With a compensating balance program, the insured frees up cash and receives current tax deductibility for this amount because "economic performance" has been satisfied by the payment of premium to the insurance company.
The insured has to have compensating balance requirements with its bank to take advantage of this structure, and compensating balance requirements are becoming increasingly rare.
Because banks cannot attract demand deposits through the payment of explicit interest, they often try to attract these deposits, aside from compensating balances
, through the provision of services at little or no cost.
The fee can be avoided through easy-to-maintain compensating balances
Early in the year, demand deposits surged as lower rates required businesses to build up compensating balances
and as mortgage servicers held larger balances during the mortgage refinancing boom.
According to data from an annual survey by the Japan Fair Trade Commission, the reliance on these compensating balances
for loans to small businesses declined steadily throughout the 1980s, from 45 percent of surveyed loan contracts in 1980 to 26 percent in 1990.
Even on a fourth-quarter-average to fourth-quarter-average basis, demand deposits increased at a sluggish 3 1/2 percent rate, likely because corporations continued to shift away from compensating balances
, and toward fees, to pay for bank services.
However, the proportion of bank liabilities represented by demand deposits fell in 1990, as businesses likely continued their shift away from compensating balances
and toward fees to pay for bank services.
To some extent, such fee income reflects the ongoing shift by businesses away from compensating balances
and toward fees as a means of paying banks for services.
After changes in market rates of interest, banks often adjust with a lag the "earnings credit" rates used to determine the level of required compensating balances
; thus, downward adjustments to compensating balances
can continue for some time after market rates have stopped rising.
Demand deposits, the other highly interest-sensitive component of M1, again declined in 1988, partly reflecting increases in their opportunity costs and declines in compensating balances
In addition, reductions in compensating balances
in response to earlier increases in market interest rates were expected to be more pronounced late in the year, though such adjustments would have their major impact on M1 growth.