Compensating balances

Question

Explain the term: compensating balances and why do banks require compensating balances from some customers?  When can a bank impose compensating balances?

Answer 1

Compensating balances are funds that a bank requires a customer to maintain in a non-interest bearing account until the loan is retired.  Banks sometimes impose compensating balance requirements so as to increase the return of bank on a loan. Compensating balances are most likely to be used when the stated interest rate on a loan is below the bank’s required rate of return.