Compensating balances have been important for banks because their existence allows them to make loans at lower quoted rates.

Question

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Compensating balances refer to minimum balances that borrowers must maintain in their deposit accounts with the lender. These balances help banks to offset the risk they incur while lending money and also generate interest income for the bank. By requiring a compensating balance, the effective interest rate on the loan is higher than the quoted rate, which enables the bank to offer a lower rate than it could without the balance requirement. Therefore, compensating balances are important for banks as they allow them to make loans at lower quoted rates.

Compensating Balances Have Been Important for Banks Because Their Existence