A popular social media chestnut arising out of demonetisation is an estimate of the number of monetary economists in India - in last count, it was 500 million and counting! With such massive proliferation of economists/astrologers, "serious" commentary has shifted to banking. It is being widely discussed that bringing cash into the banking system as deposits is a sinister plan to use the same (deposits) to write off bad loans that Indian banks are saddled with.
Normally, such drivel would be dismissed out of hand. But when "serious media" like The Wire publish monographs by academics, and the theme is picked up by Rahul Gandhi as something that merits his (generally limited) attention, it should be examined a bit more closely.
In (practitioner) financial circles, banking capital is a topic of intense scrutiny, attention and action, especially so after the global financial crisis of 2008. Global blue ribbon standards are set out by the Bank for International Settlements (BIS), popularly referred to as Basel "N" (we are currently in Basel III) norms, and local banking regulators set out their own specific guidelines around Basel requirements.
In a nutshell, various types of capital used by banks to fund their balance sheets look like this:
Senior Secured Debt (very rarely used these days) form the safest form of banking capital. Should a bank go bust, the specific securities earmarked against this debt are liquidated to pay back the creditors.
Next comes deposits of all types - checking (current/savings accounts) and term (also known as fixed) deposits. In most countries, retail deposits form the bedrock of public confidence in the financial system. As a result, regulators create an architecture of "protection" around deposits. To start with, most countries have deposit insurance programmes - in India, it is extended by a govt-owned entity called DICGC. Like any other insurance, there is a cost to this, and hence the amount insured is capped (in India, the cap is Rs 1 lac). Extending the insurance to cover all deposits would make costs prohibitively high for depositors, leaving a far lower amount for them on the table as interest on the deposit.
Besides deposit insurance, the entire structure of the rest of banking capital is used to protect deposit-holders from bankruptcies. Whenever there has been a run on a (major) bank, regulators have quickly clamped down by using equity capital (and sometimes taxpayer money) to bail out deposit-holders. From Bank of Rajasthan to Global Trust Bank in India to Washington Mutual during the financial crisis in US - regulators and governments have tended to bail out deposit-holders. In no circumstance can deposit funding be used, structurally, legally and in terms of regulatory forbearance, to fund a NPA write-off by the bank.
How is the above accomplished? By building in "bail in" clauses in ALL other types of banking capital - bonds, hybrids and equtiy. What is "bail in"? Basically, the opposite of "bail out", ie, investors in these instruments would suffer haircuts, either in principal or in interest due, should defined performance benchmarks are missed.
Even "senior unsecured debt" have traditionally tended to be treated with kid gloves by governments (post Lehman Bros, every single major bank bailout globally bailed out all sr unsecured bondholders, at a level equivalent to deposit-holders). Today though, most new issuances of such instruments have "bail in" clauses. In other words, the bond-holders will be asked to take haircuts if certain (steep) benchmarks are missed by the issuing banks.
There has also been a proliferation of subordinated and hybrid instruments in the last few years. These are typically structured as bonds, and have fixed coupon payments, but have relatively narrow performance benchmarks below which investors start losing interest payments and/or principal. In India, the widely popular AT1 bonds (Additional Tier 1 bonds) are an example of such hybrids. These instruments provide additional cushion in bank capital to absorb losses and provide time and space to regulators to move-in with a revival/rescue plan.
Last, but not by far the least, is CET1 (Common Equity Tier 1) capital - this constitutes primarily of capital and retained earnings of the bank, and form the first loss-absorbers for the banks. Over the last 7-8 years, CET1 capital requirements have been enhanced. Under new Basel III guidelines, banks need to have at least 4.5% of their Risk-weighted Assets as CET1 capital. Traditionally, in India and elsewhere, this capital (and its owners, basically the shareholders) has been the first loss-absorbers.
Total capital requirements, comprising of CET1, Subordinated, Hybrids together, touch double digits today (11-13% of risk-weighted assets, under Basel III). On top of that, senior unsecured bonds increasingly have "bail in" features. Depositors, lying "senior" to all of these, usually have little to fear unless there is an Armageddon scenario.
Net net, deposits, and deposit-holders, structurally, philosophically and in terms of precedent, are NOT the first port of capital call when a bank needs to write-off losses. Money coming into the banking system as a result of demonetisation is coming in as deposits. There might be differential views on demonetisation, but conflating deposits with banking capital is indulging in narcissism of really major differences, with due regards to Sigmund Freud!
Normally, such drivel would be dismissed out of hand. But when "serious media" like The Wire publish monographs by academics, and the theme is picked up by Rahul Gandhi as something that merits his (generally limited) attention, it should be examined a bit more closely.
In (practitioner) financial circles, banking capital is a topic of intense scrutiny, attention and action, especially so after the global financial crisis of 2008. Global blue ribbon standards are set out by the Bank for International Settlements (BIS), popularly referred to as Basel "N" (we are currently in Basel III) norms, and local banking regulators set out their own specific guidelines around Basel requirements.
In a nutshell, various types of capital used by banks to fund their balance sheets look like this:
Senior Secured Debt (very rarely used these days) form the safest form of banking capital. Should a bank go bust, the specific securities earmarked against this debt are liquidated to pay back the creditors.
Next comes deposits of all types - checking (current/savings accounts) and term (also known as fixed) deposits. In most countries, retail deposits form the bedrock of public confidence in the financial system. As a result, regulators create an architecture of "protection" around deposits. To start with, most countries have deposit insurance programmes - in India, it is extended by a govt-owned entity called DICGC. Like any other insurance, there is a cost to this, and hence the amount insured is capped (in India, the cap is Rs 1 lac). Extending the insurance to cover all deposits would make costs prohibitively high for depositors, leaving a far lower amount for them on the table as interest on the deposit.
Besides deposit insurance, the entire structure of the rest of banking capital is used to protect deposit-holders from bankruptcies. Whenever there has been a run on a (major) bank, regulators have quickly clamped down by using equity capital (and sometimes taxpayer money) to bail out deposit-holders. From Bank of Rajasthan to Global Trust Bank in India to Washington Mutual during the financial crisis in US - regulators and governments have tended to bail out deposit-holders. In no circumstance can deposit funding be used, structurally, legally and in terms of regulatory forbearance, to fund a NPA write-off by the bank.
How is the above accomplished? By building in "bail in" clauses in ALL other types of banking capital - bonds, hybrids and equtiy. What is "bail in"? Basically, the opposite of "bail out", ie, investors in these instruments would suffer haircuts, either in principal or in interest due, should defined performance benchmarks are missed.
Even "senior unsecured debt" have traditionally tended to be treated with kid gloves by governments (post Lehman Bros, every single major bank bailout globally bailed out all sr unsecured bondholders, at a level equivalent to deposit-holders). Today though, most new issuances of such instruments have "bail in" clauses. In other words, the bond-holders will be asked to take haircuts if certain (steep) benchmarks are missed by the issuing banks.
There has also been a proliferation of subordinated and hybrid instruments in the last few years. These are typically structured as bonds, and have fixed coupon payments, but have relatively narrow performance benchmarks below which investors start losing interest payments and/or principal. In India, the widely popular AT1 bonds (Additional Tier 1 bonds) are an example of such hybrids. These instruments provide additional cushion in bank capital to absorb losses and provide time and space to regulators to move-in with a revival/rescue plan.
Last, but not by far the least, is CET1 (Common Equity Tier 1) capital - this constitutes primarily of capital and retained earnings of the bank, and form the first loss-absorbers for the banks. Over the last 7-8 years, CET1 capital requirements have been enhanced. Under new Basel III guidelines, banks need to have at least 4.5% of their Risk-weighted Assets as CET1 capital. Traditionally, in India and elsewhere, this capital (and its owners, basically the shareholders) has been the first loss-absorbers.
Total capital requirements, comprising of CET1, Subordinated, Hybrids together, touch double digits today (11-13% of risk-weighted assets, under Basel III). On top of that, senior unsecured bonds increasingly have "bail in" features. Depositors, lying "senior" to all of these, usually have little to fear unless there is an Armageddon scenario.
Net net, deposits, and deposit-holders, structurally, philosophically and in terms of precedent, are NOT the first port of capital call when a bank needs to write-off losses. Money coming into the banking system as a result of demonetisation is coming in as deposits. There might be differential views on demonetisation, but conflating deposits with banking capital is indulging in narcissism of really major differences, with due regards to Sigmund Freud!
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