Compensatory Balance

Compensatory balance is also called as compensating balance is the minimum balance which might be maintained in the account and still meet the requirements for the loan.  Bankers generally provide this as the means for getting a better interest rate on advances or loan extended to the existing customers of the bank. As a result of this the compensating balance would go below the minimum required and the interest rate applied to the loan would increase consequently.  Compensatory balance is also sometimes known as offsetting balance, the purpose of the compensatory balance is to balance the expenses related with the servicing and extending the loan. By letting the money or funds to remain in the non-interest bearing account for the period of the loan, the bankers or bank is free to use that money as part of their investment plans or strategies. In this way, the cost for offering loans is reduced, and both the borrower and the bank would benefit from this transaction.

In addition to the loans, the compensatory balance approach might be utilized in order to secure a line of credit. As with the loan, the business entity or individual obtaining the line of credit should have the accounts already in place with the bankers, and agree to maintain a minimum account balance for the loan duration.  As a result of this the balance falls below that lowest, the rate of interest is adjusted upwards and generally does not drop back down, although the minimum balance to the account is restored. The most general structure for the compensatory balance is quite simple, which is known as 5 and 10 compensatory balance, the structure calls for the customer to have atleast 10 % of the extended line of credit in the bank account when the credit line is created, and an additional 5 % before drawing against the credit line.

Questionnaire:

• What is compensatory balance?
• Explain briefly compensatory balance?