The FBR’s probable aim to raise an additional Rs 70-100 billion in tax by imposing a higher tax on banks with a low advance-to-deposit ratio (ADR) is likely to fail. This is because some banks have engineered their books to reach a 50 percent ADR (to incur the additional tax), while others are likely to meet this threshold before December 31st, the date on which the tax will be applied.
As a result, the additional tax collection is likely to be minimal, and the so-called objective of promoting higher credit to the private sector has not been fully realized. It is true that banks’ ADR has increased from 39 percent at the end of August to 47 percent in mid-November. However, it is also a fact that banks’ loan portfolios have increased by 20 percent since September. There has been zero growth in deposits over the last three months, and some banks have even shed deposits. This undermines the primary objective of banks to channel savings.
The main issue is that the ADR tax creates a distortion in the short-term market yield curve and undermines the monetary policy set by the central bank. Three-month and six-month treasury bills are trading at 12.2-12.3 percent, while the policy rate is at 15 percent, making the SBP policy rate largely irrelevant.
Why is this happening?
To counter the higher tax on low ADR, banks began lending to NBFIs, private companies, and others at rates lower than the market rates. This creates an arbitrage opportunity for borrowers to invest in risk-free government securities at a premium over the rates at which they borrowed. Banks are offering new loans at a 3-5 percent (or even steeper) discount to KIBOR, and borrowers are lining up to buy T-bills, which in turn is driving down the T-bill rate. Their margins are very favorable, and investors are indifferent to slight squeezes in returns.
Additionally, banks were imposing service charges on large deposits, a practice that was ended by the SBP’s revision of the Minimum Deposit Requirement (MDR) policy. The MDR for financial institutions, public sector companies, and public limited companies was removed. The previous policy was an anomaly, and it is good that the SBP has taken action.
The MDR was intended to ensure adequate returns for small savers, and it should be linked to the size of the deposit. The SBP should revisit this and set a deposit amount limit for the application of MDR, regardless of the depositor’s nature. This would help develop the debt capital market, as large depositors seek alternative investment avenues, thus creating demand for corporate bonds, especially as there is a limit to government borrowing.
Any policy aimed at improving banking intermediation should start by growing the deposit base. ADR tax certainly does not support this. The policy should consistently encourage private lending, and taxation is not the right way to achieve this. This is the job of the SBP, which has sufficient tools at its disposal.
The current high ADR is in effect until the end of December, and now every customer is demanding lower rates, which banks are providing. This will add money into the system, which could have consequences in terms of generating demand beyond the objective of monetary policy for the next few months. Things may begin to normalize in 2025, and ADR may fall again into the 40s or late 30s.
The FBR is considering the option of taxing ADR on an average basis rather than a year-end snapshot. This is a relatively better approach, but it would still create distortions. It’s best to leave the incentivization of private credit to the SBP. If the FBR is desperate to collect more taxes, it should simply increase the super tax on banks—taxing them at 60, 70, 80, or even 90 percent on income—but this should not be linked to balance sheets or any other conditions. If this practice is not discouraged, tomorrow the FBR could tax banks based on the number of branches, borrowers, or any other metric.
A few banks have gone to court over the ADR tax, and hearings are currently taking place daily at the Islamabad High Court. We will have to wait and see what the courts decide.
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