Why Long-Term Debt Instruments Cannot Be Deposit Substitutes

TL;DR

This paper argues that long-term debt instruments cannot serve as deposit substitutes due to their inability to provide liquidity and capital preservation, emphasizing the importance of short-term maturity for deposit substitutes within shadow banking.

Contribution

It clarifies the mismatch between long-term debt instruments and deposit substitutes, proposing a maturity limit of one year for deposit substitutes based on theoretical and legal analysis.

Findings

Long-term bonds cannot replicate deposit features like liquidity and capital preservation.

Deposit substitutes are essential for maturity transformation in shadow banking.

Maturity of deposit substitutes should be limited to 1 year.

Abstract

The definition of deposit substitutes in Philippine tax law fails to consider the maturity of a debt instrument. This makes it possible for long-term bonds to be considered as deposit substitutes if they meet the 20-lender rule, taxable at 20% final tax. However, long-term debt instruments cannot realistically function as deposit substitutes even if they fall in the hands of 20 or more lenders. First, long-term debt instruments cannot simultaneously replicate the twin features of capital preservation and liquidity, which are integral to the nature of a deposit substitute. Second, deposit substitutes are an integral part of the maturity transformation process (i.e. short-term borrowing for the purpose of long-term lending) in financial intermediaries, which means that they should have low borrowing cost, made possible only by having short-term maturity. To prove these propositions, this paper situates the function of deposit substitutes within the context of shadow banking, where said instruments originated and are generally used. To show the incompatibility between a deposit substitute and a long-term debt instrument, the paper applies the fundamental theory of bond values to 10-year zero-coupon treasury notes called 'PEACe Bonds' in Banco De Oro, et al. vs. Republic (2015 and 2016). The paper recommends that deposit substitutes should be limited to debt instruments with maturity of not more than 1 year.