From Savings to Credit: The Role of Banks
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From Savings to Credit: The Role of Banks

DEPOSITS ARE A CRUCIAL SOURCE OF FINANCING FOR BANKS, NEEDED TO SUPPLY CREDIT TO THE REAL ECONOMY. FOR THIS REASON, THEIR INCREASE IS ESSENTIAL TO FUND THE RECOVERY IN 2021. A STUDY ANALYZES HOW THE ALLOCATION OF THE HOUSEHOLD PORTFOLIO HAS CHANGED SINCE THE TAX REFORM AND HOW IT HAS AFFECTED LOANS

by Elena Carletti and Filippo De Marco, Full Professor and Assistant Professor, Department of Finance

In 2012, Italian households held around €360 billion in bonds issued by Italian banks. Since then, however, banks have stopped placing bonds directly with households and the stock of retail bank bonds slowly has steadily decreased to virtually zero in 2020, as bonds matured and were not renewed. At the same time, bank deposits held by households have never been as high as today (€1.2 trillion). What caused this large change in households’ portfolio allocation? And did the substitution of bank funding from retail bonds to deposits affect bank lending? In this paper we attempt to answer both of these questions by exploiting the effects of the Italian tax reform on securities holdings in 2011, coupled with granular lending data from Bank of Italy.

While many factors certainly contributed to the shift away from retail bonds (e.g., the “burden-sharing” rules on junior debt approved by the European Commission in 2013, or the “bail-in” rules introduced with the Bank for Recovery and Resolution Directive in 2016), we identify a clear pattern in the data in September 2011, after a new tax regime for securities held by households was approved by the last Berlusconi government. Before then, the interest income on deposits and bonds was taxed at 27% and 12.5%, respectively, while thereafter the two tax rates were equalized at 20%. This change induced a shock in household demand for bank bonds and deposits as deposits became more attractive relative to bonds. It followed that within two years from the reform households substituted €75 billion of their bank bond holdings with deposits, causing a significant change in banks’ retail funding.

This substitution from retail bonds to deposits happened following the 2011 tax reform presents a unique opportunity to evaluate how the distinctive characteristics of the deposit contract may affect bank lending. Deposits are a demandable contract that exposes banks to the threat of runs, especially in crisis periods when bank fundamentals are weak. In contrast, because of the longer maturity and the limited secondary market liquidity, retail bank bonds represent a more stable source of funding. The difference in the probability of a run between the two sources of funding is crucial to understand the effect of a greater reliance of banks on deposits for their lending policies.
Since its incipit, the literature on financial intermediation has in fact recognized the demandable nature of the deposit contract as the distinctive contractual feature explaining the traditional business model of commercial banks combining short-term deposit funding with long-term lending, often together with lending commitments in the form of credit lines. The main idea is that the threat of runs embedded in a demandable debt contract such as deposits explains the advantage for banks of providing both credit lines (Kashyap, Rajan, and Stein, 2002) and funding opaque and illiquid long-term loans with debt (Calomiris and Kahn, 1991, and Diamond and Rajan, 2001).

Our results are quite striking. First, we study the substitution from retail bonds to deposits in detail, and show that banks in provinces with higher volumes of bank bonds prior to the reform experienced a larger increase in total deposits –and in particular, term deposits- and a corresponding reduction in bonds. Second, we study how the increase in banks’ reliance on deposit funding affects their lending policies. We find that the change in bank funding following the reform led to important compositional changes: the greater reliance on deposits led to an increase in both credit lines and long-term loans, in particular towards low-risk firms. In contrast, term credit to risky firms is instead found to decrease, particularly from banks with worse fundamentals that are naturally more exposed to runs.

Overall, these results are consistent with the idea that deposits are a crucial source of funding for banks, which are needed to support lending to the real economy. This may be important also in light of the surge in deposits following Covid-19: in the US in fact the largest banks received a large influx of new deposits at the onset of the crisis, as households looked for a safe place for their savings. The increase in deposits will be needed by banks to finance the much needed recovery in 2021 and beyond.

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