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Compensating Motive

Yet another motive to hold cash balances is to compensate banks for. providing certain services and loans. Banks provide a variety of services to business firms, such as clearance of cheque, supply of credit information, transfer of funds. and So on. While for some -of these services banks charge a commission or fee, for others they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at the bank. Since this balance cannot be utilized by the firms for transaction purposes, the banks themselves can use the amount to earn 3 return. Such balances are compensating balances. Compensating balances are also required by some loan agreements between a bank and its customers. During periods when the supply of credit is restricted and interest rates are rising, banks require a borrower to maintain a minimum balance in his account as a condition precedent to the grant of loan This is presumably to ‘compensate’ the bank for a rise in the interest rate during the period when the loan will be pending.

The compensating cash balances can take either of two forms: (j) an absolute minimum, say, Rs 5 lakh, below which the actual bank balance will never fall; (ij) a minimum average balance, MY, Rs 5 lakh over the month. The first alternative is more restrictive as the average amount of cash held during the month Quits be above Rs 5 lakh by the amount of the transaction balance. From the firm’s viewpoint, this is obviously dead money. Under the second alternative ..the balance could fall to zero one day provided it was Rs 10 lakh some other day with the average working to Rs 5 lakh of the four primary motion’s of holding cash balances, the two most important arc the transactions motive and the compensation motive. Business firms normally do not speculate and need not have speculative balances. the requirement of precautionary balances can be me. out of short term borrowings.

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