Refinancing risk
Encyclopedia
In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt
. Many types of commercial lending incorporate balloon payment
s at the point of final maturity; often, the intention or assumption is that the borrower will take out a new loan to pay the existing lenders.
A borrower that cannot refinance their existing debt and does not have sufficient funds on hand to pay their lenders may have a liquidity problem. The borrower may be considered technically insolvent
: even though their assets are greater than their liabilities, they cannot raise the liquid funds to pay their creditors. Insolvency may lead to bankruptcy
, even when the borrower has a positive net worth
.
In order to repay the debt at maturity, the borrower that cannot refinance may be forced into a fire sale
of assets at a low price, including the borrower's own home and productive assets such as factories and plants.
Most large corporations and bank
s face this risk to some degree, as they may constantly borrow and repay loans.
Refinancing risk increases in periods of rising interest rate
s, when the borrower may not have sufficient income to afford the interest rate on a new loan.
Most commercial banks provide long term loans, and fund this operation by taking shorter term deposits.
In general, refinancing risk is only considered to be substantial for banks in cases of financial crisis
, when borrowing funds, such as inter-bank deposits, may be extremely difficult.
Refinancing is also known as “rolling over” debt of various maturities, and so refinancing risk may be referred to as rollover risk.
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
. Many types of commercial lending incorporate balloon payment
Balloon payment
When a debt is repaid in payments of varying amounts there are some colourful jargon terms used to describe the different loan structures. The term balloon payment arises because if you hold back most of a debt and pay it only towards the end of the agreement, both those last payments and the total...
s at the point of final maturity; often, the intention or assumption is that the borrower will take out a new loan to pay the existing lenders.
A borrower that cannot refinance their existing debt and does not have sufficient funds on hand to pay their lenders may have a liquidity problem. The borrower may be considered technically insolvent
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
: even though their assets are greater than their liabilities, they cannot raise the liquid funds to pay their creditors. Insolvency may lead to bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, even when the borrower has a positive net worth
Net worth
In business, net worth is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time...
.
In order to repay the debt at maturity, the borrower that cannot refinance may be forced into a fire sale
Fire sale
A fire sale is the sale of goods at extremely discounted prices, typically when the seller faces bankruptcy or other impending distress. The term may originally have been based on the sale of goods at a heavy discount due to fire damage...
of assets at a low price, including the borrower's own home and productive assets such as factories and plants.
Most large corporations and bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s face this risk to some degree, as they may constantly borrow and repay loans.
Refinancing risk increases in periods of rising interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s, when the borrower may not have sufficient income to afford the interest rate on a new loan.
Most commercial banks provide long term loans, and fund this operation by taking shorter term deposits.
In general, refinancing risk is only considered to be substantial for banks in cases of financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
, when borrowing funds, such as inter-bank deposits, may be extremely difficult.
Refinancing is also known as “rolling over” debt of various maturities, and so refinancing risk may be referred to as rollover risk.