Compensating Balance
The financial accounting term restricted cash and compensating balances refers to monies that are reserved and not generally available to the company. Restricted cash can include minimum balances on bank accounts while compensating balances include money needed to repay a loan.
Example
Company A has entered into an agreement with First Federal Savings and Loan for a $1,000,000 line of credit. As part of that agreement, Company A is required to maintain a cash account with First Federal in the amount of $100,000.
Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. Bankers often offer this as a means of obtaining a more favorable interest rate on loans extended to existing bank customers. In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly.
Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending and servicing the loan. By allowing the funds to remain in the non-interest bearing account for the duration of the loan, the bank is free to make use of those funds as part of their investment strategies. In this manner, the cost of providing loans is reduced, and both the bank and the borrower benefit from the transaction.
In addition to loans, a compensating balance approach may be used to secure a line of credit. Just as with a loan, the individual or business entity receiving the line of credit must have accounts already in place with the bank and agree to maintain a minimum account balance for the loan period. In the event that the balance drops below that minimum, the interest rate is adjusted upward and usually does not drop back down, even if the minimum balance to the account is restored.
