 25.00 50.00 75.00 100.00125.00
IDLNCORR IDLNCORR
0.00 1.00
25
20
15
Count
10
1.00 2.00 3.00 4.00 5.00 6.00 1.00 2.00 3.00 4.00 5.00 6.00
INTEXPY INTEXPY
0.00 1.00
40
30
Count
20
10
0.00 1.00
40
30
Count
20
10
2.00 4.00 6.00 8.00 10.00 2.00 4.00 6.00 8.00 10.00
LNATRESR LNATRESR
0.00 1.00
20
15
Count
10
0
0.00 25.00 50.00 75.00 100.00 0.00 25.00 50.00 75.00 100.00
LNLSDEPR LNLSDEPR
0.00 1.00
100
75
Count
50
25
0
2000.00 4000.00 6000.00 8000.00 2000.00 4000.00 6000.00 8000.00
LNRESNCR LNRESNCR
0.00 1.00
60
Count
40
20
0
0.00 5.00 10.00 15.00 0.00 5.00 10.00 15.00
NCLNLSR NCLNLSR
0.00 1.00
30
20
Count
10
0
2.50 5.00 7.50 10.00 12.50 2.50 5.00 7.50 10.00 12.50
NIMY NIMY
0.00 1.00
40
Count 30
20
10
0.00 1.00
40
30
Count
20
10
0.00 1.00
30
20
Count
10
0
2.00 4.00 6.00 8.00 10.00 2.00 4.00 6.00 8.00 10.00
NONIXY NONIXY
0.00 1.00
75
50
Count
25
0
0.00 4.00 8.00 12.00 0.00 4.00 8.00 12.00
NPERFV NPERFV
0.00 1.00
60
Count
40
20
0
0.00 2.00 4.00 6.00 0.00 2.00 4.00 6.00
NTLNLSR NTLNLSR
0.00 1.00
30
Count
20
10
0
-4.00 -2.00 0.00 2.00 -4.00 -2.00 0.00 2.00
ROA ROA
0.00 1.00
40
30
Count
20
10
0.00 1.00
40
30
Count
20
10
0.00 1.00
20
15
Count
10
0
1.00 2.00 3.00 4.00 5.00 6.00 1.00 2.00 3.00 4.00 5.00 6.00
ASTEMPM ASTEMPM
0.00 1.00
75
50
Count
25
0
100.00 200.00 300.00 400.00 100.00 200.00 300.00 400.00
EEFFR EEFFR
0.00 1.00
75
50
Count
25
0
-5000.00 0.00 5000.00 10000.00
-5000.00 0.00 5000.00 10000.00
ELNANTR ELNANTR
0.00 1.00
40
30
Count
20
10
0.00 1.00
125
100
Count
75
50
25
0.00 1.00
25
20
15
Count
10
1.00 2.00 3.00 4.00 5.00 1.00 2.00 3.00 4.00 5.00
INTEXPY INTEXPY
0.00 1.00
50
40
Count
30
20
10
0.00 1.00
30
20
Count
10
0
0.00 2.00 4.00 6.00 0.00 2.00 4.00 6.00
LNATRESR LNATRESR
0.00 1.00
50
40
Count
30
20
10
0.00 1.00
100
75
Count
50
25
0
2500.00 5000.00 7500.00 10000.00 2500.00 5000.00 7500.00 10000.00
LNRESNCR LNRESNCR
0.00 1.00
60
40
Count
20
0
0.00 5.00 10.00 15.00 0.00 5.00 10.00 15.00
NCLNLSR NCLNLSR
0.00 1.00
40
30
Count
20
10
0.00 1.00
75
50
Count
25
0
-12.00 -8.00 -4.00 0.00 -12.00 -8.00 -4.00 0.00
NOIJY NOIJY
0.00 1.00
40
30
Count
20
10
0.00 1.00
40
30
Count
20
10
0.00 1.00
75
50
Count
25
0
0.00 5.00 10.00 15.00 0.00 5.00 10.00 15.00
NPERFV NPERFV
0.00 1.00
75
50
Count
25
0
0.00 2.00 4.00 0.00 2.00 4.00
NTLNLSR NTLNLSR
0.00 1.00
75
50
Count
25
0
-12.00 -8.00 -4.00 0.00 -12.00 -8.00 -4.00 0.00
ROA ROA
0.00 1.00
60
40
Count
20
0
-80.00 -40.00 0.00 40.00 -80.00 -40.00 0.00 40.00
ROE ROE
0.00 1.00
50
40
Count
30
20
10
0.00 1.00
20
15
Count
10
0
1.00 2.00 3.00 4.00 5.00 6.00 1.00 2.00 3.00 4.00 5.00 6.00
ASTEMPM ASTEMPM
0.00 1.00
60
Count
40
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
EQV EQV
0.00 1.00
20
15
Count
10
0
0.00 0.50 1.00 0.00 0.50 1.00
ROLLPS5TA ROLLPS5TA
0.00 1.00
25
20
Count
15
10
0.10 0.20 0.30 0.40 0.50 0.10 0.20 0.30 0.40 0.50
ROVLTA ROVLTA
0.00 1.00
20
15
Count
10
0
1.00 2.00 3.00 4.00 5.00 6.00 1.00 2.00 3.00 4.00 5.00 6.00
ASTEMPM ASTEMPM
0.00 1.00
60
Count
40
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
EQV EQV
0.00 1.00
30
20
Count
10
0
0.00 0.50 1.00 0.00 0.50 1.00
ROLLPS5TA ROLLPS5TA
0.00 1.00
20
15
Count
10
0
0.00 0.10 0.20 0.30 0.40 0.00 0.10 0.20 0.30 0.40
ROVLTA ROVLTA
0.00 1.00
20
15
Count
10
0
1.00 2.00 3.00 4.00 5.00 6.00 1.00 2.00 3.00 4.00 5.00 6.00
ASTEMPM ASTEMPM
0.00 1.00
75
50
Count
25
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
EQV EQV
0.00 1.00
30
20
Count
10
0
0.25 0.50 0.75 1.00 1.25 0.25 0.50 0.75 1.00 1.25
ROLLPS5TA ROLLPS5TA
0.00 1.00
25
20
Count
15
10
0.00 0.10 0.20 0.30 0.40 0.00 0.10 0.20 0.30 0.40
ROVLTA ROVLTA
0.00 1.00
60
Count
40
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
EQV EQV
0.00 1.00
75
50
Count
25
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBC1AAJ RBC1AAJ
0.00 1.00
60
40
Count
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBC1RWAJ RBC1RWAJ
0.00 1.00
60
40
Count
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBCRWAJ RBCRWAJ
0.00 1.00
60
Count
40
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
EQV EQV
0.00 1.00
75
Count
50
25
0.00 1.00
60
40
Count
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBC1RWAJ RBC1RWAJ
0.00 1.00
60
40
Count
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBCRWAJ RBCRWAJ
0.00 1.00
75
50
Count
25
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
EQV EQV
0.00 1.00
75
50
Count
25
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBC1AAJ RBC1AAJ
0.00 1.00
60
40
Count
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBC1WAJ RBC1WAJ
0.00 1.00
60
40
Count
20
0
20.00 40.00 60.00 80.00 20.00 40.00 60.00 80.00
RBCRWAJ RBCRWAJ
MODEL
229
MODELS
233
Table (continued).
MODEL
236
Table (continued).
Table K1
Table K1 (continued).
Table K1 (continued).
Table K1 (continued).
Table K2
Table K2 (continued).
Table K2 (continued).
Table K2 (continued).
Table K3
Table K3 (continued).
Table K3 (continued).
Table K3 (continued).
Validation Analysis
Hypotheses Classification
Table M1
Table M2
Table M3
Casewise List
** Misclassified cases
259
Analysis of Outliers
Alternative Chi-square df p
Table (continued).
Analysis of Outliers