Compensating balance is a proportion of:

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Question restatement: Compensating balance is a proportion of:

Option a: a loan that a borrower is required to hold on deposit in foreign reserves.
- This is not accurate because compensating balances are linked to deposits with the lending bank itself, not with foreign reserve accounts. The concept involves maintaining a minimum balance with the lender, not with a central bank’s reserves.

Option b: the investment that a borrower is required to hold on deposit at the lending institution.
- This wording is misleading. A compensating balance is typically a balance kept in the borrower’s account at the lending bank to secure a loan, but the phrase “the investment” and the way it’s described makes it sound like a separate investment vehicle rather than a deposit tied to the loan facility. This distinction matters for the precise accounting and purpose of the arrangement.

Option c: a loan that a borrower is required to hold on deposit at the lending institution.
- This is the most accurate description. A compensating balance is the portion of the loan that the borrower is required to maintain on deposit with the lender as a condition of obtaining the loan. It represents immediate liquidity kept with the bank, reducing the effective yield or usable funds for the borrower.

Option d: a loan that a borrower is required to hold on deposit at a correspondent bank.
- This option incorrectly specifies a correspondent bank. Typically, the compensating balance is deposited with the lending institution itself, not with a correspondent bank, making this option inaccurate.

In summary, the correct understanding is that compensating balance involves a loan with a deposit requirement kept at the lending institution, rather than at foreign reserves, an unspecified investment, or a correspondent bank. This aligns with standard banking practice where the borrower maintains a specified balance with the lender as part of the loan terms.

BFF2401 - S2 2025 Moodle Exercise 2

Compensating balance is a proportion of:

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