Compensating Balances : A New Look

Average balances in a business checking account at commercial banks derive out of excess receipts over disbursements during the course of a normal month of transaction activity. Such balances - which are in a sense volunteered to the bank by the customer - can serve to lower the nominal loan coupon rate charged to commercial customers since the bank can earn returns by re-lending the balances to other borrowers. Banks have named such balances compensating balances in the sense that the bank gives a credit to, or compensates, borrowers for balances the borrower can do nothing about but which the bank can use. Banks set compensating balance requirements for the borrower as a means of keeping such valuable balances from being moved to other banks. Banks tend to try to set balance requirements to equal the voluntary balances provided by each customer. Borrowers with thin balances would receive less compensation and would be required to pay a higher nominal loan rate on a line of credit. Thus, balances and loan rates are traded off. This article also shows the circumstance where the loan rate cannot be traded off with balances. When a given percentage compensating balances is required of all customers, and a customer voluntarily provides smaller balances, the bank is in a position where the combination of loan rate and balances might not compensate for risk and services provided. In such a circumstance, the bank will require the customer to borrow additional balances to pull the combined rate up to an acceptable level