Which statement best describes compensating balances?
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 compensating balances they hold.

Question

Quizplus · Accepted Answer

Compensating balances are funds that a borrower must keep on deposit with a lender to reduce the riskiness of a loan. If the required compensating balance is greater than the firm's typical transaction balance, it would be paying a higher effective interest rate than stated by the lender. Thus, option C is the best choice. A is incorrect because compensating balance can be required from individuals as well, but it is rare. B is incorrect because compensating balances come at a cost to the firm, as they cannot be used for any other purpose. D is incorrect because banks typically charge fees for holding compensating balances, which help offset the cost of funding loans.

Which Statement Best Describes Compensating Balances