What is the Twenty Percent Rule? Definition, Application, and Examples
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Summary:
The twenty percent rule, a convention in finance, mandates debtors to maintain bank deposits equal to at least 20% of their outstanding loans. Although less common today, it impacts borrowers’ cost of capital and banks’ risk management practices.
What is the twenty percent rule?
In finance, the twenty percent rule is a convention used by banks regarding credit management. It mandates that debtors must maintain bank deposits equal to at least 20% of their outstanding loans. This rule serves as a compensating balance, reducing the risk for lenders.
How the twenty percent rule works
The twenty percent rule exemplifies a compensating balance, aimed at mitigating lending risks for banks. Historically, banks strictly enforced a 20% deposit requirement, but modern practices offer more flexibility, sometimes even waiving this requirement with alternative arrangements or bank service charges.
The funds allocated to the compensating balance are typically drawn from the loan principal, then placed in a non-interest-bearing account held by the lender. Consequently, the bank gains access to these funds for lending or investment purposes without compensating the depositor.
From the borrower’s standpoint, the compensating balance increases the loan’s cost of capital, as the funds could otherwise generate returns. However, for banks, holding significant deposits reduces loan risk and provides investment opportunities, benefiting from deposited funds’ returns.
Example of the twenty percent rule
Emily, a real estate developer, seeks a $10 million loan for a condominium project. Her lender enforces a twenty percent rule, requiring her to deposit $2 million in a non-interest-bearing account. Despite borrowing $10 million, Emily can only access $8 million, yet she pays interest on the full amount.
Frequently asked questions
What is the purpose of the twenty percent rule?
The twenty percent rule serves as a compensating balance, reducing lending risks for banks by mandating debtors to maintain deposits equal to at least 20% of their outstanding loans.
How does the twenty percent rule affect borrowers?
For borrowers, the twenty percent rule increases the cost of capital, as funds held in compensating balances could otherwise generate returns. It also restricts access to a portion of the loan amount.
Do all banks enforce the twenty percent rule?
No, enforcement of the twenty percent rule varies among banks. Some may strictly adhere to the 20% deposit requirement, while others offer more flexible arrangements or waive the rule with alternative terms.
Key takeaways
- The twenty percent rule mandates debtors to maintain bank deposits equal to at least 20% of their outstanding loans.
- Modern banking practices offer more flexibility in enforcing the rule, with some banks waiving the requirement under certain conditions.
- From the borrower’s perspective, the twenty percent rule increases the cost of capital, while benefiting banks by reducing loan risks and providing investment opportunities.
- Despite variations in enforcement, borrowers should be aware of the potential impact of the rule on their loan terms and costs.
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