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(^358) Financial Management
Compensating Balances
Banks require client firms with a line of credit or a revolving credit arrangement to
maintain a current account or demand deposit balance that is related either to the credit
limit or to the amount borrowed. The required balances are called compensating balances
and under some circumstances have the effect of raising the interest rate on the loan.
The usual practice is for banks to require that 10 to 20 per cent of the borrowed on a
line of credit be kept as a demand deposit balance.
Assume that a firm borrows Rs 2 crore on a line of credit and the lending bank requires
a 15 per cent credit balance; 15 per cent of this Rs 2 crore loan, or Rs 30,00,000, will
have to be kept in the firmís current account at the bank to meet the compensating
balance requirement. Whether this compensating balance raises the interest rate on the
loan is dependent on whether the firm has a need to maintain a cash balance of Rs
300,000. Assume that the interest rate on the loan is 8 per cent. The firm wants to
maintain a minimum balance of Rs 37,00,000 in its unit account. In this case meeting
the compensating balance requirement does not increase the interest rate on the credit
line.
Next, assume that the firm has no need to maintain any unit account balance at the
lending bank. By maintaining a compensating balance of 15 per cent of the loan, it is
effectively getting to use only 100 ñ 15 = 85 per cent of the loan. However, the interest
rate is applicable on 100 per cent of the loan. Therefore, the effective interest is higher
than 8 per cent and is given by effective interest rate
= stated interest rate / 1 ñ compensating balance fraction
= 8 % / 1 ñ 0.15 = 9.4 %
The effective interest rate is 9.4 per cent.
Firms borrowing on a line of credit can try to reduce the effective interest rate by
shifting some of their cash maintenance needs to the bank where they have their line of
credit. The effective interest rate can also be lowered by securing a line of credit at the
bank where the firm conducts the majority of its cash receipts and disbursements
transactions.
Interest Rates on Unsecured Loans
Interest rates on unsecured loans are negotiated between the bank and the client firm.
In general, though, the interest rate is related to the clientís credit worthiness. The most
creditworthy clients pay the prime rate. The prime rate is the lowest rate applicable to
business loans. The lower the credit worthiness of the firm, the higher the interest rate
the bank is going to charge on unsecured loans. The interest rates applicable to a firmís
are determined by the bankís risk classes and loan pricing matrix.