What is a Compensating Balance?

A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender. The lender requires this arrangement in exchange for lending funds to the borrower. The amount of funds to be held at the bank is typically set at a percentage of the loan balance.

The purpose of this balance is to reduce the lending cost for the lender, since the lender can invest the cash located in the compensating bank account and keep some or all of the proceeds. The borrower may also benefit from being granted a somewhat lower interest rate. However, the borrower is also paying interest on a net loan balance that is smaller than the amount of the loan, so the effective interest rate for the entire arrangement is higher than would be the case without the compensating balance arrangement.

Presentation of a Compensating Balance Arrangement

A borrower who has entered into a compensating balance arrangement may need to disclose this situation in the footnotes to its financial statements, if the amount is material. This is not necessary when the financials are only being distributed internally, to the management team.

Example of a Compensating Balance

As an example of a compensating balance arrangement, a corporation has a $5 million line of credit with a bank. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000. When the two sides of the arrangement are netted, the loan is actually $4,750,000.