In what scenario is a compensating balance typically required?

A compensating balance is a minimum balance that a borrower is required to maintain in a bank account as part of a loan agreement. This requirement is often stipulated by lenders, including banks, to mitigate their risk when providing loans. By requiring a compensating balance, the lender ensures that the borrower has a certain level of funds available, which can enhance the borrower's creditworthiness and provide the bank with additional collateral.

In the context of a loan agreement, the compensating balance acts as a security measure for the lender. It reduces the effective amount of the loan that the borrower can utilize, as part of the loan proceeds must remain deposited as a balance with the lender. This arrangement benefits both the borrower, who may receive a lower interest rate due to the requirements, and the lender, providing them with assurance regarding the borrower's financial stability.

Other scenarios, such as fulfilling liquidity requirements, tax audits, or preparing financial statements, do not inherently involve the specific need for a compensating balance in the same structured way that loan agreements do. Thus, understanding the context of financial agreements helps clarify why the requirement for a compensating balance is primarily observed in loan arrangements.