14 2 Funding: Introduction
First, there is thus a general risk of not having access to sufficient funding. This
risk is increased by over-reliance on one source or institution. Over-reliance can
be part of the business model of the firm (as in the case of Northern Rock) or
caused by its commercial choices (such as over-reliance on one bank) or legal
choices. For example, funding contracts between the firm and one source may
make it difficult for the firm to raise funding from other sources. Over-reliance is
likely to increase other risks inherent in funding.
Second, there is the exit risk (such as the acceleration risk in debt funding). For
many reasons, the source of funding may disappear and the firm may have to re-
pay funds that it already has received. (a) An investor may claim the repayment of
funds he has invested and exit the firm according to the normal terms of the in-
vestment. (b) On the other hand, exit can also be surprising and happen earlier
than expected. Such acceleration may be caused by the materialising of counter-
party commercial risk (for counterparty commercial risk, see Volume II). For ex-
ample, the firm might prefer long-term investors, but a particular investor might
choose to terminate the investment for many reasons, such as: because it may do
so under the terms of the investment contract; because of the firm’s own default
and the investor not wanting to give a waiver; because of the investor’s need to in-
crease liquidity; because of the investor’s own insolvency; or for other reasons. (c)
Acceleration may also be caused by the materialising of a general legal risk (Vol-
ume II). For example, the funding transaction may turn out to be invalid due to a
change of law.
Third, there is the replacement risk. After the termination of a funding ar-
rangement, it may be difficult for the firm to replace the funding arrangement with
a similar arrangement. The lack of funding can, in the worst case, lead to insol-
vency of the firm.
There were two sources of pressure on the banks in 2008, concern about solvency and li-
quidity. The former was caused by non-performing loans and mark-to-market losses. In ad-
dition, it caused problems with the latter, because banks were having trouble raising long-
term debt and replacing or refinancing shorter-term debt. Questions about solvency and li-
quidity ruined the reputation of the banking sector as a whole, and made the problems
worse.
Fourth, there is the refinancing risk. If the firm replaces the funding arrangement
with a similar arrangement, the firm may have to pay more for its funding. For ex-
ample, refinancing costs in a mortgage transaction include not only the new inter-
est rate but also transaction costs. Part of the costs may be caused by terms of the
existing funding arrangement. The firm may have agreed to pay fees and charges
in the event that it wants to terminate the arrangement. The firm may also have
agreed to pay a prepayment penalty or to reimburse the investor for the loss that
the investor has sustained.
Fifth, there is the risk of repossession. (a) Repossession risk may depend on the
firm’s actions. The risk of repossession is relevant, for example, in asset finance
where the firm has granted security interests or ownership-based functional
equivalents to security in its assets. (b) Repossession risk may depend on the
firm’s contract party. For example, there may be a higher repossession risk where: