Compensating Balance

A compensating balance is a sum of money deposited at a bank by a customer, which acts as a condition for the bank to lend money to the customer. It serves as a form of collateral or security for the loan.
On this page

Definition

A compensating balance is a credit arrangement condition where the borrower is required to maintain a minimum balance in a deposit account as collateral for the loan. This balance ensures the bank against default risk. It is typically a portion of the loan amount and usually remains in the account until the loan is paid off.

Examples

  1. Small Business Loan: A small business seeking a $100,000 loan may be required to maintain a compensating balance of 10%, or $10,000, in a bank account. This means the actual usable loan amount is $90,000.
  2. Personal Loan: An individual applying for a $50,000 personal loan may need to keep a 5%, or $2,500, compensating balance in the account. For the term of the loan, the individual cannot withdraw this $2,500.

Frequently Asked Questions (FAQ)

Q1: Why do banks require a compensating balance? A1: Banks require a compensating balance to minimize their risk of default. It serves as a security measure and helps the bank ensure there is enough liquidity to cover potential loan losses.

Q2: Can the borrower use the compensating balance? A2: No, the compensating balance often remains untouchable while the loan is active. The funds must stay in the deposit account as security.

Q3: Does the compensating balance affect the interest rate? A3: Yes, a compensating balance might lead to a lower interest rate, as it reduces the risk for the lender.

Q4: Is the compensating balance included in the loan principal? A4: Technically, the compensating balance is separate from the loan principal; however, the borrower needs to maintain this balance for the duration of the loan.

  • Collateral: An asset that a borrower offers to a lender to secure a loan.
  • Loan Agreement: A contract between a borrower and a lender outlining the terms and conditions of the loan.
  • Credit Line: A pre-approved amount of credit extended by a lender to a borrower.
  • Bank Reserves: The cash minimums banks must maintain as per regulations, either with the central bank or in their vaults.
  • Interest Rate: The cost of borrowing the loan principal, expressed as a percentage of the loan.

Online References

Suggested Books for Further Studies

  1. “Bank Management & Financial Services” by Peter Rose & Sylvia Hudgins
  2. “Principles of Banking” by American Bankers Association
  3. “Financial Institutions, Instruments & Markets” by Christopher Viney & Peter Phillips
  4. “Risk Management in Banking” by Joël Bessis
  5. “Commercial Lending” by Rosemarie O’Neill & Margery O’Neill

Accounting Basics: “Compensating Balance” Fundamentals Quiz

Loading quiz…

Thank you for exploring the concept of compensating balances with us! Happy studying!

Compensating Errors
Compensated Absences