How compensating balance works?

Economics Asked by q126y on September 6, 2020

Assume a clothing store needs a 100,000 line of credit (LOC) to
manage its operating cash flow each month. The store plans to use the
LOC to make inventory purchases at the beginning of the month, and
then pay down the balance as the store generates sales. The bank
agrees to charge a lower interest rate on the LOC if the clothing
store deposits a $30,000 compensating balance. The bank loans the
clothing store’s compensating balance to other borrowers, and profits
on the difference between the interest earned and the lower rate of
interest paid to the clothing store.


Why can’t the bank provide only 70,000 loan to the clothing company at an adjusted equivalent interest rate?

I can’t see the value of compensating balance.

One Answer

The short answer is that the bank could do that, but it prefers to hold the $30,000 as collatoral on the LOC since presumably this clothing store is a relatively high-risk client.

Answered by heh on September 6, 2020

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