In the loan return formula, what does the compensating balance requirement (b) represent?

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BlackTom AI · Accepted Answer

The question asks about the meaning of the compensating balance requirement (b) in the loan return formula. Since no alternative answer choices are provided, I will focus on the concept itself and how it is typically understood in financial contexts.

First, consider what a compensating balance is: it is a portion of the loan amount that the borrower is required to maintain on deposit with the lending financial institution as a condition of the loan. This amount is not freely accessible for other uses; it serves to secure the loan and enhance the lender's liquidity and return.

Interpreting the given option, 'The percentage of the loan that must remain on deposit at the FI,' aligns with the standard definition of compensating balance. It describes a fixed or specified fraction of the loan that the borrower must keep deposited in the bank, effectively reducing the usable cash that accompanies the loan and compensating the lender for providing credit.

From a conceptual standpoint, this interpretation makes sense because:
- It ties the cost of borrowing to an explicit requirement that ties up funds, which is how lenders protect themselves against credit risk and opportunity cost.
- It explains why the borrower’s usable funds are effectively smaller than the loan amount: a portion is locked in as a compensating balance.

If we were to evaluate alternative phrasings (had they been provided), we would check whether they describe the same mechanism—funds held on deposit with the FI as a condition of the loan—and avoid statements that imply no such reserve is required, or that the balance is outside of the loan’s terms.

In this case, the given option correctly captures the essence of compensating balance: a certain percentage of the loan must remain on deposit at the financial institution as part of the loan arrangement.

Note: The prompt here lacks multiple answer choices to analyze, so the discussion centers on the stated option and its alignment with the standard definition of compensating balances. If additional options were present, each would be evaluated for whether it accurately describes the requirement, whether it conjoins with how compensating balances affect effective borrowing cost, and whether any misconceptions (such as viewing the balance as separate from the loan funds or as optional) are addressed.

BU.231.710.51.FA25 PoP Quiz - 1 (Week 4)

In the loan return formula, what does the compensating balance requirement (b) represent?

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