compensating balance

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Compensating balance

An excess balance that is left in a bank to provide indirect compensation for loans extended or services provided.

Compensating Balance

Money from a loan that a borrower keeps in an account with a lender providing some surety that the lender will be repaid. A compensating balance is especially common with corporate loans. It increases the cost of capital to the borrower because he/she is paying interest on more money than he/she is permitted to use.

compensating balance

The funds that a corporate borrower is required to keep on deposit in a financial institution in order to satisfy the terms of a loan agreement. The deposit may be in a checking account, savings account, or certificate of deposit, depending on the nature of the agreement. The net effect of a compensating balance requirement is an increase in the effective cost of the loan because the borrower is unable to use all the funds on which interest is paid.
References in periodicals archive ?
Because banks cannot attract demand deposits through the payment of explicit interest, they often try to attract these deposits, aside from compensating balances, through the provision of services at little or no cost.
According to data from an annual survey by the Japan Fair Trade Commission, the reliance on these compensating balances for loans to small businesses declined steadily throughout the 1980s, from 45 percent of surveyed loan contracts in 1980 to 26 percent in 1990.
Even on a fourth-quarter-average to fourth-quarter-average basis, demand deposits increased at a sluggish 3 1/2 percent rate, likely because corporations continued to shift away from compensating balances, and toward fees, to pay for bank services.
However, the proportion of bank liabilities represented by demand deposits fell in 1990, as businesses likely continued their shift away from compensating balances and toward fees to pay for bank services.
To some extent, such fee income reflects the ongoing shift by businesses away from compensating balances and toward fees as a means of paying banks for services.
After changes in market rates of interest, banks often adjust with a lag the "earnings credit" rates used to determine the level of required compensating balances; thus, downward adjustments to compensating balances can continue for some time after market rates have stopped rising.
Demand deposits, the other highly interest-sensitive component of M1, again declined in 1988, partly reflecting increases in their opportunity costs and declines in compensating balances. The amount of such balances that businesses must hold in these non-interest-bearing accounts to compensate banks for services falls when interest rates rise.
In addition, reductions in compensating balances in response to earlier increases in market interest rates were expected to be more pronounced late in the year, though such adjustments would have their major impact on M1 growth.
One set of shifts in M1 demand affected corporations.(10) First, banks offered them preferable loan rates, provided that part of the loan was held in a demand deposit (known as a compensating balance).