Systemic operational risk: smoke and mirrors

Patrick McConnell

Abstract

ABSTRACT

Christmas 2009 did not bring much festive cheer to the shareholders of Australia's largest banks. On December 23, the so-called four pillars announced simultaneously that their subsidiaries in New Zealand had settled with the New Zealand Inland Revenue Department (IRD) in respect of long-running litigation that resulted in payments of unpaid tax and interest totaling some NZ$2.2 billion. The settlement followed a finding in October 2009, in the High Court of New Zealand, in favor of the local tax authorities regarding a series of "structured finance transactions", which the IRD claimed were specifically designed to avoid paying tax in New Zealand. The transactions in dispute, which numbered only around thirty across the four banks, were, at face value, highly complex and intricate, but, when stripped of the "smoke and mirrors" were little more than standard commercial loans. The profitability, or otherwise, of these disputed transactions depended very much on how profits, losses and tax were accounted for. Because of various tax treaties between New Zealand and Australia, the Australian parents of New Zealand banks are able, under certain circumstances, to offset operating losses against profits being repatriated from New Zealand. This, in effect, could turn a loss-making transaction into a powerful device for shielding profits from tax. The Inland Revenue argued that this tax benefit was, in fact, the "tax tail that wagged the commercial dog" in such transactions. New Zealand courts at various levels agreed with this interpretation and unanimously found that the banks concerned were using these transactions to avoid paying tax. This paper argues that the losses to the Australian banks incurred as a result of the New Zealand tax scandal were, for the most part, a result of systemic operational risk, and, in particular, legal risk. Using examples from published court cases, the paper identifies some of the legal risk that arose using these transactions. The paper then suggests proactive approaches to systemic risk management that should help detect and minimize the impact of similar scandals in future.