What Is the Twenty Percent Rule?
In finance, the twenty percent rule is a convention used by banks in relation to their credit management practices. Specifically, it stipulates that debtors must maintain bank deposits that are equal to at least 20% of their outstanding loans. In practice, the exact figure used varies depending on interest rates, the perceived creditworthiness of the debtor, and other factors.
Key Takeaways
- The twenty percent rule is a convention used by banks that stipulates the percentage of a loan that is required to be deposited in a compensating balance account.
- This rule has become less common in recent decades, and is often treated flexibly by lenders, and varies based on a variety of factors, such as interest rates and the creditworthiness of the borrower.
- The money held in the compensating balance account will be drawn from the principal of the loan itself, where it is then placed in a non-interest-bearing account provided by the lender.
- Banks are then free to use these funds for their own lending and investment purposes, without compensating the depositor.
- A borrower is not able to use the 20% of the loan earmarked for the compensating balance account but nonetheless must pay interest on that portion as it is part of the entire loan.
How the Twenty Percent Rule Works
The twenty percent rule is an example of a compensating balance; that is, a balance held at a bank for the purposes of reducing the risk of a loan given by that bank. Although in the past it was commonplace for these balances to be held at a strict percentage, such as 20%, this has become less common in recent decades. Today, the sizes of compensating balances tend to range widely and are sometimes even waived entirely with the payment of bank service charges or other such arrangements.
Generally, the money held in the compensating balance account will be drawn from the principal of the loan itself, where it is then placed in a non-interest-bearing account provided by the lender. The bank is then free to use these funds for its own lending and investment purposes, without compensating the depositor.
From the perspective of the borrower, this represents an increase in the cost of capital of the loan because the money being held in the compensating balance could otherwise be used to generate a positive return on investment. In other words, the opportunity cost associated with the compensating balance raises the cost of capital for the borrower.
From the perspective of the bank, the opposite is true. By holding a significant deposit from the borrower, the bank reduces the effective risk of their loan while also benefiting from the return on investment which they can generate from the deposited funds. Understandably, borrowers will only agree to provide a compensating balance when they are unable to find more generous terms elsewhere, such as in instances where the borrower is struggling with liquidity or has a poor credit rating.
Importantly, the interest paid on the loan is based on the entirety of the loan principal, including any amount kept in a compensating balance. For example, if a company borrows $5 million from a bank under terms that require it to deposit 20% of that loan at the lending bank, then the interest on that loan would nonetheless be based on the full $5 million. Even though the borrower is unable to withdraw or invest the $1 million (20%) compensating balance, they would still need to pay interest on that portion of the loan.
Example of the Twenty Percet Rule
Emily is a real estate developer seeking to borrow $10 million to finance the construction of a new condominium tower. She approaches a commercial bank that agrees to finance her project under terms that include a twenty percent rule.
Under the terms of her loan, Emily is required to deposit $2 million from the $10 million loan into a non-interest-bearing account held at the lending bank. The bank is then free to invest or lend those funds without paying Emily any interest on her deposit.
Although she is only free to use $8 million out of the $10 million she borrowed, Emily nonetheless must pay interest on the full $10 million loan. Effectively, this raises the cost of capital of her loan, while the opposite is true from the bank’s perspective.
