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Assume a clothing store needs a 100,000 line of credit (LOC) to manage its operating cash flow each month. The store plans to use the LOC to make inventory purchases at the beginning of the month, and then pay down the balance as the store generates sales. The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. The bank loans the clothing store’s compensating balance to other borrowers, and profits on the difference between the interest earned and the lower rate of interest paid to the clothing store.

From https://www.investopedia.com/terms/c/compensating-balance.asp

Why can't the bank provide only 70,000 loan to the clothing company at an adjusted equivalent interest rate?

I can't see the value of compensating balance.

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The short answer is that the bank could do that, but it prefers to hold the $30,000 as collatoral on the LOC since presumably this clothing store is a relatively high-risk client.

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  • $\begingroup$ So in the worst case if the clothing store defaults then the bank only loses \$70,000? They could also do that if they loaned \$70,000 to the clothing store. $\endgroup$ – user253751 Nov 29 '19 at 12:39
  • $\begingroup$ @user253751 this is like arguing that instead of paying 10% down on a mortgage for a \$100,000 house, the bank should let you pay 0% down on a mortgage for a \$90,000 house. $\endgroup$ – heh Nov 29 '19 at 15:01

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