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, also known as rollover riskRollover RiskRollover Risk refers to the risk arising out of rollover of a financial debt obligation or a derivative position taken for hedging purposes, due for maturity. It is frequently managed by banks and financial institutions while doing a rollover of their liabilities and is an integral part of asset-liability management..
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form of Term Deposits, Demand DepositsDemand DepositsMoney deposited with a bank or financial institution that can be withdrawn without notice is known as a demand deposit. Due to the shorter lock-in time, it does not pay any interest or a nominal amount of interest. (ranges typically from a day to a period of 5 years and so on) and finance assetsFinance AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash. 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 conglomerateConglomerateA conglomerate in business terminology is a company that owns a group of subsidiaries conducting business separately, often in distinct industries. It reflects diversification of operations, product line and market to allow business expansion. group with a business interest in real estate. The company is basically into the construction of turnkey projects with a long gestation period. It 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 unpaid in the next year: $300000
- Short-Term Asset expected to be realized in the next one 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 complete the liquidity gap.
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 the finds three years ago at libor+ 3% and rolled over the debt whenever the same becomes due at the same rate to avoid any cost overrunAny Cost OverrunCost overrun, also known as budget overrun, is a scenario in which the cost of a project or business tends to rise above what was budgeted for. This can be due to improper budgeting or underestimating of the actual cost owing to unforeseen scenarios that were not factored into the budgeting process. 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 national group. The company was unable to raise finance, resulting in a complete standstill of its operations and severe liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. shortages leading to bankruptcy and closure.
Advantages of Refinancing Risk
Although the risk of any kind ideally does not carry any advantage, however, certain benefits of keeping refinancing risk offer 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 better net interest margin to banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. .
- 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 expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense..
Disadvantages of Refinancing Risk
Rollover risk can affect the survival of the business and suffers from various disadvantages:
- If a company cannot refinance its mature liabilities, 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 the cost for business as interest won’t remain the same forever. The business will have to refinance its liabilities at the rate prevalent at the time of refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure., 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 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 wholly avoid refinancing risk 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 required 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, 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 this risk because it is impossible to fund long-term assets with long-term liabilitiesLong-term LiabilitiesLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). . 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.
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 –