Final answer:
Being required to maintain a compensating balance can limit access to funds for short-term borrowing and may result in higher borrowing costs.
Step-by-step explanation:
When a bank requires a customer to maintain a compensating balance, it means that the customer must keep a certain amount of money in their account at all times. This serves as a form of collateral for the bank, as it helps to offset any potential losses. However, this requirement can impact the cost of short-term borrowing for the customer.
By tying up a portion of their funds in the compensating balance, the customer has less money available to use for other purposes, including short-term borrowing. This can limit their ability to access additional funds when needed and may result in higher borrowing costs, as the customer may need to seek alternative, potentially more expensive, sources of short-term financing.
For example, if a business needs to borrow $10,000 for a short period of time and is required to maintain a compensating balance of $5,000, they will only have access to $5,000 for their borrowing needs. This may force them to seek alternative financing options, such as a higher-interest short-term loan, in order to meet their funding requirements.