The practice of requiring compensating balances to borrowers by the lending institution has been widely used around the world for a number of years. It is especially useful when banks are making loans to informationally opaque firms, thereby reducing adverse selection problems. Anecdotal and empirical evidence suggests that banks in Korea came to exercise power after onset of the financial crisis in late 1990s. Requiring greater portion of borrowed proceeds can be viewed as a typical practice by a main bank to exercise power against their client firms.
This paper develops a model which explains why banks ask their clients to put aside part of their borrowed proceeds. An endogenously arisen 'compensating balance' that requires the borrower to leave part of the loan proceeds at its checking account at the lending institution appears to have the features in our model. The compensating balance functions as collateral. In the model, the 'security-deposit' set aside ahead of time in effect is collateral. A bank can ask the borrower to keep some fraction of the loan proceeds at its account with the bank, so that the bank can effectively rule out 'fake' entrepreneurs from taking out loans (i.e., a reduction in adverse selection problem). It also gives incentives to the entrepreneurs to liquidate the project when it receives the bad signal.
There exists much recent evidence that when banks gain power, then they can exercise it by charging higher interest rates to their clients or asking compensating balance at the time of lending. Our theory provides theoretical foundation for those findings, and further shows that close bank-firm relationship may result in costly consequences.
