Which of the following statements is most correct?
A) Compensating balance requirements apply only to businesses, not to individuals.
B) Compensating balances are essentially costless to most firms, because those firms would normally have such funds on hand to meet transactions needs anyway.
C) If the required compensating balance is larger than the transactions balance the firm would ordinarily hold, then the effective cost of any loan requiring such a balance is increased.
D) Banks are prohibited from earning interest on the funds they force businesses to keep as compensating balances.
E) None of the statements above is correct.

Question

Quizplus · Accepted Answer

Compensating balances are funds that banks require borrowers to maintain in deposit accounts as a condition of granting loans. These balances usually do not earn interest and are held as collateral by the bank to offset the credit risk of loaning money. If the required compensating balance is larger than the amount of funds the borrower would ordinarily hold for transactions purposes, then the effective cost of the loan is increased because the borrower is effectively paying interest on the funds held as compensating balances. Therefore, statement C is the most correct. Statements A, B, and D are incorrect. Statement E is not necessarily true as statement C is correct.

Which of the Following Statements Is Most Correct