Refinancing Risk

Updated on March 18, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Refinancing Risk?

Refinancing Risk refers to the risk arising out of the inability of the individual or an organization to refinance its existing debt due to redemption with new debt. Refinancing risk carries the risk of the failure of the business to roll over its debt obligation and, as such, is also known as rollover risk.

Key Takeaways

  • Refinancing risk, also known as rollover risk, is the risk of being unable to refinance existing debt with new debt, which can result in higher interest rates or the need to repay the debt in full, putting financial strain on individuals, organizations, banks, and financial institutions.
  • It encompasses the danger of a company’s inability to fulfill its loan obligations and is relevant to individuals, organizations, banks, and financial institutions.
  • During an economic slowdown and liquidity constraints, holding cash becomes preferable, leading to reduced credit creation and the inability of individuals and institutions to meet their maturing liabilities, further aggravating refinancing risk.

How Does Refinancing Risk Affect Banks?

Refinancing risk can also take the form of the ability of the bank or financial institution to refinance the matured liabilities but at very high interest, which adversely impacts its income profile, which is measured through the net interest income earned by the bank.

Naturally, banks raise funds which are usually short-term in nature, in the form of Term Deposits, Demand Deposits (ranges typically from a day to a period of 5 years, and so on), and finance assets in the form of loans (which can extend up to 30 years) which are usually long term in nature and that inherently creates a mismatch in the asset-liability profile of the bank.

In a rising interest scenario or, at worst, in a liquidity crunch market, when it becomes difficult for banks/financial institutions to raise funds to refinance the matured liabilities, it gives rise to refinancing risk.

Refinancing Risk

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Examples of Refinancing Risk

Let’s understand rollover risk with the help of a few hypothetical examples:

Example #1

Laurel International is a conglomerate group with a business interest in real estate. The company is basically into constructing turnkey projects with a long gestation period. It requires funding for the long term, which it borrows using short-term debt and rolls over the same with another short-term debt to keep meeting its requirement. The following schedule of obligations is mentioned below:

  • Short-term debt due in the next six months: $200000
  • Short-term debt unpaid in the next year: $300000
  • Short-Term Asset expected to be realized in the next year: $100000
  • Net Gap: ($200000 + $300000 – $100000)

Due to a severe liquidity crunch in the market on account of recessionary pressure, companies in real estate could not raise finance. Laurel international, being into real estate, could not raise finance to meet its short-term matured liabilities, resulting in refinancing risk and having to sell its projects at slump cost to complete the liquidity gap.

Example #2

Federal Group is an infrastructure company that issued convertible bonds three years back, amounting to $10 Mio to fund its infrastructure project, which will complete in 10 years. The company raised funds three years ago at libor+ 3% and rolled over the debt whenever the same becomes due at the same rate to avoid any cost overrun on account of increased interest. Recently due to the market downturn and liquidity crunch, the federal group has been unable to refinance the short-term debt to make payments to the short-term debt, which led to a default on the part of the national group. The company was unable to raise finance, resulting in a complete standstill of its operations and severe liquidity shortages leading to bankruptcy and closure.

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Advantages of Refinancing Risk

Although the risk of any kind ideally does not carry any advantage, however, certain benefits of keeping refinancing risk offered to the banks/financial institutions and individuals:

  • Raising short-term funds at a cheaper cost to fund long-term projects is comparatively more comfortable and provides a better net interest margin to banks and financial institutions.
  • In a rising interest rate scenario, if banks and financial institutions expect rates to moderate or fall in the medium term, it makes sense to raise short-term funds to meet long-term projects, which can be refinanced later at lower interest rates.
  • In low-interest rate cycles, individuals can refinance their debts at a lower cost, thereby saving interest expenses.

Disadvantages of Refinancing Risk

Rollover risk can affect the survival of the business and suffers from various disadvantages:

  • Suppose a company cannot refinance its mature liabilities. In that case, this can lead to default and can cause the bankruptcy of the company despite the business being able to meet its day-to-day expenses. Despite being solvent, due to a liquidity crunch, refinancing risk can lead to bankruptcy for the business.
  • Refinancing risk increases business costs as interest won’t remain the same forever. The business will have to refinance its liabilities at the rate prevalent at the time of refinancing, which can be higher than well, thereby impacting the margins of the business.

Important Points to Note about Refinancing Risk

  • Refinancing Risk is not just confined to banks and financial institutions but can be faced by individuals and businesses.
  • The refinancing risk gets aggravated when there is a slowdown and liquidity crunch in the economy as keeping cash is preferred, which results in less credit creation and the inability of individuals and institutions to meet their matured liabilities, thereby aggravating the problem further.
  • Banks and FI can’t wholly avoid refinancing risks inherent in the business model. Therefore, they need to frequently assess their maturity profile and weightage of short-term financing to total financing and take appropriate actions as and when required to avoid any future trouble.

Conclusion

Refinancing risk is a common phenomenon in banks and financial institutions. Banks regularly take this risk to fund long-term assets such as infrastructure projects, home loans, etc. This risk is managed by specialized functions known as the asset-liability management (ALM) department in every bank and Financial Institution. Despite the potential disadvantages this risk brings for the business, banks accept it because it is impossible to fund long-term assets with long-term liabilities. A sustainable solution lies in understanding the risk in detail and deciding how much to accept and how much to transfer or mitigate through better maturity profile mapping of short-term assets and long-term liabilities.

Frequently Asked Questions (FAQs)

1. How is refinancing risk part of interest rate risk?

Refinancing risk is a component of interest rate risk because it relates to the potential negative impact of changing interest rates on the refinancing of existing debt. When interest rates rise, the cost of refinancing debt or replacing existing loans with new ones at higher interest rates increases. This can result in higher borrowing costs for individuals, businesses, or financial institutions, leading to financial strain or reduced profitability.

2. How to manage refinancing risk?

To manage refinancing risk, organizations can employ several strategies. One approach is to carefully analyze and monitor interest rate movements to anticipate potential changes in borrowing costs. This allows them to time their refinancing activities strategically.

3. What is the difference between reinvestment risk and refinancing risk?

Reinvestment risk refers to the risk faced by investors when they receive cash flows from fixed-income investments (such as bonds or certificates of deposit) and must reinvest that money at lower interest rates. This leads to a lower yield on reinvested funds. On the other hand, refinancing risk primarily affects borrowers who face the challenge of replacing existing debt or loans at higher interest rates when they mature or when refinancing is required.

Recommended Articles

This has been a guide to what refinancing risk is and its definition. Here we discuss examples of rollover risk along with advantages and disadvantages. You can learn more about financing from the following articles –

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