Compensating Balance

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

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.
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

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

Accounting Basics: “Compensating Balance” Fundamentals Quiz

### Why do banks often require compensating balances for loans? - [ ] To increase their loan outflow - [ ] To improve customer loyalty - [x] To minimize default risk - [ ] To manage operational costs > **Explanation:** Banks require compensating balances to minimize their risk of default. It serves as a security measure ensuring the borrower maintains adequate liquidity. ### Can a borrower freely withdraw the compensating balance during the loan term? - [ ] Yes - [x] No - [ ] Only with permission - [ ] Only after the halfway mark of the loan term > **Explanation:** The compensating balance must typically remain untouchable during the loan term as it serves as collateral for the bank. ### How does a compensating balance affect a borrower's utilizabe loan amount? - [ ] Increases it - [x] Decreases it - [ ] Does not affect it - [ ] Doubles it > **Explanation:** A compensating balance decreases the utilisable loan amount since a portion of the borrowed funds must remain as a deposit in the bank. ### Who benefits financially from the interest on a compensating balance? - [x] The bank - [ ] The borrower - [ ] The borrower and bank equally - [ ] Neither party > **Explanation:** The bank benefits from the interest on a compensating balance as the funds remain deposited with the bank. ### What typically happens to the compensating balance after the loan is paid off? - [x] It becomes available to the borrower - [ ] It remains frozen - [ ] It converts to a higher balance requirement - [ ] It is forfeited to the bank > **Explanation:** Once the loan is paid off, the compensating balance becomes available for withdrawal by the borrower. ### What percentage of the loan amount is typical for a compensating balance? - [ ] 1-2% - [ ] 3-5% - [x] 5-20% - [ ] 25-30% > **Explanation:** A compensating balance typically ranges between 5-20% of the loan amount, depending on the risk and bank policy. ### What document outlines the terms of maintaining a compensating balance? - [ ] Mortgage agreement - [x] Loan agreement - [ ] Declaration of Deposit - [ ] Interest Certificate > **Explanation:** The loan agreement outlines all terms, including the requirement and details of maintaining a compensating balance. ### How does a compensating balance impact the effective interest rate on a loan? - [x] It effectively increases it, considering the unusable loan portion - [ ] It decreases it for the borrower - [ ] It makes no impact - [ ] It makes the rate variable > **Explanation:** Although nominal interest rates may decrease, the unusable portion effectively increases the cost of funds for the borrower, thus increasing the effective interest rate. ### In what situation might a borrower prefer agreeing to a compensating balance? - [ ] High-interest rate alternative - [ ] Non-existent deposit account - [x] Lowering nominal interest rates on a highly needed loan - [ ] No loan alternatives > **Explanation:** Borrowers might prefer compensating balances if it results in lower nominal interest rates on a highly needed loan, aligning better with their cash flow management or borrowing strategy. ### Does the compensating balance form part of the bank's capital reserves? - [ ] Yes, directly - [x] No, but it adds to usable assets - [ ] Only for a specified period - [ ] Only if indicated > **Explanation:** Although not part of regulatory capital reserves, compensating balances add to a bank's available assets, improving their financial standing and liquidity.

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