What it means
Liquidity gap analysis lines up the cash inflows and outflows into time buckets, such as overnight, up to one week, one month, three months and one year. For each bucket, the gap is simply the inflows minus the outflows.
The result shows when money is likely to be short, and by how much. Banks use the method as a core tool of asset and liability management.
Their assets, such as loans, mature on one schedule, while their liabilities, such as deposits, can be withdrawn on another. When short-term liabilities exceed short-term assets, the bank has a negative gap in the near term and must be ready to raise money or sell assets.
Companies use a simpler version in cash forecasting. A treasurer will list expected receipts from customers and expected payments to suppliers, staff, tax authorities and lenders for each week, and then look for weeks where the gap is negative.
That tells her when to draw on a credit line or arrange extra funding. Gaps can be shown for each period and also cumulatively, adding each bucket to the ones before it.
The cumulative figure is more useful for planning, because a small shortfall in one week can be covered by a surplus in the next, but a series of negative weeks builds a larger hole. The method relies on assumptions about when cash will really move.
Customers pay late, deposits behave differently under stress, and loans are repaid early, so analysts usually test the gaps under cautious assumptions as well as the expected case. Good practice is to document each assumption so that reviewers can challenge it.
In practice
Real-world examples.
Example
A bank finds a negative gap of $30,000,000 in its one-month bucket. The treasury team arranges to borrow from other banks and holds extra liquid securities in case the funding is not available. The head of treasury reports the position to the risk committee, which checks it against the bank's approved limits.
Example
A construction company prepares a weekly forecast and sees that payroll and a large supplier payment fall in the same week, before a client payment arrives. It asks the client to pay early and draws on a credit line to bridge the difference.
Example
A retailer reviews its monthly gaps and sees that January, after the holiday season, is always negative. It builds up cash in November and December to cover the shortfall. The following year it negotiates longer payment terms with suppliers, which narrows the gap further.
Formula
Calculation
Liquidity gap = cash inflows - cash outflows in each period. Cumulative gap = sum of the gaps to date.
Suppose a bank expects $120,000,000 of inflows and $150,000,000 of outflows in the first 30 days. The first-month gap = 120,000,000 - 150,000,000 = -$30,000,000. In days 31 to 90 it expects $200,000,000 of inflows and $170,000,000 of outflows, so the second gap = 200,000,000 - 170,000,000 = $30,000,000. The cumulative gap after 90 days = -30,000,000 + 30,000,000 = $0. The first-month gap as a share of outflows = -30,000,000 / 150,000,000 = -20%.Case study
Seen in the real world.
Southgate Savings is an illustrative, fictional bank that raised short-term deposits and lent the money out as five-year loans. Its liquidity gap report showed a modest negative gap in the first month and a large negative gap over the first year.
When rumours about a competitor made depositors nervous, the bank's treasurer reran the gap report with the assumption that 10% of deposits would leave within a month. The gap widened to about -$80,000,000, much more than the bank's liquid assets.
In this illustrative case, the bank responded by lengthening its funding, selling some loans and building a bigger liquidity cushion. The board agreed to review the gap report weekly, not monthly, during periods of stress. The treasurer also began reporting the gap under three scenarios, so directors could see the range of outcomes.
Watch out
Common mistakes.
- Using only the expected case, when a stress test with slower collections and faster withdrawals shows the real risk.
- Confusing a negative gap with a loss, since it is a timing shortfall that can be covered, not an accounting loss.
- Looking at each period alone, when the cumulative gap shows how shortfalls build up.
Questions
People also ask.
Is a negative gap always bad?
No, banks often run negative gaps in short buckets because they fund long-term loans with shorter deposits, but they need a plan to cover it and limits that cap how large the gap can become.
How is a liquidity gap different from an interest rate gap?
A liquidity gap looks at cash timing, while an interest rate gap looks at how rate changes affect assets and liabilities that reprice.
How often should it be reviewed?
Banks usually review daily or weekly, while companies update cash forecasts weekly or monthly depending on how tight cash is.
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