Question

A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?

Short answer

Reasons to keep compensating balances at the bank

• Compensating balances allow the bank to monitor the actions of a borrowing firm, which decreases the ethical hazard situation.
• Compensating balances can perform as collateral.
• Compensating balances may be transformed into income-producing aids, which increases bank profitability.
• Compensating balances can be utilized as a replacement for a revolving sequence of credit.

Step-by-step solution

Concept Introduction

Compensating balances are utilized as collateral by banks or financial institutions which allows them to minimize default risk. For example, if a borrower defaults then net losses incurred by financial institutions will be compensated with these balances. Another thing is, if compensating balances are held with the bank then it will allow decreasing the risk-taking preferences of the borrower which helps to decrease moral hazard issues. Available compensating balances will be utilized by banks as another source of credit line so that profitability would be enhanced.

Reasons to keep Compensating Balances at the Bank.

Reasons to keep compensating balances at the bank are:

• Compensating balances allow the bank to monitor the actions of a borrowing firm, which decreases the ethical hazard situation.
• Compensating balances can perform as collateral.
• Compensating balances may be transformed into income-producing aids, which increases bank profitability.
• Compensating balances can be utilized as a replacement for a revolving sequence of credit.