The role of taxation in lending

The crucial influence of taxation on the functioning of banks is not, however, limited to the charges on banks and the impact they have on the profitability of financial institutions. Their impact on savings and investment behaviour, and by extension on the banks’ deposit base, can hardly be overestimated. Nor, therefore, can its impact on lending.

A crucial factor in this respect is the possibility financial institutions are given of attracting capital. Because savings deposits are so important to the financing of the economy, a shift in the deposit base could negatively affect lending. The study by Professor Huyghebaert (see How sustainable is the Belgian savings volume?) examined what impact the possible scrapping of the tax exemption on interest income could have on the volume of deposits. The regulated savings account currently benefits from a specific scheme under which interest income is exempted from withholding tax of 15% for a certain amount that is indexed annually. For 2013 the exemption is EUR 1,880.

Tax exemption 

It goes without saying that the scrapping of the tax exemption will have less of an effect in a period of low interest rates than in a period of high rates. This is because low interest rates generate less income, so fewer taxes have to be paid. In such circumstances, consumers will also be less inclined to move their money around. However, a relatively high interest rate will undeniably lead to a shift to other savings schemes covered by a more attractive tax regime.

Moreover, if the economy brightens and a climate of greater economic security arises – with a rebounding stock market and lower unemployment – a large proportion of the risk aversion will disappear and some of the savings deposits will find their way to, for example, the equity market.

The combination of these factors – higher taxes, a more attractive stock market and lower unemployment – may cause the banks’ financing base to shrink and make it more difficult to finance the economy through lending.

Professor Huyghebaert estimates that in concrete terms, scrapping the tax exemption would lead to a 7.49% drop in the volume of regulated savings deposits. In figures, that would amount to almost EUR 16.3 billion. To put that into perspective, this equates to a contraction of the economy by 0.56% (measured via households’ disposable income).

That insight strengthens the financial sector in its belief that possible changes to the tax regime of the savings account must be analysed very closely before being pushed through. It must be remembered that a fiscally stable framework is crucial to ensuring the continued financing of the economy.

Deposits as a stable source of finance

As already stated, the volume of deposits is crucial to letting the banks fulfil their commitment to finance the economy within the framework of the Basel III regulations. This situation is also apparent from a study by Professor Nancy Huyghebaert of KU Leuven (see How sustainable are Belgian deposits?).

Deposits provide a stable source of financing because of their comparatively low risk of a “flight response”. This is all relative, however, because not all savings are the same, explains Professor Huyghebaert’s study. Household savings, for example, are invested in the short term (e.g. in a savings account) in uncertain times. When the economy picks up, households switch to investments with a fixed term over a longer period.

The financing capacity of a bank remains a fragile web of disparate strands and anyone who pulls on one of these strands risks shaking the entire web. For this reason, policymakers should be very wary of measures that could affect the deposit base.

The volume of the less flight-sensitive savings invested by companies in the longer term remains largely constant. That explains why the Belgian banks, given their dependence on these deposits, cannot continue to increase their financing capacity unchecked: it would be imprudent to consider today’s temporary situation, where there are plenty of savings available, as permanent.

If the volume of deposits were to shrink, for instance through a combination of the scrapping of the tax exemption on savings accounts, a drop in unemployment figures and the attraction of equity markets, the financial sector would either relatively quickly find it difficult to comply with the liquidity rules, or have to scale down its credit capacity.

The assumption of the general public that financial institutions are sitting on unseen abundant sources of savings that enable them to increase their financing capacity unchecked without consequences in terms of liquidity thus appears to be wrong. Quite the reverse: a sensitivity analysis revealed that a sudden outflow of 5% of the deposit base would already put the Belgian banking sector in difficulty as regards liquidity regulations.

In that case, the financial sector would have to make up for lost financing in one of the following ways:

  • reducing the balance sheet and granting fewer loans. The sector would then not have problems meeting the liquidity requirements, but the real economy would suffer from the reduction in the financial sector’s financing capacity
  • attracting financing on the interbank market. Given the fact Basel II deters interbank financing, this could result in the LCR scores of the financial sector falling below the required threshold

The last consequence seems at least to be at odds with the regulator’s attempt to push the banks in the direction of longer-term financing.

That as well is anything but self-evident for Belgian banks. The shift to long-term financing prescribed by the regulatory authority via the Net Stable Funding Ratio is being hampered because long-term investors mainly invest in fiscally-stimulated pension savings products and life assurance policies.

All this means that the rules will make it more difficult in the near future for Belgian financial institutions to be able to provide credit over very long periods and for large amounts. In actual fact this usually involves SME loans with a term of more than 5 years, mortgages of more than 20 years and project funding, for example for hospitals, motorways or schools, with terms of more than 20 years.