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FUNDING RISK

Funding Gap Risk

In Section 7.1 we have mentioned the concept of capital requirements: these were debt-to-loan ratios imposed by an external body. Even without an intervention from outside, an institution usually tries to maintain a balance between the amount it raises in debt and the amount it issues in loans. To understand why this is important, let us build a concrete example. In this example we are going to look at the balance between bonds and loans. We

A representation of the debt-to-loan balance of a possible portfolio.

FIGURE 7.1 A representation of the debt-to-loan balance of a possible portfolio.

are using bonds and loans because it is the simplest possible way of picturing the management of debt and income. This will allow us to make specific points that are nonetheless applicable to the more general mechanism of a financial institution in which debt is issued in order to generate income.

Let us imagine that today is November 3, 2011, and we have disbursed a 10-year loan with 100 units of principal. Let us also imagine that we have issued two five-year bonds, each with a principal of 40, one and two years ago respectively (on October 27, 2009, and on November 10, 2010). Let us also assume that we had 20 units of equity.

Figure 7.1 offers a graphic representation of our situation in terms of principal profile, a plot in time of the outstanding principal of debt and loans. The first thing we need to state is that, as we gather from the plot and as we have mentioned in Section 3.1.1, loans are amortizing instruments and bonds are not. This is true in the near totality of situations (there are some exceptions in the form of bullet loans where the principal is repaid at the end, but they are not the norm). Describing the situation as depicted from the figure, we had 20 of equity, we raised 80 in debt from the two bonds, and we lent 100 over a 10-year period with repayments of principal in semiannual amounts of five.

Before entering into the merit of the dynamic balance between debt and loans, we can comment on the leverage of the situation to continue what we discussed at the beginning of the chapter. At the moment we are simply discussing principals and not interests payments, so the way to repay the bonds' principals is through the principal repayments in the loan. We have used 20 units of equity and a combined 80 units of debt to fund 100 units of loan: overall we are balanced. Let us assume that very early in the life of the loan the borrower defaults on the entirety of the loan. In this situation the amount of equity we have used to fund the loan (the rough equivalent of the capital requirement) is crucial: the equity amount is a loss for us but the debt is potentially a loss for the bond holders, should we be unable to raise other debt. In our case, should we be unable to raise another 80 units, the loss of 80 would be transferred to someone else. There is a push toward high capital requirements exactly to avoid contagion since the lower the amount of equity used to fund the loan, the more the loss from one defaulting loan will propagate throughout the financial world.

Leverage aside, looking at Figure 7.1 we can see that, although overall we are balanced, since debt maturities and loan repayments take place at different times throughout the lives of the different instruments, we are far from balanced. In three years' time, for example, we will need to pay the bond holders of the first bond, the one expiring on October 27, 2014. If we look at the plot of the cash that has been repaid by the borrower and is available to pay the bond holder, on that date we will only have 30 units, not enough.

In order to repay our bond holders we need to issue additional debt on that date; hence, on October 27, 2014, we are going to issue our first rebalancing bond, a four-year bond with a principal of 20 units. With the cash thus raised, plus the one we have received from the borrower, we can return the face value of the bond to the investors. On November 10, 2015, we will be facing the same problem when we need to return the face value of 40 units to the investors of the second original bond. We can issue another, a second, rebalancing four-year bond on that date with a principal of 20 units. With this amount, what we have from the first rebalancing bond and what we are receiving from the borrower we can return the 40 units from the bond holders. The loan proceeds are enough to repay the first rebalancing bond, however, we need to issue a third and final rebalancing bond on November 10, 2019, with a principal of 5 in order to repay the second. A summary of all the instruments in our portfolio is given in Table 7.10.

This seemingly complicated process is shown in Figure 7.2 where we plot the principal profile of the initial situation plus the additional rebalancing debt. In this new plot the proceeds from the loan are reduced each time we use them to repay the bond holders.

TABLE 7.10 A summary of the debt and loan portfolio in our example.

Instrument type

Issue date

Maturity date

Principal

Loan

November 3, 2011

November 3, 2021

100

Bond 1

October 27, 2009

October 27, 2014

40

Bond 2

December 10, 2010

December 10, 2015

40

Bond 3

October 27, 2014

October 27, 2018

20

Bond 4

December 10, 2015

December 10, 2019

20

Bond 5

December 10, 2019

December 10, 2021

5

To rebalance a debt/loan portfolio (or, in general, a debt/revenue one) is crucial and it is a particularly common mechanism carried out by sovereign treasuries. During a sovereign debt crisis sometimes we experience quiet moments: these are the moments in between principal repayments (at the moment we are excluding coupon payments).

The reader might wonder why there is a need to enter into such a complicated mechanism, why bonds and loans can't have the same maturity and the same profile, wouldn't it simplify things considerably? It would simplify things, but it is not done for many reasons, two of which we are going to

A representation of the debt-to-loan balance of a possible portfolio after additional debt has been issued to rebalance.

FIGURE 7.2 A representation of the debt-to-loan balance of a possible portfolio after additional debt has been issued to rebalance.

present. Under a legal point of view a loan is a different instrument from, say, a derivative: crucially, no collateral is paid. No collateral is paid on bonds either, but bonds are securitized instruments for which there is a, sometimes active, secondary market.

It would be a generalization to say that loans are usually extended to entities that would have difficulties raising funds in the bond market, but not a gross one. Should a loan have a profile similar to a bond, that is, with the largest payment at maturity, the risk for the lender would, of course, be much greater and the terms for the borrower would certainly be harsher. It therefore suits both parties for loans to have an amortizing profile.

The second reason, which shall be discussed in the next section, can be understood by considering what we have up to now ignored: coupon payments. In the rebalancing exercise we have carried out, we were only rebalancing principal; we have ignored the fact that both bonds and loans carry interest payments.

The bonds pay a coupon, which we service not directly but through an asset swap structure, meaning that we have a funding cost usually linked to a LIBOR. From the loan we receive a coupon, which we assume, for simplicity, to be also linked to a LIBOR. In all cases, for the sake of the profitability of the institution, our income from the loans must be greater than the cost we incur through servicing the debt. In addition to this we should try to maximize this positive difference between the rate we receive and the rate we pay. In case we are an investment bank, this is in order to increase our profits; in case we are a development bank charging only costs, in order to issue loans with the lowest possible rate.

We have already seen that funding costs, not surprisingly, tend to increase with the maturity of the debt. Therefore one of the best ways to maximize the spread between income and costs is to issue short-dated debt to fund long-dated loans. This is possibly the single most important reason for the mismatch in maturity between loans and bonds and we are going to discuss this in greater detail in the next section.

 
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