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Capital markets provide several long and intermediate-term funds for corporate or economic investment.
These firms use commercial banks as a source of funds. The banking system provides economies of scale, in terms of, transaction cost to small and large organizations.
Many companies have the possibility of an impending change in financials.
In addition to paying interest on the amount of borrowing, a company has to keep a certain level of deposit with the banks which are known as the compensating balance.
The amount of compensating balance can differ depending on the nature of the loan liquidity, while, the financial credit can be used for certain monetary transactions.
The same balance is often used to support banks’ functions like - some banks demand that the net balance and the net of reserve requirements must always be kept above a certain level.
So it is expected that banks keep the compensating balance, that does not support any other functions and earns no interest, but at the time of borrowing, the firm will not keep more balance than required and this could be used to repay part of the outstanding loan with the excess.
In the case of the firm that keeps compensating balance, the effective amount borrowed is calculated by deducting the amount.
Such options are often treated as bank assets of the firm, which can be used in case of bankruptcy.
It also affects the value of the lenders’ claim as it can change the risk of the firm.
Even in case, when there is a certain amount of balance in such an account, in case of default, the bank needs to consider the maximum possible borrowing risk.
The amount kept in such an account is considered risk-free. However, if the amount is invested in risky assets, it increases the risk factor.
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