Compensating Balance

Yachts 4 Less wants a business loan from the Deep Pockets Bank. The two entities have never done business. Therefore, the bank requires Yachts 4 Less to establish an account with a compensating balance. The compensating balance required in the account is the minimum balance to offset the costs that Deep Pockets Bank incurs to set up a business loan for Yachts 4 Less.

The perk for Yachts 4 Less is the compensating balance account establishes a level of trust (if trust can be defined monetarily...and it can). The perk for the Deep Pockets Bank is that it is able to use the compensating balance to make money (invest and lend) and the bank will keep some (if not all) of the profits from this activity.

Example: Yachts 4 less wants a $5,000,000 loan. The Deep Pockets Bank requires that Yachts 4 Less establish a compensating balance account of $500,000. Deep Pockets uses the $500,000 to make money, maybe just by purchasing an indexed CD (low risk, better return than a money market). The proceeds of the indexed CD are kept by Deep Pockets Bank. The bank may also agree to a lower interest rate for Yachts 4 Less's loan, in return for a certain level of dollars placed in the compensating balance account.

As they say, you gotta spend money to make money.