What it means
Banks borrow money from depositors and other lenders and lend it out, and both sides of the balance sheet respond to changing interest rates, but not at the same speed. Some loans and funding reset within weeks, whereas others stay fixed for years.
Gap analysis sorts assets and liabilities into time buckets according to when they reprice. The gap for each bucket is the rate-sensitive assets minus the rate-sensitive liabilities.
If the liabilities that reprice in the next year are larger than the assets that do, the gap is negative. A bank with a negative gap is exposed to rising rates, because the cost of its funding rises faster than the income from its assets.
For example, a bank that funds long-term fixed-rate loans with short-term deposits will have a negative gap. If market rates rise, it must pay more to keep depositors while its fixed-rate loans keep paying the old rate, so its margin is squeezed.
The bank may eventually lose deposits as customers move to higher-paying alternatives. Managers use gap reports to set limits and decide whether to hedge, for example with interest rate swaps (contracts to exchange fixed and floating payments).
The aim is not necessarily a gap of zero, since a bank may deliberately hold a negative gap if it expects rates to fall. Regulators expect the board to approve limits and to understand the risks being taken.
Gap analysis has limits. It assumes that all items in a bucket reprice at the same time and by the same amount, it ignores how customers change behaviour as rates move, and it looks at income and not at the value of the whole portfolio.
More advanced tools such as duration analysis and simulation are used alongside it. Non-bank businesses use a similar idea.
A company with more floating-rate debt than floating-rate assets or income has a negative gap in the same sense and is hurt when rates rise.
In practice
Real-world examples.
Example
A community bank has fixed-rate mortgages funded mainly by deposits that reprice every few months. Its gap report shows a negative gap, so the risk committee limits further fixed-rate lending until it adds a hedge. The bank also tests how large a rise in rates its capital could absorb.
Example
A manufacturer has $10,000,000 of floating-rate loans and only $2,000,000 of floating-rate cash deposits. Its treasurer sees a negative gap of $8,000,000, so each 1% rise in rates costs about $80,000 a year, and she considers fixing part of the debt.
Example
A finance company expects interest rates to fall over the next year and deliberately keeps a modest negative gap. If the forecast is correct, its funding costs will decline faster than its asset yields.
Formula
Calculation
Gap = Rate-sensitive assets - Rate-sensitive liabilities
Change in net interest income = Gap x Change in interest rate
Worked example: within the next 12 months, a bank has $40,000,000 of assets that reprice and $52,000,000 of liabilities that reprice.
Gap = $40,000,000 - $52,000,000 = -$12,000,000 (a negative gap)
If interest rates rise by 1%, the change in net interest income = -$12,000,000 x 0.01 = -$120,000.
If rates fall by 1%, the change would be -$12,000,000 x -0.01 = +$120,000.
The exposure is simplified, since it assumes all repricing happens at the start of the period.Case study
Seen in the real world.
Riverbend Savings is an illustrative, fictional bank that funded most of its lending from short-term deposits and had a one-year negative gap of $90,000,000. The asset-liability committee had accepted this because rates had been stable for years. Nobody had asked what would happen if the situation changed suddenly.
When the central bank unexpectedly raised rates by 2%, the bank's funding costs rose within a few months while the income from its fixed-rate loans barely moved. A simple estimate showed net interest income falling by about $1,800,000 a year.
The committee responded by lengthening deposit terms, selling some fixed-rate loans and entering swaps that converted fixed income into floating income. In this illustrative story, the gap fell to -$20,000,000 and the board set a formal limit for the maximum permitted gap.
Watch out
Common mistakes.
- Assuming a negative gap is always bad, when it can benefit the institution if interest rates fall.
- Using gap analysis alone, when it ignores changes in customer behaviour and the value of long-term positions.
- Mixing up the sign, when a negative gap means more rate-sensitive liabilities than assets.
Questions
People also ask.
What is a positive gap?
It is when rate-sensitive assets exceed rate-sensitive liabilities, so the institution benefits when rates rise.
How do banks fix a negative gap?
They can lengthen funding, shorten asset maturities, use floating-rate loans or use swaps and other derivatives.
Why use time buckets?
Different items reprice at different times, and the buckets show the exposure for each period, such as three months or one year.
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