Compensating balance is a proportion of a loan that a borrower is required to hold on deposit at the lending institution.

Question

BlackTom AI · Accepted Answer

This statement concerns the concept of a compensating balance in lending.
Option 1: True. A compensating balance is typically a portion of the loan amount that the borrower is required to keep on deposit with the lender as a condition of obtaining the loan. The purpose is to provide the bank with a cash reserve or reduce credit risk, effectively increasing the lender's security and sometimes allowing a lower stated interest rate on the loan. The requirement is not tied to the use of the funds by the borrower but to hold them as a deposit.
Option 2: False. If someone chose this option, they would be asserting that no cash or liquid reserve is required as a condition of the loan. In practice, many lenders impose a compensating balance, which means the borrower must maintain a deposit (often a percentage of the loan) to satisfy banking policy or to secure the loan terms. Saying there is no such requirement would misstate how some credit arrangements are structured, especially for certain businesses or lines of credit.
In summary, the statement aligns with the standard definition of a compensating balance as a required deposit tied to a loan arrangement, while the false option would contradict that common banking practice.

FINS5530-Financial Institution Mgmt - T3 2025

Compensating balance is a proportion of a loan that a borrower is required to hold on deposit at the lending institution.

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