By Valentina Za and Stefano Bernabei

MILAN (Reuters) - Residents' deposits with Italian banks fell by 68 billion euros ($75 billion) year-on-year in April as higher interest rates prompted mostly corporate depositors to shift money from current accounts to seek better returns for their cash.

Deposits fell by 3.7% year-on-year in April to 1,796 billion euros from 1,781 billion in March, when they had dropped 3.0% annually, a monthly report by Italian banking association ABI showed on Tuesday.

Depositors' search for higher returns is set to push up funding costs for Italian banks, which reported record profits in the first quarter thanks to higher interest rates on loans.

The boost from the rising cost of money is set to wane in coming quarters as banks tighten lending and borrowers struggle to repay their loans.

Lending to businesses and households stagnated in April, ABI said, adding this was the weakest reading since January 2016.

Meanwhile, the gap between the average rate Italian banks charged on loans to businesses and households and that paid to raise funding rose to 317 basis points in April, from 301 basis points in March.

Last week digital bank Fineco cut its guidance on its net interest margin after losing 1.4 billion euros in deposits between January and April, as it refuses to offer any interest on current accounts.

In a newspaper interview on Saturday, veteran banker and chief executive of challenger bank illimity, Corrado Passera, said competition for deposits would intensify in coming months.

His bank is advertising a 2.5% rate on current accounts to retain depositors.

ABI said the average rate on sight deposits in euros was 0.29% in April.

($1 = 0.9084 euros)

(This story has been corrected to clarify the amount and drop are on yearly, not monthly, basis in the headline and paragraphs 1-2, and cut paragraph 3 to remove duplication)

(Editing by Christina Fincher and Sharon Singleton)