Define compensating balances, Financial Management

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What are compensating balances and why do banks require them from some customers?  Under what circumstances would banks be most likely to impose compensating balances?

Compensating balances are funds which a bank needs a customer to keep in a non-interest bearing account till the loan is retired.  Banks occasionally impose compensating balance needs so as to increase the bank’s return on a loan.  Compensating balances are most similarly to be employed when the stated interest rate on a loan is below the bank’s required rate of return.


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