What is a 'compensating balance'?

A compensating balance refers specifically to a minimum balance that a borrower must maintain in a bank account as part of a loan agreement. This requirement is often negotiated between the borrower and the lender to ensure that the lender has access to a portion of the funds, which reduces the risk associated with the loan. The compensating balance cannot generally be used by the borrower, effectively serving as a safeguard for the lender, as it ensures that the borrower maintains a certain level of liquidity in the account, which can be used to repay the loan if necessary.

This concept is critical in understanding how banks manage credit risk and how borrowers can be influenced by the conditions set forth during the loan agreement. The other options do not accurately capture the nature of a compensating balance; they refer to different financial concepts like cash reserves for emergencies or reinvestment of profits, which are not tied directly to the requirements set by loan agreements.