Purchase Solution

advantages of compensating balances for banks

Not what you're looking for?

Ask Custom Question

What advantages do compensating balances have for banks? Are the advantages to banks necessarily disadvantages to corporations?

Purchase this Solution

Solution Summary

This solution discusses the advantages of compensating balances for banks.

Solution Preview

Occasionally, loan interest rates are subsidized by a method other than a cash payment made in exchange for the reduced income. Instead, government agency or socially-motivated investor deposits funds with the lender at no interest or a low interest rate. The terms of the deposit are designed to compensate for the lender's loss of interest income from making a low-interest loan.

For example, the Pleasantville city government wants to help Nonprofit Housing Corp. build 20 low-rent apartments. The project works only with a 7 percent interest rate. The Pleasantville bank is willing to make the loan, but its current rates are higher. The city doesn't want to pay out interest subsidies and never get them back, so it gets the bank to agree to a compensating balance arrangement, which looks like this:

Current bank interest rate 11%

Reduction in interest rate needed 4%

Compensating balance arrangement:

Bank loan at 7%, 20 yrs. $1,000,000

City deposit at 0%, 20 yrs. $500,000

Compare with the cost to city of a one-time interest subsidy $250,000

The city pledged to keep its deposit in the bank at that rate for as long as the loan is outstanding. Every year, a portion of deposit may be withdrawn--but only equal to the amount of loan principal paid down. However, if the borrower defaults, the deposit is not forfeited as if it were a guarantee. Its only purpose is to subsidize the interest rate.

The theory behind the compensating balance is this: Pleasantville Bank will use the non-interest-bearing deposit to fund market-rate loans or other high-yielding investments. Thus, extra income is generated for the bank to offset the below-market loan made to Nonprofit Housing Corp.

This arrangement is not as clear-cut as the payment of an up-front ...

Purchase this Solution

Free BrainMass Quizzes
Transformational Leadership

This quiz covers the topic of transformational leadership. Specifically, this quiz covers the theories proposed by James MacGregor Burns and Bernard Bass. Students familiar with transformational leadership should easily be able to answer the questions detailed below.

Understanding the Accounting Equation

These 10 questions help a new student of accounting to understand the basic premise of accounting and how it is applied to the business world.

Situational Leadership

This quiz will help you better understand Situational Leadership and its theories.

Marketing Research and Forecasting

The following quiz will assess your ability to identify steps in the marketing research process. Understanding this information will provide fundamental knowledge related to marketing research.

Organizational Leadership Quiz

This quiz prepares a person to do well when it comes to studying organizational leadership in their studies.