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Defining "Right of Offset" and "Compensating Balances"
Answer by: John Burnett, BOL Guru
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Question: What is the "right of offset? What does it have to do with compensating balances?

Answer: Last question first. The "right of offset" has nothing to do with compensating balances. Compensating balances are deposit balances left with a lender, usually by business borrowers, under a formal or informal loan agreement. It's a time-honored (some would say outmoded) method of "yield enhancement" for lenders.

The "right of offset" is a common-law concept that has been codified in some states and restricted or modified in others. It stems from early trade settlements in which two merchants, each of whom owed the other some amount, would "offset" or "net" their receivables balances and the net debtor would pay the net balance to the net creditor.

Brought forward to current practices, offset occurs when a creditor holds a (usually) defaulted debt, as well as a deposit balance in the name of a debtor. To make collection of the debt more efficient, the creditor offsets the balance in the deposit account and applies it to the overdue loan balance. There is usually a requirement that a notice be given at the time of offset. There may be other requirements depending on state law.

Offset cannot be used to collect on open-end balances.

First published on BankersOnline.com 8/12/02
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