Strategic Partnership model for Defence - Modi govt's SEZ moment?

After a long and tortuous journey, the Ministry of Defence (MoD) recently finalised the Strategic Partnership (SP) model for defence manufacturing. The salient points of the new policy are as follows:

1. Four key systems - Single engine fighter aircraft, helicopters, submarines and Main Battle Tank/Armoured Fighting Vehicles - have been opened up for private sector manufacturing. While the first two have been opened up exclusively for private sector manufacturing, the last two are open for PSU/OFB to bid for as well.

2. There will be ONE SP per project selected.

3. The SP will require tie-ups with foreign Original Equipment Manufacturers (OEM), to cover manufacturing, transfer of technology (ToT), assistance in training skilled human resources and other support.

The putative objectives of the policy are clear and have been discussed for years. Create a Military Industrial Complex (MIC) in India, provide competition to an inefficient PSU eco-system, and prmote indigenous solutions to our large defence requirements. The question is, does the policy do so?

Shorn of the hype and hyperbole, not only does the policy not seem to achieve any of the stated objectives, it in fact lends itself to massive rent-seeking opportunities (or at least motivations for the same). At its core, the policy seems geared to simply replace a public sector license-manufacturing monopoly into a private sector license manufacturing monopoly. 

Lets look at the structural elements. 

First, the defence industry, by its very nature, is a monopsony (a market that has only one buyer, and multiple sellers). Typical other examples of monopsony markets are Railway engines, British National Health Service. In such a market, the buyer can maximise value from this market by promoting a high level of competition among many sellers. The issue though is, military technologies, by their very nature, are available with few companies/entities. Ergo, in the best of times, it is difficult to find enough competing sellers to foster genuine competition. Governments around the world therefore try various incentives to foster competition. The new SP policy however, reverses the logic, by creating monopolies in key areas. In short, now the monopsony buyer (the government) creates a monopoly seller to buy from, instead of fostering wide competition to derive maximum value for itself!

Second, the structure envisaged in the new policy is exactly what has prevailed for many decades in India. Typically, the government (and the military) ask a bunch of foreign OEMs to bid for a contract, select one from those who respond (or remain left in the fray after many years of dilly dallying), and then designate a PSU (or OFB) to license produce the product in India. From Mig21s to Su30s, T55s to T90s - this has been the model adopted. The new policy simply replaces the PSU license producer with a selected PRivate Sector SP. The process remains the same - a foreign OEM provides the know-how, a partner Indian SP sets up the manufacturing facilities to license produce the system in India. In other words, convert a public sector monopoly into a private sector monopoly!

Third, the policy supposes that somehow private ownership is the panacea of all ills plaguing the defence industry. Problem is, private sector operates on principles of profit maximisation (as it should). When a policy seems geared to award monopoly status around license manufacturing of a major system owned by a foreign OEM, there is little incentive for the SP to invest in large R&D and achieve true self sufficiency. Long years of license production of Mig21 didnt enable HAL to design a new fighter (or fighter engine) on its own, because it knew when the time comes, it will license manufacture the next generation (which it did, with the Su30). Similarly, a monopoly private company license producing the F16 (say) has no incentive to set up capabilities to design and manufacture the next generation of single engine fighter. It would rather focus on maximising profits for the assembly line by "working the system".

Many years ago, the UPA government unveiled an ambitious SEZ policy, to emulate China's success with SEZ. But thanks to the design of the same, the policy became a tool for tax avoidance and real estate - related land grabbing. Very quickly, the entire process got embroiled in litigations, allegations of corruption and controversies. It was a design defect with the policy itself. The defence SP policy portends to a similar fate

India's defence expenditure - its a problem of quality, not quantity

Do we spend enough on defence? The general narrative in the commentariat forever is a resounding NO. The point received some recent impetus when the Army Chief, General Bipin Rawat said that the military is not getting its due share of national resources. For good measure, the Chief also said that India should take lessons from China in this regard.

Lack of enough spends on defence is an old chestnut - question is, how valid or even accurate is it?

Lets look at the headline number everyone quotes (often inaccurately), military spending as a % of GDP.

Source: World Bank

As can be seen, not only is India well in line with rest of the world in terms of how much of our GDP we spend on defence, we are in fact ahead of China in this regard. Of course, given the disparity in the relative economic sizes, China spends a lot more on absolute terms, but the solution to that is to expand our own resource base (GDP) to afford a greater spend. However, do we spend too little? Data doesnt suggest that at all, in fact its quite to the contrary.

However, its not just about GDP, but also budget expenditure-intensity of defence. Finally, defence can be funded only out of the public exchequer. And there are competing demands for the limited tax-kitty that funds defence too. And it is here that India is an absolute outlier, on the negative kind.

Chinese budget numbers are not available, but India spends clearly a very high proportion of its Central Budget on defence. Comparable to the US, and only marginally short of Pakistan, where the military is in charge of government and tends to have outsized share of resources and influence.

Put the two together - proportion of GDP and proportion of central govt expenditure, and the oft-repeated lament of low spend on military doesnt stand up to scrutiny. So, what really is the issue?

In simple terms, its quality not quantity. We spend enough, but we underspend on quality. It has 2 facets.

One, we spend too much on salaries and pension. In the last 4-5 years, 45-50% of the defence budget has been spent on personnel costs. As a comparative benchmark, US spends around 25-30% of its defence budget on personnel costs. Bad news doesnt end there though. Thanks to OROP and a steady increase in the number of personnel (Indian Army has expanded around 25% in the last 15 years, a period when almost all major militaries have downsized on personnel), the pressure of salaries/pension is only going to increase.

Two, India is unique in terms of its import-intensity of expenditure on military. For years, we have been amongst the top 3/4 weapons importers in the world. Of late, we have acquired the dubious distinction of being the numero uno!

Source: SIPRI

Countries which spend more than India on defence (as proportion of GDP) - Russia, US, Israel - typically are large net exporters. The military industrial complex is a large part of their domestic economies/employment. For India, conversely, large chunks of the defence budget go to financing imports, with no network externalities in the domestic economy. Its a double whammy, where we spend a pretty large sum of money, while not creating long term benefits for the economy. There is adverse military impact too, as imported weapons are often not available when they are most needed (ammunition for Bofors gun during Kargil as a case in point).

In nutshell, Gen Rawat (and the commentariat) is completely wrong. India doesnt lag in spending on defence - we spend as much as we can afford (and some more). The issue is on quality. Unless we improve upon that, we will continue to derive sub-optimal outcomes for the considerable sums that we are spending on securing India. 

SEATO – an idea whose time has (finally) come

Of the many alliances spawned by the Cold War, few died as unmourned as SEATO (South East Asia Treaty Organisation). Marketed as a South-east Asian version of NATO, an anti-Soviet/Communist security alliance, it bore few of the imprimatur of its European inspiration. To start with, it had too many members that were very far (geographically, as well as in terms of political mindspace) from South East Asia. Most importantly, while it was a military alliance in essence, it lacked NATO’s “boots on the ground” – member countries didn’t contribute to and create standing forces of soldiers, ships and aircraft.

As a result, when SEATO formally disbanded in 1977, few tears were shed. Its time to consider a rebirth though. A newly imagined SEATO would serve two mutually re-inforcing imperatives facing Asia today. One, as an alliance against an increasingly assertive and confrontational China, a country with boundary (or maritime) disputes with almost all of its neighbours. 

Two, as a hedge for the increasingly isolationist United States, whose military umbrella (and nuclear too, for many Asian countries) has enabled the region profit from globalisation in relative peace.

The imperative for an alliance is clear – Chinese belligerence radiating out of its periphery across the length and breadth of Asia. The Dash9 issue, seizing Singaporean APCs in Hong Kong, open bullying of Mongolia (and the more recent diplomatic kerfuffle with India) on the Dalai Lama issue, simmering disputes with Vietnam, exacerbating old disputes with India – Chinese hawkishness has assumed a dramatically higher level of edge in the last 5/6 years. The existing security architecture, both diplomatic (APEC/ASEAN/Indo-China Boundary Commission) as well as military (essentially US military presence in Asia) have proven to be insufficient in tempering the noise. With the “America first” approach of President Trump, the sufficiency of the existing architecture comes under even greater scrutiny.

A resurrected SEATO becomes an interesting policy response in the current scenario. The toughest part of a new SEATO would be the balance between the structural and the political. A formal military alliance will invariably meet with violent diplomatic reaction from China. An informal multilateral exercise effort (like Red Flag, Malabar etc) reflects a transient, ephemeral optics without any real deterrence value. There is also the issue of different, sometimes zero-sum political disputes between various Asian states (Singapore and Malaysia for example) that would bedevil a security alliance with strong military commitments.

To start off with meaningful chance of success, the new SEATO should be formulated around 2 core principles. One, it needs to be led by Asian member countries. US participation could be a glue (and a source of technical and military support), but the organisation cannot be led by the US. This would immunise new SEATO from Sino-US tensions and disputes, substantially. Two, the core of new SEATO should be around existing, well-discovered security dialogues. Membership can radiate out from a consistent core.

Keeping the above in mind, new SEATO would be best constructed around an Indo-Japanese core, with invitation open to all Asian countries willing to join. Why India and Japan? First, economically and strategically, these are two biggest Asian powers, after China, with the military and economic capacity to building a “boots on the ground” security architecture. Second, India and Japan share an enormous convergence on key strategic issues facing the region, and very few dissonances. Third, complimentary military capabilities (eg, Japanese Navy has top class ASW, while Indian Navy brings heavy Surface/Land attack firepower). A SEATO led by Asia’s second and third largest economies (and militaries) would provide the centripetal impetus for other Asian countries to join up. In the first phase, Vietnam, Singapore and Indonesia would be the first obvious candidates for membership.

The good news is there are existing infrastructure available to kickstart formation of a standing security force for the new SEATO, in the form of India’s Andaman and Nicobar Command (ANC). Based out of the Andaman and Nicobar islands, straddling the chokepoint of straits of Malacca in the Indian Ocean, ANC is like an “unsinkable aircraft carrier”. Today, it is India’s only operational joint services command, with one infantry brigade, some small naval ships and a squadron of IAF transport choppers. In recent years though, there’s been significant upgrades to the infrastructure in ANC. The base today can house and operate destroyer-sized ships and Su30/P8I class aircraft. Adding in 2-3 frigates and LSTs each from both Indian Navy and JMSDF, a squadron of fighters on rotation and a mixed squadron of P8I and P3C maritime patrol aircraft– it would represent a very formidable strike force. The joint strike force would draw upon the experiences of Malabar and Sahyog-Kaijin maritime exercises to enhance interoperability. Other potential member states like Indonesia and Vietnam operate Russian platforms (Su30 aircraft, Kilo-class submarines, Petya-class frigates) maintained by India and whose crews are trained by the Indian military.

Formation of such a strong permanent standing force at the heart of the Straits of Malacca will send a powerful message to China, as well as to the broader region. It will be about Asia taking charge of its own security by putting boots on the ground, and refusing to be picked off in individual disputes with China.

Its not very often that history comes full circle, so soon. But the idea of a new SEATO is one whose time has re-arrived!

India's nuclear posture - the change is in (expert) minds!

In the last few weeks, the niche (but rapidly growing, and influential) community of strategic affairs experts have been agog and abuzz with a new postulate – a putative change in India’s NFU doctrine governing use of nuclear weapons. A few months back, then-Defence Minister Manohar Parrikar created some flutters by “thinking aloud”, in a public function, the merits of NFU. But the latest round of speculations have largely owed their origins to ex-NSA Shiv Shankar Menon’s book, Choices.

Three widely-read commentators – VipinNarang, Shashank Joshi and Ajai Shukla – wrote interpretive pieces on a couple of paragraphs in Menon’s book. The key message was essentially the following:

1. India’s NFU has suspect credibility with the Pakistanis, especially w.r.t a response to a Pakistani tactical nuclear strike on Indian formations within Pak.
2. Menon is alluding to carving out a “first strike” option outside of NFU for India, which would mean India could go for pre-emptive Counter Force posture (seeking to destroy Pakistani nukes), rather than Counter Value (destroying Pakistani cities/population centres) posture latent in NFU today.
3. In simple words, what it means is that India would look to strike first, and look to seek and destroy Pakistani nuclear weapons. This is obviously a 180 degree turn in India’s current posture, which is NFU (No First Use), and strike second in response to an attack, and hit the enemy’s population centres.

Nuclear postulates by definition are dense, prone to heavy interpretation of sentences (even words!), and generally light on real data/information. It is one area where the number of people who are “in-the-know” is small, and “those who know don’t talk, those who talk don’t know”. Hence, drawing conclusions is more hazardous than in the field of economics (which for good reason, is always compared unfavourably with astrology)!

In this case though, it would seem that the authors have collectively ended up over-interpreting a few sentences (Group Think perhaps?).

Leaving aside Menon’s book for a moment, lets look at (relatively) confirmed information on hand.

One, India continues to consider nuclear weapons as weapons of deterrence, and not of warfighting. What it means is that India does NOT expect to use these weapons ever, and possesses them merely to deter other countries from using them against us. This is the reason why India hasn’t embarked upon a tactical nuclear bomb programme, despite having the means to do so (2 out of the 5 tests in Pokhran II were tactical warheads). Importantly, when ManoharParrikar “though aloud”, the Ministry of Defence (MoD) came out with a clarification within hours contradicting its own minister. This isn’t something that is usual in India, and the Establishment wouldn’t have reacted with such decisive alacrity if there was something more serious about Parrikar’s kite flying.

Two, a first strike, Counter Force doctrine involves crucial changes on the weapon profiles. To start with, it requires a vastly greater number of warheads (as the country using nukes first would necessarily have to be prepared for a third strike, in retaliation of the adversary’s invariable second strike). The glacial pace of India’s nuke accretion indicates nothing of this sort. Further, a CF posture would almost necessarily require MIRV warheads, to increase the possibility of success of the “first strike”. India’s MIRV programme has progressed at an extremely slow pace. On the contrary, the focus of the strategic programme has been overwhelmingly on survivability of missiles (hence road-mobile, caniserised Agni) and of the launch platforms (hence the Arihant fleet of nuke submarines). Both of these are a lot more expensive and time-consuming than either producing more warheads or MIRV, and actually fit nicely with the current stated NFU posture.

Three, Pakistani geography makes hoary distinctions between CF and CV rather moot. A decapitating first strike against (say), Kahuta, is likely to cause large-scale damage to Rawalpindi. Sans a 100% take-out of Paki weapons (an outcome that even US forces cannot guarantee), a proportionate retaliation by Pakistan will invariably be on major Indian cities. India’s primary objective (unlike Pakistan’s) is precisely to avoid such outcomes altogether. Hence, there is little incentive for India to carry out such an attack.

Finally, coming back to Menon and his book. While interpretation is the mother of discovery in nuclear affairs, in this very candid interview, the author himself seems to only reiterate the validity of India’s current stance.

So it’s important that we keep reviewing [NFU] but so far I think it’s actually served our purpose.
Retaliation for us – we’ve laid down quite clearly the conditions under which we would use them. And I think we’ve made that quite clear in the doctrine. We are, in fact, one of the first countries to be so clear and one of the quickest off the mark in terms of declaring a doctrine.  And we have so far matched that in terms of our posture, in terms of what we do.
I think it’s quite clear that no matter what the scale, any nuclear attack will be met with retaliation, and the retaliation will be big.

In a nutshell, more of the same! Net net, it made for interesting reading, but it would seem that India’s nuke posture would keep giving everyone only a sense of déjà vu. Not great for analysts, but good for all of us hoi polloi!

The very BAD idea of a Bad Bank

The idea of a "Bad Bank" as a solution to India's large bank NPA problem isnt new. Its been around for many years, discussed, implemented in parts (through different experiments of Asset Reconstruction Companies, ARCs). But recently, the idea received some high level policy support, when the CEA Arvind Subramanium wrote an entire section of the Economic Survey on the idea, essentially saying "its an idea whose time has come". Now, while Victor Hugo might disagree from his grave, but this is one idea against which all powers must be used, even if its time has come. Simply because its a really bad idea - structurally, conceptually and implementation-wise. How? Read on...

What are the basic parameters of resolving a bad loan (NPA) issue? As practising bankers (as opposed to many Central Bankers, and most/all journalists/academics) would instinctively know, it consists of 4 basic rules:

One, estimating and affecting a haircut on the loan amount, in order to make the underlying operating business viable, and able to service the loan.
Two, a turnaround plan for the business that extracts maximum value for the bank - both on loan recovery as well as potentially on the equity that replaced the loan haircut taken. This includes changing promoters, structuring, legal etc.
Three, immediate capital to enable the bank absorb the haircut.

Four, specialist bankers with the skillsets to carry out #1 and 2.

Why has India's NPA issue been so intractable? Very simple - there are structural impediments to #1 and #4 above.

One, thanks to the scourge of the 3 Cs (CBI, CAG, CVC), public sector bankers (PSB) have been loathe to structuring haircuts for any of the loans gone bad, or under stress. They have found it a lot easier to simply evergreen the liability - in simple language, leave the problem for their successors to resolve. As a result, a stressed loan of (say) INR 100, after unpaid interest, interest on interest, fines on delay on interest payment, balloons to double or even more by the time someone starts taking action. The storied Kingfisher Airline is a case in point - of both bankers evergreening the loan for years, as well as refusing a sensible haircut-backed settlement. 

Secondly, bank recapitalisation has progressed in wholly inadequate quantums. Nifty acronyms (like INDRADHANUSH) has been hilariously tried in lieu of adequate capital being injected. Thanks to depressed valuation levels (as well as lack of investor appetite), it has been impractical for banks to tap capital markets for equity capital.

How does a Bad Bank (BB) resolve any of the above two issues? It doesnt. A govt-owned BB would simply be a case of "left pocket right pocket", both in terms of capital as well as in terms of enabling operating environment (3 C's). A private sector BB would have moral hazard questions (for example, at what value would be buy the NPAs from the existing banks?) that would compound the 3 C's related issues for PSBs.

We have no dearth of #4, ie, bankers who know the industry domain and can come up with solutions. Over the years, the legal-regulatory architecture for #2 - creating new lending structures, knocking off promoters, bringing in specialist managers - have also become a lot more conducive.

And there lies the nub of the real solution. As Mark Antony remarked, "the fault, dear Brutus,is not in our stars, but within ourselves". The issue is within the government - a 3rd party structure isnt going to help. A large dose of capital (good news - demonetisation has injected part of it into balance sheets), financed through any of the many clever ideas long debated (RBI reserves, SPV, Bank HoldCo listing etc) will be a first step. Taking PSBs off the category of "public servants", and hence taking them away from the ambit of the 3 C's, will complete the enabling circle. This will free up banker energies towards searching for pragmatic, real solutions, ring fence them from much-abused and uninformed criminal investigations and incentivise true problem-solving.

Talk is cheap, acronyms cheaper, and bad ideas have negative value. The government should concentrate on walking the real talk now - there's been enough of talk/acronyms/bad ideas!

Cold Start - a real Hot option, only leaves our commentariat cold!

The new Army Chief, Gen Bipin Joshi set the proverbial cat among the pigeons when he made a clear, unambiguous reference to Cold Start Doctrine (CSD) as a live war strategy option against Pakistan. It led to a flurry of "deja vu" responses - from Pakistan and the Indian (and global) commentariat. From Pakistan, the usual "we will nuke India with tactical weapons" narrative was trotted out. Given the frequency with which Pakistani politicians (and military) make nuclear threats, the marginal concern about a new one is rather low. More interesting though was the response of the global strategic commentariat. In a series of newspaper columns, analysts Vipin Narang, Walter Ladwig, George Perkovich (and many others) addressed (or referred to) Cold Start. The general view was the same, and can be encapsulated in the following points:

1. Indian military doesnt have the required capacity to carry out CSD.
2. Indian tanks lack nightfighting equipment, artillery hasnt seen any new induction for 30 years, IAF has 33 squadrons of fighters against a projected 42, Indian submarine programme is running decades late.
3. The higher defence organisation envisaged in CSD (formation of 8 IBG - Integrated Battle Groups) hasnt been affected. Nor has the long pending reforms around Chief of Defence Staff seen any great traction.

In a nutshell, neither in equipment nor in doctrinal/structural developments is the Indian Army in a position to execute CSD. Given that it gives Pakistan the excuse to trot out destabilising Tactical Nuclear Weapons (TNW) it is a futile exercise to refer to it.

Unfortunately, the commentariat has got it wrong, completely. Born out of the experience of the ponderous (and hence ultimately fruitless) mobilisation of Indian Army's Strike Corps during Op Parakram, Cold Start effectively has 3 broad objectives:

One, mobilise a sizeable assault force in quick time (4-5 days) around 1/2 sectors along the International Boundary with Pakistan.
Two, establish local superiority in these sectors by concentrating disproportionate firepower with the assault force.
Three, execute a quick shallow strike along those sectors - "salami slice" enough territory in those sectors to get a time/space advantage over Pakistan, before the international pressure bears down on both countries to cease operations.

A close reading of developments over the last 15 years (since Op Parakram, 2002) shows that there has been steady, perhaps slow, but definite movement towards building up capabilities to execute the limited objectives envisaged under CSD. Lets take a look at some of them.

Force accretion and placement

From 4 RAPIDS (Reorganised Army Plains Infantry Division) - a lightly mechanised/armoured division - in 2002, the Army now has 6 RAPIDs. Of them, 3 of them have been placed (some moved) close to the International Border (in Jodhpur, Kota and Bikaner). These 3 formations form the nuclei of rapid reaction forces near the IB.

A third artillery division, 42 Artillery Division, was raised under SWC in 2008-09. Comprising of both tube and rocket artillery (given the lack of tube artillery acquisition in the last 15 years, this means a conscious strategy of concentrating existing firepower in frontline deployed formations). Further, this new division was also moved to Bassi near Jaipur (from Alwar), closer to the International Border, in 2012. Such a massive concentration of firepower prepositioned near the IB enables high volume fire support at short notice to any quick operation across the border.

Defensive formations (known as Holding Corps) near the IB have been equipped with more mechanised, armour and air defence resources. For example, Jalandhar-based 11 Corps now has mobile SA8/6 SAM systems, transferred from the strike corps (that are being equipped with Akash SAM systems). Such "beefing up" of defensive formations enable them support assault units better by plugging sector-specific gaps in armour/air defence/artillery.

A very large part of the chopper fleet today is night-flying enabled (all Mi17V and ALH-Dhruv can fly at night). As is the renewed transport fleet comprising of C17/C130 planes. All of which enables quick mobilisation of troops at launchpads near the border.

Airbase modernisation has been concentrated around forward air bases. The first IAF base with a fully underground hangars is Uttarlai, near Barmer. 

Structural changes to operations

The jargon used often are "manoevre warfare", "air land" battles. Most of the Indian Army's division (and corps) level exercises in the last 15 years have practised exactly these concepts. From Ex Divya Astra to Ex Shatrujeet, various IA formations have practised mobilising fast, manoevering in integrated air-land battle formations and operating under an NBC umbrella.

In Ex Sudarshan Shakti (2011), the Army publicly explained how it is honing its operations. Instead of static formations with limited number of mechanised/armour assets, the Army now prepares for all formations pooling in assets to smaller assault forces leading an offensive.

The “theatre concept” that army headquarters is trying out is intended to shake the chain of command out of its ennui. Over the years, largely because of a paucity of resources, commands were reluctant to part with their assets to favour units that were not directly under them.
Now, they are being asked to put all assets on the ground to assist the head of an assault force. This will demand a seamless flow, and probably a merger, of logistics branches — like the Army Service Corps — with the strike elements (like the strike corps) and also better co-ordination between commands. 

Threat of nuclear weapons - managing the escalation

Barring the point on Indian "incapabilities", the big bugbear on CSD is the Pakistani threat of using Tactical Nuclear Weapons (TNW) in such a scenario. Besides the bizarre prospect of a country threatening to nuke its own territory (after all, the Indian armoured columns would be inside Pak if CSD was activated), the Indian Army trains and equips extensively for it. Most frontline tank units are equipped with NBC suites. Mechanised units too are being equipped with them now. Most exercises involve a nuclear umbrella as a default operational scenario.

Arrayed against this is a Pakistani Army involved in the deadly Zarb-e-Azb operation against TTP and other islamist groups in FATA/Balochistan, as well as raising new units to protect the CPEC project being executed. 

In a nutshell, the higher defence management in India as well as military capability in India have a lot to be desired. the gaps are many. However, this doesnt mean that limited objectives like the sort envisaged under CSD are way outside the realm of India's capabilities. A military modernised by the sheer weight of 15 years of spectacular economic growth will have something to show for it at the end (against an adversary that has barely staved off bankruptcy in the same period). Crucially, many empirical evidence (some of which explained above) suggest that the Indian military has been preparing for CSD with intent and purpose, and its not just a "war plan on paper".

In an information age where narrative matters in determining national security outcomes (no better instance than Kargil as an instance), it is important that the narrative around Indian capabilities breaks out of the "cannot do anything" paradigm!

Banking capital - Narcissism of rather major differences

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!