Credit rationing - Essay Example

Comments (0) Cite this document
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…
Download full paperFile format: .doc, available for editing
GRAB THE BEST PAPER98.9% of users find it useful
Credit rationing
Read TextPreview

Extract of sample "Credit rationing"

Sur 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. Part of the cost faced by a bank is offset by the compensating balance when extending a loan or credit to a business or an individual. It is calculated as an outstanding loan percentage. Bankers often require a compensating balance so that they can obtain favorable interest rates on loans extended to the existing bank customers (Mohr 15). 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 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 interests do not. There is a third and less interesting type of credit rationing known as disequilibrium rationing of credit. It arises due to some discord preventing clearing and is temporary in nature. 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 being equalized. An example of credit rationing Works Cited Mohr, Angie. Financial management 101: get a grip on your business numbers. 2nd ed. Bellingham, WA: Self-Counsel Press, 2008. Print. Read More
Cite this document
  • APA
  • MLA
(“Credit rationing Essay Example | Topics and Well Written Essays - 750 words”, n.d.)
Credit rationing Essay Example | Topics and Well Written Essays - 750 words. Retrieved from
(Credit Rationing Essay Example | Topics and Well Written Essays - 750 Words)
Credit Rationing Essay Example | Topics and Well Written Essays - 750 Words.
“Credit Rationing Essay Example | Topics and Well Written Essays - 750 Words”, n.d.
  • Cited: 0 times
Comments (0)
Click to create a comment or rate a document


Credit cards

...?A famous French poet once said, ‘It is only the poor who pay cash, and that not from virtue, but because they are refused credit.’ The term credit has different meanings for different people. For the poor, credit is delaying payment not out of choice but from necessity. For the rich, credit is a means of delaying payment for an item simply because the opportunity exists to purchase several resources without the use of cash transactions. For the business man credit is the chance to provide persons with resources without immediate payment whilst gaining extra income for the customer’s delayed payment. Credit therefore can be an advantage...
5 Pages(1250 words)Essay

Rationing health care

...?Rationing Health Care Recent years have witnessed considerable political and social considerations in regards to health care. The growing and oftentimes exorbitant costs of health care have come to present a significant problem for contemporary society. While the Obama administration recently passed a prominent health care bill, a number of concerns remain. One of the prominent responses to the health care crisis has been increasing support of health care rationing. Health care rationing takes on a variety of forms, but is understood as the restriction of health care services to best maximize their economic efficiency. This essay argues that health care rationing...
3 Pages(750 words)Essay

Credit Rationing

...standard introduced in 1988, this ratio of a bank's capital to its total assets is required by the regulating authorities to be above a minimum appropriate level to reduce the chances of the bank becoming insolvent. The extent of this level depends entirely on the perceived risks in the bank's lending or investment activities. This limitation sometimes leads to credit rationing, which is a situation where a bank refuses credit to a borrower at an interest rate set by the bank itself, because of unavailability of sufficient free capital. To understand the pressures on the capital free for lending available to the bank, we need to understand the limitations placed on it by the central...
4 Pages(1000 words)Essay

Credit Crunch

...Credit Crunch Credit Crunch The economics profession is unclear as to what constitutes a "credit crunch." The crucial differences in definition depend on the cause of the contraction and whether credit is rationed by means other than price. Bernanke and Lown (1991) define a credit crunch as: A decline in the supply of credit that is abnormally large for a given stage of the business cycle. Credit normally contracts during a recession, but an unusually large contraction could be seen as a credit crunch. In their analysis, Bernanke and Lown compare the contraction in...
4 Pages(1000 words)Essay

Distributive Justice: Access; Rationing; Futility

...DISTRIBUTIVE JUSTICE: ACCESS, RATIONING, FUTILITY Organ Transplantation is no more an impossible or tedious work. Nowadays many hospitals provide facilities for transplanting organs. Most of the organs of humans can now be transplanted, thanks to the vast development in medical sciences. The most common transplant is the process of transplanting the heart. Generally if a patient is diagnosed with an organ failure, the concerned hospital then decides whether that organ could be replaced. If it is found to be possible, the hospital then takes the further step of helping the patient for a transplant. The doctors will try and inform other hospitals and some service organizations to locate people who are willing to donate the organ... JUSTICE:...
2 Pages(500 words)Essay

Credit Crunch

...Credit Crunch Introduction The current financial crisis is a topic of discussion among the economists worldwide because of its arrival quite unexpectedly in the month of August in 2007. “The years leading up to August 2007 had seen the development of new and sophisticated ways for the financial markets to make - and, as has subsequently been revealed, lose money. Consumers in the US and Britain were living beyond their means, borrowing money to buy houses and fund their spending habits. Asset prices - particularly the cost of homes - rose rapidly” (Elliott). This paper analyses the major reasons for the current credit crunch or financial crisis. Reasons for the current economic financial crisis The...
2 Pages(500 words)Essay

Credit Crunch

...Credit Crunch Introduction These days the world is facing severe credit crunch and because of this the economic recession has appeared in entirety. People have lost jobs, banks have come down, financial companies seen the worst of times and so on. The entire fabric of the world has been hit by this credit crunch, which surely projects a very gloomy picture of how things are in the present times (Elliott 2008). Suddenly people have become unemployed, house prices have risen and banks have stopped helping the common man and woman on the street. It looks like a war; however the scale is of a magnanimous effect. Credit crunch can be thwarted by sound efforts on the part of...
2 Pages(500 words)Essay

U02d1 Research and Discuss Rationing

...RUNNING HEAD: RATIONING DEBATES Rationing Debates u02d1 Research and Discuss Rationing Submitted by: XXXXXX Number: XXXXXX of XXXXXXXX There have been several different approaches to the concept of rationing. This paper aims at providing a few of the different sides of debates of this topic. The main stakeholders that are included in the initiative include the healthcare providers, the citizens of America and the Government. It has been noted that irrespective of the costs the healthcare providers are more focused on the quality of care that is given to the customers. Similarly the government has been more focused on reducing the expenses related to healthcare while...
2 Pages(500 words)Essay

Credit crunch

... Credit Crunch Credit crunch refers to the reduction in the common accessibility to loans or the abrupt contraction of the conditions necessary to acquire loans from the financial institutions. Credit crunch essentially consists of a contraction in the accessibility of loans following a rise in formal rates of interests. In such condition, the connection between the interests rates and the availability of credit has unconditionally changed in such a manner that either the loan is fundamentally less than any quoted formal rate of interest or there stops to be a precise connection between the credit available and the rate of interest. At this point, credit rationing takes place. In most times, a credit crunch is followed by a shift... to...
10 Pages(2500 words)Essay

Ethics of Rationing Healthcare for the Aging

...Effects of Rationing Healthcare for the Aging Effects of Rationing Healthcare for the Aging The Relationship between Natural Deathand Natural Life Span Natural death results from customary closing of the human form when one loses responsiveness and cognizance. Normally, this results from natural syndromes. In addition, death from viciousness and misfortunes are not included in the description. In contrast, natural life span is subject to ailments and calamities. In the main, it is the total years a person is anticipated to live under these circumstances. Natural Life Span and the Maximum Life Span Maximum life span can be defined as a ration of time occupants of a region have been...
2 Pages(500 words)Research Paper
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.

Let us find you another Essay on topic Credit rationing for FREE!

Contact Us