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 inability of the business to roll over its debt obligation and as such also known as rollover risk.
How Does Refinancing Risk Affect Banks?
Refinancing risk can also take the form of 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.
Normally banks raise funds which are usually short term in nature in the form of Term Deposits, Demand Deposits (normally ranges 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.
Examples of Refinancing Risk
Let’s understand rollover risk with the help of a few hypothetical examples:
Laurel International is a conglomerate group with a business interest in real estate. The company is basically into the construction of turnkey projects with a long gestation period and requires funding for the long term which it borrows using short-term debt and roll 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 due in next 1 year: $300000
- Short-Term Asset expected to be realized in next 1 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 and laurel international being into real estate also could not raise finance to meet its short term matured liabilities which resulted in refinancing risk and have to sell its projects at slump cost to meet the liquidity gap.
Federal Group is an infrastructure company that issued convertible bonds 3 years back amounting to $10 Mio to fund its infrastructure project which will complete in 10 years. The company raised the finds three years back 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 is unable to refinance the short-term debt to make payment to the short-term debt and which led to a default on the part of the federal group. The company was unable to raise finance and that resulted in a complete standstill of its operations and severe liquidity shortages leading to bankruptcy and closure.
Advantages of Refinancing Risk
Although Risk of any kind ideally does not carry any advantage however certain advantages of keeping refinancing risk offers to the banks/financial institutions and individuals:
- Raising short-term funds at a cheaper cost to fund long-term projects is comparatively easier and offers 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:
- If a business cannot refinance its mature liabilities, this can lead to default and can cause the bankruptcy of the business despite 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 the cost for business as interest won’t remain the same forever and 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 as well.
- Refinancing Risk gets aggravated when there is slow down 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 completely avoid refinancing risk as that is inherent in the business model and therefore need to frequently assess their maturity profile and weightage of short-term financing to total financing and take appropriate actions as and when needed to avoid any future trouble.
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, and so on, and this risk is managed by specialized functions known as asset-liability management (ALM) department in every bank and Financial Institution. Despite the potential disadvantages this risk brings for the business, banks accept this risk 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 by the business.
This has been a guide to what is refinancing risk, and it’s a definition. Here we discuss examples of rollover risk along with advantages and disadvantages. You can learn more about financing from the following articles –