Question

Assume that as part of the asset transformation process a bank borrows money long-term with a 30 year maturity and “transforms” this capital into a short-term loan to a small business with a maturity of less one year. • Is this example considered to be short funded or long funded? • Would the bank be exposed to refinancing risk or reinvestment risk? • What movement in interest rates will negatively impact the bank?

Answer 1

1. This is an example of short funding since the bank has financed its assets with short term liabilities, i.e. for a period of less than a year.

In the given question the assets of the bank has been financed by liabilities having maturity period of less than a year, and therefore it is an example of short funding.

2. What is refinancing risk?

Refinancing risk is the risk that the cost of reborrowing funds will rise above the returns being earned on asset investments. This risk occurs when a financial institution is holding assets with maturities greater than the maturities of its liabilities.

What is reinvestment risk?

Reinvestment risk is the risk that the returns on funds to be reinvested will fall below the cost of funds. This risk occurs when a financial institution holds assets with maturities that are shorter than the maturities of its liabilities.

In the given question the maturity period of the asset is 30 years which is greater than maturity period of its liability, which is less than a year. And hence the bank is exposed to refinancing risk.

3. When interest rate increases , the value of fixed-rate asset decreases and vice versa because of the discounted present value of the cash flows. To the extent that the change in market value of the assets differs from the change in market value of the liabilities and the difference is realized in the economic or market value of the equity of the financial institution.

And therefore, increase in interest rates will adversely affect the bank.