advantages of compensating balances for banks

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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 Every year, a portion of deposit may be withdrawn--but only equal to the amount of loan principal paid down.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 ...