Credit Rationing and Compensating Balance - Essay Example

Bankers often require a compensating balance so that they can obtain favorable interest rates on loans extended to existing bank customers (Mohr 15).

In cases whereby the compensating balance falls below the minimum required, the interest rate applicable on the loan will rise accordingly to compensate. A requirement for borrowers by the bank to deposit money is vital to offset part of the loan cost and qualifies it to issue a credit to other borrowers and seek alternative investment projects. The individual will only see a low applicable rate of interest on the issued loan. A compensating balance is an account for holding funds and does not generate any interest, and the banks are free to use the money in other investment opportunities.

Compensating balance is also known as offsetting balance since its purpose is to offset expenses associated with servicing and the issuing of loans (Mohr 22). The compensating balance thus helps to reduce the cost of provision for loans by the bank, and this generates benefits for both the bank and the borrower from the agreement. In addition to credit, an approach of compensating balances is used to obtain a credit line. The person or corporation taking the credit line just like the loans must agree to maintain a minimum account balance for the loan period. The individual or corporation must have an account already existing with the bank.

In cases where the compensating balance drops below the required amount, the interest rates are fixed, so they do not fall back down and are similar, even if the minimum balances in the accounts are restored to their original position.

The well-known structure for compensating balance is simple and is referred to as the 10 and 5 compensating balance. The structure requires the investor borrowing funds to have 10% as a minimum of the issued credit line in the account at the time the credit line is created, and an extra five percent before drawing against the line of credit. That suggests that if a line of credit worth $100,000 was established, then a minimum of $10,000 is required in the borrower’s account at the time of committing to the credit line. The balance in the compensating account will be $15,000 by the time the credit line is looked at, and drawn on.

To ascertain the effective rate of interest of a compensating balance loan, the interest rate is divided by one minus a compensating balance which is revealed in decimal. The formula is as follows;
The effective rate of interest of a compensating balance = interest rate/ (1-compensating balance in decimal form)

For example, a compensating loan with a 9 percent rate and 30% compensating balance have an effective rate of 12.85% (0.09 / (1-0.3) =0.1285). The calculation of interest rates on a compensating balance and installment loan will assist an individual or a business entity as investors to understand the true cost of debt.

Credit rationing is the situation whereby lenders limit the supply of extra credit to borrowers who demand funds. This occurs although they are willing to pay higher interest rates on those funds. This is an example of market failure or imperfection because the price mechanism fails to bring about equilibrium in the market (Mohr 35). This is a situation whereby, at the prevailing market rates, the demand exceeds the supply, but the lenders are less likely to either issue extra funds or increase the rate of interest charged as they are currently maximizing profits made. Credit rationing is a market outcome and the result of asymmetric information. There are two main types of credit rationing namely, Redlining and pure credit rationing.

Redlining refers to a situation whereby the bank or financial lender does not lend to some group of borrowers with a given supply of funds to lend. This group has an identifiable characteristic, and can only be issued credit to if the supply were increased (Mohr 54). Pure credit rationing, on the other hand, is a situation whereby within an observable indistinguishable group, some borrowers secure loans whereas others though willing to pay higher rates of interest do not.

There is a third and less interesting type of credit rationing known as the disequilibrium rationing of credit. It arises due to some discord preventing clearing and is temporary. This type of credit rationing can be alleviated by policy changes or the passage of time. This can be achieved without depicting the aspects of the credit market that are structural. The graph below is an example of credit rationing in the credit market. The graph shows that the credit market is out of equilibrium due to friction in the market or some government policies that prevent the demand and supply from being equalized. Read More