# Refinancing

Refinancing ( English funding , financing ) generally means the raising of funds in order to extend credit. Especially at banks , it is the technical term for raising capital to finance the lending business .

The use of the term is not uniform in German. The usage is sometimes based on the English term refinancing , which corresponds to a rescheduling or, colloquially, a loan repayment . The conceptual proximity also leads to confusion with the more general process of financing .

## Word origin

The compound “refinancing” is made up of the Latin prefix “re” ( back , back but also against , against ) and the root word “financing” ( Latin financia , payment ) and is a deverbal derivation. Refinancing is linguistically either renewed financing as in English refinance or, as in German, the backward one , e.g. B. on the liabilities side of the balance sheet , financing for customer loans granted on the assets side.

## Justification in the context of money creation by commercial banks

When granting loans or purchasing assets on the asset side of their balance sheet, commercial banks generate book money in the form of sight deposits on current accounts for their customers on the liabilities side (see Money creation ). By transfers from customers of these funds to other banks through withdrawals as well as transactions of the bank itself, these liabilities change the bank in other forms, such as futures and savings deposits and debt securities ( savings bonds ), interbank loans or deposits from the central bank . In addition, banks must meet minimum reserve requirements and minimum capital requirements for credit risks under Basel III .

In the broadest sense, the risk-appropriate management of all balance sheet items that arose in return for lending business is called refinancing at a bank. Sight deposits are also counted among the refinancing sources. In the narrowest sense, however, the Deutsche Bundesbank defines refinancing merely as the procurement of central bank money by commercial banks .

In banking , one speaks of refinancing only in the case of cash loans that affect liquidity . However , this does not apply to credit transactions within the framework of loan transactions ( guarantee credits such as guarantees ).

## Origin of funds in banking

The funding sources are liabilities (the liabilities side of banks' balance sheets in question) and capitalized (the asset side to distinguish the relevant bank's balance sheet) sources.

### Passive sources

In the case of self-financing , in addition to the retention of profits, the stock market is the main source for raising equity by means of a capital increase through the issue of shares or profit participation rights . In the case of non-joint stock banks, their shareholders are the source for capital increases. Equity capital serves - also with credit institutions - primarily to refinance fixed assets and as a basis for determining the core capital ratio . This means that capital increases can also represent compliance with statutory provisions - such as the capital adequacy requirement in Article 92 (1) of the Capital Adequacy Ordinance.

Refinancing sources for the much more important outside financing ( deposit business ) are money and capital markets as well as the foreign exchange market for refinancing in foreign currencies . Financing instruments of the financial and capital markets are visual , forward and deposits and bonds ( savings bonds ). Foreign currency loans can be taken out on the foreign exchange market as part of international credit transactions . Data parameters for passive capital raising are stock exchange rates , interest rates and exchange rates .

### Active sources

While the passive borrowing usually leads to a balance sheet extension , both the asset swap and the balance sheet extension play a role in active refinancing . Main source forms in particular the central bank , the European Central Bank (ECB) within the euro area under the Eurosystem the commercial banks grants funding options. The main sources are the main refinancing instrument and the marginal lending facility . In the former, commercial banks must pledge eligible collateral in the form of securities , while the marginal lending facility is available as unsecured credit . In both cases, the commercial banks receive central bank money from the ECB in return , which they can convert as part of an asset swap to refinance loans to non-banks . The freely disposable excess reserve can also be used for loans. As part of the open market operations with the ECB, the commercial banks can receive central bank money by selling securities and use it for refinancing. If the ECB buys government bonds from the banks as part of its open market policy, it will take over potentially risky asset positions from them in return for central bank money that the commercial banks can use to grant less risky loans. There are similar refinancing options internationally outside the Eurosystem. The central banks can act as lenders of last resort in times of economic or banking crisis and, in the worst case, become the only source of refinancing.

Through selective sale from the loan portfolio , loan trading is another, albeit very limited, active source of refinancing. The liquidity gained from the sale of loans is available for other loans, this also applies to securitization . In interbank trading , money market paper , securities lending , securities repurchase and repo transactions can also be carried out for the purpose of refinancing .

True sales represent a still new form of refinancing . Here, a lender bundles loans with identical terms and the same risk structure and sells them to investors in securitized form. If the lender is a credit institution, the equity ratio can be improved, but on the other hand there is no interest income from the loans sold. The securitization of subprime mortgages played a central role in the subprime crisis .

## Banking aspects

The bank management is concerned, at least since the "golden rule of banking" from 1854 in detail with issues of funding, because the "asset and liability management" has an existential significance for banks.

### General

The banking functions of maturity transformation , lot size transformation and (horizontal) risk transformation play a key role in refinancing . In connection with the refinancing, the maturity transformation has the task of converting the passively accepted maturities into the maturities required for the lending business, taking into account the legal restrictions ( liquidity regulation ). In the case of a positive maturity transformation, the repayment dates for liabilities are earlier than the due dates for receivables , and the capital commitment periods on the assets side are therefore longer than on the liabilities side. The particular task of lot size transformation is to convert many small investments into a few larger loans. The horizontal risk transformation consists in the fact that the credit risk of an investor due to (inter-company) deposit protection is usually much lower than the credit risk that a bank is allowed to take when lending.

### Liquidity risk

The dispositive liquidity risk consists of a refinancing risk, a call risk and a deadline risk. Deadline and call risks are counterparty risks because they are based on the behavior of bank customers.

#### Refinancing risk

Theoretically, there is no refinancing risk if banks were to refinance their lending business strictly within the framework of matching maturities. However, since they (are allowed to) enter into mismatches in order to maximize profits , they accept refinancing risks. The refinancing risk is the risk that a bank cannot meet its current and future payment obligations or cannot meet them on time (liquidity risk) and, in the event of a liquidity bottleneck, short-term funds cannot be obtained or can only be obtained at a higher interest rate . It results primarily from the maturity transformation with which banks want to benefit from the interest rate differences between lending and deposit business and different terms.

Refinancing via the financial markets involves further risks. Self-financing is associated with the risk of a stock market that is not ready to buy or financial bottlenecks among shareholders. The bottleneck in external financing is the unwillingness of the creditors to make funds available to a bank for the first time or as part of a follow-up financing or to extend it ; in the worst case, even a bank run in financial crises leads to unexpected deposit withdrawals . Credit institutions can use their own rating , the prevailing interest rate level and the key interest rate as data parameters for external financing .

The insolvency of Lehman Brothers in September 2008 led to a considerable loss of confidence in the interbank market , with the result that credit institutions barely granted each other loans, but instead switched to the ECB. Excess bank investments were placed with this or it had to step in as a lender at other commercial banks that no longer received interbank loans. This hit the specialist banks , car banks and regional banks , which are heavily dependent on interbank refinancing , particularly hard.

The deadline risk is the risk of an unplanned extension of the capital commitment period of lending transactions, for example through late loan interest and / or loan repayments . This can be triggered by the deterioration in creditworthiness of the borrowers, who have to be granted deferrals . In international business, the worsening country risk can lead to moratoria resulting in late payment .

#### Retrieval risk

The call risk is the risk that - previously unused - loan commitments may be called upon in accordance with the contract, but unexpectedly in terms of time ( active call risk ) or that deposits will be called unexpectedly ( passive call risk ). It is particularly important for large loans and large deposits.

### Interest rate risk

There is no interest rate risk - and also a liquidity risk - with refinancing with absolutely matching maturities , but there is a margin risk . In the event of mismatches, the interest rate risk is the risk that follow-up refinancing will have to be concluded at a higher interest rate than the original refinancing. Refinancing that does not match maturities creates an interest rate risk, the profit or loss of which is referred to as a transformation contribution . It is speculation because the refinancing does not take place on the same day as the loan is paid out. It leads to an interest margin risk because the profits or losses of this transformation contribution are reflected in the profit and loss account of the refinancing bank. The interest rate risk arises as a result of the maturity transformation due to the lack of elasticity of the interest income compared to the interest expense and vice versa.

## Regulatory implications

If there is a normal (i.e. not inverse) interest rate structure , refinancing long-term loans through short-term deposits leads to an interest gain because the short-term deposit interest rates are lower than the long-term loan interest rates. Then banks exercise the function of maturity transformation, which in this case leads to a positive transformation result. However, this is associated with a refinancing risk because follow-up refinancing must be sought on a revolving basis. In order to limit this risk, banks must meet two liquidity ratios, which according to Section 2 (1) LiqV must not fall below the value one:

### Short-term liquidity ratio

The short-term, stress- based Liquidity Coverage Ratio or short liquidity ratio (LCR) to the solvency guarantee of a bank without having to rely on outside help. Highly liquid assets include cash holdings, available central bank balances, and safe government bonds. With price markdowns ( discount ) as well as other securities holdings can be included:

${\ displaystyle {\ frac {\ text {Stock of highly liquid assets}} {\ text {Net outflow of payments in 30 days under stress}}} \ geq 1}$

The key figure indicates whether it is possible to sell assets possibly at a loss in order to meet the liquidity requirements under unfavorable circumstances for at least 30 days. It will be implemented 60% from January 2015, its full effectiveness has been decided for January 2019.

### Structural liquidity ratio

The medium-term, structural liquidity ratio (NSFR) compares available refinancing funds (English available stable funding ; ASF) with the assets to be refinanced (English required stable funding ; RSF). It is intended to ensure that in the medium term the assets of a bank are at least partially refinanced with “stable” liabilities. The liquidity of the assets is taken into account:

${\ displaystyle {\ frac {\ text {actual available refinancing funds}} {\ text {required assets to be refinanced}}} \ geq 1}$

"Actually available refinancing" is considered to be those liabilities that are available to a bank for at least 1 year even in stressful situations. The “assets required to be refinanced” include highly liquid government bonds ; they are taken into account with a weight of 5%. The indicator creates incentives to refinance assets with the help of long-term, less volatile liabilities. The key figure will be mandatory from 2018. The total of the “liabilities weighted according to their permanent availability” ( actual stable refinancing ) must at least exceed the total of the assets weighted according to their liquidity proximity plus the medium-term financing requirements from off-balance sheet items ( required stable refinancing ). The following applies:

${\ displaystyle {\ frac {\ text {available stable refinancing}} {\ text {required stable refinancing}}} \ geq 1}$

## transformation

The refinancing costs for the lending business are to a large extent characterized by uncertainty about future interest rate developments on the money and capital markets. This uncertainty becomes greater the further the forecast interest rates are in the future. By interest rate derivatives may be trying to anticipate future developments and hedge the risk.

• As a rule, refinancing is carried out immediately before or at the latest when the loan is granted congruently (congruent). Of amount transformation is spoken, if not initially or more refinancing funds are procured, as this corresponds to the actual lending business. There are two types:
• If loans are granted without immediate refinancing, it is a so-called asset advance . If a bank decides in favor of an asset advance, an immediate refinancing transaction does not initially take place when a loan is granted. The result is a shortage of liquidity, which can be accepted due to excess liquidity. The aim of this asset anticipation is an expected decrease in interest rates on the money or capital market, which, if refinancing is carried out later, leads to lower refinancing costs and thus to additional profit (transformation profit).
• Conversely, in the case of a liability advance , interest rates are expected to rise and investors are sought (for example by issuing bank bonds) without the corresponding loans being granted at the same time. Until the loan is granted, such amounts are temporarily placed on the money market, usually with shorter terms at other banks. In the event that loans are granted at a later date, the temporarily invested funds are released and used to refinance the loans.
Both measures can also be related to an expected change in the bank rating , which in turn can have an impact on the credit interest to be paid . Prepayments of assets and liabilities involve an interest rate risk and possibly a follow- up refinancing risk .
• Increasing globalization can make refinancing measures in foreign currencies necessary or - after assessing the currency risks - even desirable. In this case, a currency transformation would have to be carried out, which can be hedged using currency derivatives . On the one hand, refinancing funds can be obtained here in currencies other than those used as loans. On the other hand, credit products are emerging on the market that allow borrowers to choose the currency in which loans are repaid.

## Earmarked refinancing

Mortgage banks , Pfandbrief banks and building societies have strictly earmarked refinancing . Mortgage and Pfandbriefbanken refinance by legal requirement ( Pfandbriefgesetz ) Real loans and other mortgage predominantly by the emission of mortgage bonds and / or mortgage bonds (also English Mortgage covered bonds called), which are associated with the mortgage loan in a cover register. This also applies to municipal / government loans (through municipal bonds / public Pfandbriefe, called English public sector bonds / municipal bonds , also with cover register). Building societies refinance their housing loans exclusively from Building society deposits ( "group insurance"), only interim financing may be included in the money market. In development loans that a bank must be liquidated, the bank has a so-called refinancing application to the development bank set up, then the funding, the bank made available for distribution to the final borrower. Refinancing for strictly specific purposes is only to be refinanced on the passive side.

## organization

According to the organizational requirements of Section 25a (1) of the KWG , credit institutions must have a "proper business organization that ensures compliance with the statutory provisions to be observed by the institution and the economic necessities". In order to meet these legal and operational requirements, most banks have their own departments that deal exclusively with refinancing tasks. These are part of the liquidity management of credit institutions. As soon as the operational management of the banking business cash flows ( deposit - and outflows ) triggers, this will affect the refinancing. The incoming and outgoing payments converge in these departments, they carry out the passive or asset balancing and optimize the operating result in compliance with the legal requirements and the liquidity target .

## Refinancing mix

The various passive sources are used in a targeted manner based on interest rates and maturities. In 2010, 34% of German credit institutions' loans were refinanced from sight and time deposits from non-banks , 28% from interbank liabilities, 27% from bank bonds and 9% from savings deposits . The proportions of the individual refinancing sources can fluctuate due to interest rates as well as to minimize creditor risks.

## Individual evidence

1. Michael Lohde: Word formation of the modern German , 2006, p. 153
2. ^ Deutsche Bundesbank, Glossary , Refinancing
3. ^ Mathias Hofmann: Management of refinancing risks in credit institutions , 2007, p. 7
4. Deutsche Bundesbank, Practice of Liquidity Risk Management in Selected German Credit Institutions , January 2008, p. 5
5. Jan Scheffler: Hedge Accounting: Annual Financial Statements Risks in Banks , 1994, p. 7
6. Karlheinz Ruckriegel: The behavior of the ECB during the financial crisis (s) , in: Economy service 02/2011, 2011, pp 107-114
7. Henner Schierenbeck : Earnings-Oriented Bank Management , 1991, p. 725
8. ^ Paul Lerbinger: Interest and Currency Swaps , 1988, p. 40
9. Henner Schierenbeck / Hubertus Moser: Handbuch Bankcontrolling , 1995, p. 333
10. Michael Cramer: The international credit business of the banks , 1981, p. 68
11. Martin Bösch: Finanzwirtschaft: Investment, Financing, Financial Markets and Control , 2013, p. 206
12. ^ Results of the Basel III monitoring for German institutions , Deutsche Bundesbank from September 2013, p. 24 f.
13. ^ Results of the Basel III monitoring for German institutes , Deutsche Bundesbank from September 2013, p. 29.
14. Deutsche Bundesbank, Guide to the new capital and liquidity rules for banks , August 2011, p. 32
15. ^ Hans Menzel: The participation of the house banks in the forgiveness and administration of public credits , 1960, p. 101
16. Jens Tolckmitt: Bank refinancing in transition - what does that mean for covered bonds / Pfandbriefe? , in: Kreditwesen 14/2011, p. 30