Reassessing MDR

There is a minimum deposit rate (MDR) on the savings deposits of banks. Then there is a higher tax on banks with lower ADR. Banks are attempting to shed their deposits with increasing interest and tax rates. That is against the very spirit of banking. Therefore, the policy of MDR and higher tax rates on ADR need to be revisited.

For the first time in the country’s history, bankers were pleading with their customers to withdraw their deposits from banks at year-end instead of asking them for more deposits. The reason was the excessive additional taxation on income from government securities if banks’ ADR fell below 50 percent. This taxation is irrational for two reasons. Firstly, it penalizes the banks for lending to the government when it needs its money most. Secondly, it forced banks to shed deposits instead of mobilizing them.

Ideally, the government should eliminate the minimum deposit rate on saving accounts, which would result in higher profits for banks and higher tax collection as banks pay a very high tax rate. Government merely collects 15 percent from most depositors, while banks pay 43 percent. Roughly Pakistani banks would have Rs6.5-7 trillion rupee saving accounts (barring savings accounts in Islamic banks and FE25 deposits). Effective October 2013, MDR has been set at 50bp below the floor rate of SBP’s interest rate corridor. The current MDR is 14.5 percent. Every 100bp reduction in MPR would generate net incremental tax revenue of around Rs20 billion. Compared with the banking tax rate of 43 percent, depositors pay only 15 percent tax on interest income up to Rs5 million, and a majority of depositors would fit into this tax rate.

Banks most likely make a loss on saving accounts after NPLs are factored in. So the elimination of MDR is required for the banking system to undertake NPL risks to run the system properly. MDR was introduced at a time when depositors didn’t have much choice. Now there are a host of Asset Management Companies, and any depositor looking for higher returns can move there if not happy with low deposit rates at banks. And then, the savor can directly invest in T-Bills to get a better return.

The government is passing all its domestic debt risk to the banks and taxing whatever return they earn against growing risk. Banks are the backbone of domestic liquidity. Then there has been a secular increase in currency in circulation (CIC) in the past few years. The incentive system should be skewed towards bringing that CIC back into the system. However, right now, what banks are doing is the opposite. This needs to be rectified.