Credit rationing - Essay Example

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Surname: Instructor: Course: Date: Credit Rationing Compensating balance is the minimum balance that must be held by an account and qualify an investor whether an individual or a company for the qualifications of a loan. For example, if an investor borrows $100,000 and the bank requires a deposit of $10,000 then that is a compensating balance loan…
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Credit rationing
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In cases whereby the compensating balance falls below the minimum required, the interest rate application 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 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 prior to drawing against the line of credit. That suggests that if a line of credit worth $100,000 was established, then a minimum $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 the follows; 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 has an effective rate of 12.85% (0.09 / (1-0.3) =0.1285). The calculation on 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 on profits made. Credit rationing Read More
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