Compensatory Balance

tl;drA minimum balance that a business must maintain in its bank account as an informal requirement for receiving certain banking services or maintaining a credit line.

These balances effectively increase the cost of borrowing since the funds cannot be used for operations. Compensatory balances serve as a form of collateral or compensation to the bank. Imagine a manufacturing company maintaining a $500,000 compensatory balance to support a $5 million line of credit. While the stated interest rate might be 6%, the effective rate is higher because the company cannot use the compensatory balance for working capital. This arrangement affects cash management strategies and the true cost of borrowed funds. Managing compensatory balances requires balancing banking relationships with working capital needs. Companies must consider the opportunity cost of restricted funds and incorporate these costs into financing decisions.