COMPENSATING BALANCES AND SMALLER BUSINESSES: EMPIRICAL EVIDENCE by ProQuest

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									               COMPENSATING BALANCES AND SMALLER BUSINESSES:
                            EMPIRICAL EVIDENCE

                        Natalie Tatiana Churyk             James M. Johnson
                                     Northern Illinois University

                                               ABSTRACT

Compensating balances (CBs) may affect the cost of bank financing, as well as the amount of
cash firms hold. Cash balances in excess of optimal balances increase financing costs. From the
lender’s perspective, CBs are monitoring tools—early warning systems should a firm’s financial
condition deteriorate. We offer the first study that actually measures CB requirements of firms,
and estimate how restrictive they are on a firm’s cash holdings. We find smaller, less profitable
firms have more restrictive CB requirements. However, using matched pair analysis, are unable
to predict which firms would be subject to CBs using a variety of financial relationships.

                                            INTRODUCTION

     Compensating balances (CBs) have been included as standard fare in corporate finance texts
for decades,1 and are considered a current accounting issue as well.2 They are typically discussed
in chapters dealing with cash management, working capital, and/or short-term financing and are
presented as a variable that can affect the cost of bank financing as well as the level of cash a firm
holds.
     The potential for CBs to be binding (i.e., to force a firm to hold more cash than optimal) on
firms and thus increase their cost of bank financing appears to be so ingrained that some texts
indicate a CB “is still a reason some companies hold so much cash” (Ehrhardt & Brigham, 2003,
p. 587) and that lines of credit “usually require that the borrower maintain a minimum balance”
(Keown, Martin, Petty, & Scott, 2003, p. 456). Whether requiring CBs is a widespread practice
and whether CBs impose binding constraints are two separate issues, and it appears to us that
these have been blurred together in a number of corporate finance texts.
     From the lender’s perspective, however, CBs offer a convenient device by which to monitor
borrowers. Banks are in the unique position of having information on their customer’s cash
balances on a daily basis, making CBs an efficient early warning system for impending
difficulties, since the level of cash holdings has been agreed to.3 The advantage CBs afford a
lender is compelling, but in a highly competitive banking market, banks would be expected to
have a greater ability to extract a CB requirement from smaller customers with arguably less
bargaining power than from larger customers.

1
  Typical is the discussion by Ross, Westerfield, and Jaffee (2005): “Compensating balances . . . increase the
effective interest rate earned by the bank” (p. 745). Under a discussion of motives for firms to hold cash:
“Another reason to hold cash is for compensating balances. . . . The cash balance for most firms can be though
								
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