Why do Indian banks are expecting a $36 billion deposits bonanza?

When the Finance Bill (the bill that gives effect to the Union Budget) was passed in parliament in the previous week, there were some surprising changes. For instance, debt STT rates were raised across futures and options by 25% compared to the previous rates. However, what really set the cate among the pigeons was the change in the taxation model for debt funds. Even as debt fund investors and mutual funds were unhappy with the changes, the banks were laughing all the way to the bank (oops no pun intended). In short, what the debt funds may lose in terms of AUM, the banks may gain in terms of deposits. But first, what are the debt fund related tax changes announced in the Finance Bill.

Finance Bill announces changes pertaining to debt funds

Before we go to the changes made in the Finance Bill, let us first look at how the debt funds are being taxed today. Currently, mutual funds are classified into equity funds and non-equity funds. Any fund that holds more than 65% of its portfolio in equity will be classified as equity fund and the rest will be classified as non-equity funds, which includes debt funds too. Here is how the taxation of debt funds happens currently.

• Debt funds (non-equity funds) earning dividends and capital gains from managing a portfolio of bonds. The dividends are treated as other income in the hands of the investor and taxed at the incremental tax rate applicable. What about capital gains?
   

• In the case of non-equity funds, if they are held for less than 36 months, it is short term capital gains and is taxed at the incremental rate of tax applicable just like dividends. It would depend on the tax bracket.
   

• If the non-equity (debt) funds are held for more than 36 months, they become long term capital gains and are then taxed at 20% concessional rate of tax with the benefit of indexation. This effectively reduces the tax rate to less than 10%, making it attractive.

What is the shift that has come about in the Finance Bill? Till now, there are just non-equity funds with equity exposure less than 65%. Here the taxation of short term and long term capital gains will be as explained above. The Finance Bill 2023-24 has broken up these non-equity funds into 2 sub-categories and they will be taxed differently. Here is how.

• For non-equity funds holding less than 65% in equity but more than 35% in equity, the same treatment will continue. That means STCG will be taxed at the peak rates applicable while the LTCG will be taxed at 20% with indexation benefits.
   

• However, if the debt component is less than 35% of the portfolio, then any gains, irrespective of whether it is short term or long term, will be classified as other income and taxed at the peak rate applicable. In short, there is no concessional rate of tax applicable if the equity exposure is less than 35%. That is the big change.

What does it imply. That is not great news for pure debt funds and fixed term plans (FTP), as the tax incidence will now move up to the peak rate applicable. In short, these debt funds holding less than 35% in equity will be at par with bank deposits, debentures, and bonds in terms of tax treatment. This likely to benefit bank deposits, since the big differential advantage that debt funds enjoyed on taxation has been taken away.

Yes, it is expected to lead to a surge in deposit flows

Now the first numbers of the likely implication of the above change on the bank deposit is out. It is expected by the Indian Banks Association (IBA) that the scrapping of tax incentives for some debt mutual funds would clear the way for banks to garner close to $36 billion in deposits from the debt funds. That is nearly Rs2.98 trillion in Indian rupees and that would largely make up for the tepid deposit growth in the last few quarters as deposits have struggled to keep pace with the rapid growth in loans. This had led to a situation wherein the credit deposit ratio had gone up sharply and the surge of deposits from AMCs money should help bridge the gap for banks for the time being. To an extent, the widening gap between credit off-take and deposits has sparked risks of asset-liability mismatches, since banks were increasingly depending on money markets to bridge the funding gap.

It is a rather piquant situation. On the one hand, the rising loan demand from companies and for consumer lending has led to 15.7% annual credit growth. This is 540 bps higher than the 5-year average loan growth of just about 10.3%. However, deposits have grown at just about 10% and that has forced banks to look at the money market for raising funds to bridge this gap. Till now, deposit rates were not too attractive as the bank deposit rates did not keep up with the spike in the lending rates. That had helped banks to an extent, but this gap was also resulting in a huge asset-liability mismatch. With $36 billion of funds expected to flow from mutual funds AMCs to banks, the deposit growth should pick up in the next few quarters. The new tax regime will cut down the migration of funds from banks to mutual funds as the tax differential will not exist any longer.

It will also prevent the compression of banking spreads

There is one more benefit that banks will derive from these changes to debt fund taxation. In the last few quarters, the deposit growth did not keep pace with loan growth. Now, banks were under pressure to pay more on their deposits to attract depositors. However, that ran the risk of paying more on deposits and compressing bank margins. That is set to change as the huge supply of deposits will give the banks more purchasing power. With people rushing back to bank deposits, they may not need to hike the rates with any degree of urgency. That will also keep the profits under check and also allows them to focus on their niche banking space. Banks can be more calibrated in raising deposit rates from here.