A compensating balance restricts cash; in effect,it increases the interest on the loan and reduces a company's liquidity.

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A compensating balance is a requirement by the lender for the borrower to maintain a certain minimum balance in a checking account or to hold a certain amount of assets with the lender as collateral for a loan. This restricts a company's available cash and reduces its liquidity, which can increase the effective interest rate on the loan as the lender is effectively earning interest on the borrower's deposited funds.

A Compensating Balance Restricts Cash; in Effect,it Increases the Interest