Market risk—the risk that a sudden change in market prices could affect earnings or capital—can be difficult to measure, but that doesn’t make it any less important. One way of capturing a bank’s exposure to changing interest rates is Gap Analysis. Although not as sophisticated as some other tools for measuring interest rate risk, Gap allows you to get a quick and intuitive sense of how a bank is positioned by comparing the values of the assets and liabilities that roll over—or reprice—at various time periods in the future.

Although the simplicity of the Gap methodology makes it an attractive tool for measuring interest rate risk, users of Gap need to be aware of its weaknesses and limitations. While Gap is a good measure of repricing risk, it is not able to measure interest rate risk stemming from options risk, basis risk or yield curve risk. As discussed next, earnings at risk and economic value of equity are interest rate risk methodologies that are able to measure these sources of risk.

Lesson Objectives

After you complete this lesson, you should be able to use the worksheet to:

• Recognize and understand potential causes of market risk
• Forecast the effects of interest-rate changes on earnings over various time horizons

Use the following text links to navigate through the lesson material:

What is a “Gap”?

• “Positively Gapped” Example
• “Negatively Gapped” Example

Once you have reviewed the Gap Analysis lesson, complete the Try This at Your Bank exercise: Gap Analysis.

What is a “Gap”?

A tool used to judge a bank’s earnings exposure to interest rate movements is called a gap report. A bank’s gap over a given time period is the difference between the value of its assets that mature or reprice during that period and the value of its liabilities that mature or reprice during that period. If this difference is large (in either a positive or negative direction), then interest rate changes will have large effects on net interest income. In the table below, the term “rate sensitive” indicates the amount of assets or liabilities whose interest rates will change during selected time intervals.

Figure 1 Effect of Gap Size on Change in Net Interest Income

To see the effect of different gap positions given a 1% rise in interest rates, select different values for rate sensitive liabilities from the drop-down menu in the second column above.

For example, lower the value for rate sensitive liabilities to 16. Notice that the maroon bar in the left chart gets smaller, because rate sensitive assets remained unchanged. The growing difference between the height of the two bars means a widening gap. As the gap widens, the change in net interest income grows in the chart on the right, telling us that the larger the gap position of a bank, the greater the potential change in net interest income for any change in interest rates. In these charts, the interest rate change is assumed to be one percent.

A Gap Analysis measures timing differences in the repricing (interest rate changes) of assets and liabilities to identify the exposure of net interest income. The greater these timing differences, the greater the bank’s risk of loss from interest rate changes. You can use knowledge about your bank’s Gap position to determine how its net interest income and, hence, its net income may be influenced by changes in interest rates.

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“Positively Gapped” Example

If your bank is positively gapped (Rate-Sensitive Assets [RSA] are greater than Rate-Sensitive Liabilities [RSL]), its net interest income will move in the same direction as the change in interest rates. If interest rates increase, net interest income will increase; if interest rates fall, so will net interest income.

Figure 2 Effects of Interest Rate Changes on the Net Interest Income of a Positively Gapped Bank

To view the effect of different interest rate changes, select a different value from the drop-down menu in the Interest Rate Change column on the right.

For example, lower the value for interest rate change to a -1. Notice that nothing changes in the left chart, because rate sensitive assets and rate sensitive liabilities remained unchanged. The change in the interest rate, however, caused net interest income to fall in the chart on the right by $20,000. Now change the -1 to a +1. Notice that net interest income rises by $20,000. Do you see the pattern? When rates dropped, so did net interest income. When rates rose, so did net interest income.

There is a positive relationship (interest rate and net interest income move together) between changes in interest rates and net interest income. In essence, the description of a bank as being positively gapped over a certain period of time, normally one year, is the same thing as saying that interest rate and net interest income move in the same direction.

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“Negatively Gapped” Example

If your bank is negatively gapped (RSLs exceed RSAs), then its net interest income will move in the opposite direction of interest rate changes. If rates increase, net interest income will fall; if rates fall, net interest income will rise. Because most banks use short-maturity deposits to fund long-maturity loans, most banks have negative short-run gaps.

Figure 3 Effects of Interest Rate Changes on the Net Interest Income of a Negatively Gapped Bank

To view the effect of different interest rate changes, select a different value from the drop-down menu in the Interest Rate Change column on the right.

For example, lower the value for interest rate change to a -1. Notice that nothing changes in the left chart, because rate sensitive assets and rate sensitive liabilities remained unchanged. The change in the interest rate however, caused net interest income to fall in the chart on the right by $20,000. Now change the -1 to a +1. Notice that net interest income rises by $20,000. This result is different than the one for a positively gapped bank. When rates dropped, net interest income rose. When rates rose, net interest income fell.

There is a negative relationship (interest rate and net interest income move in opposite directions) between interest rate and net interest income change. In essence, the description of a bank as being negatively gapped over a certain period of time, normally one year, is the same thing as saying that interest rate and net interest income move in opposite directions.

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The Gap Report

The gap analysis worksheet, or gap report, shows the maturity and repricing schedules for all of the earning assets and interest-bearing liabilities at a bank. Comparing the value of assets that mature or reprice at each point in time with the value of the liabilities that mature or reprice reveals the exposure of earnings to changes in interest rates and constitutes the heart of gap analysis.

• If assets are repricing faster than liabilities, for example, an increase in interest rates will affect interest income before it affects interest expense, leading to a short-term rise in earnings.
• If liabilities are repricing faster (which is the usually the case at most banks), the same interest-rate rise will cause earnings to fall.

Gap measures are constructed by summing the dollar value of assets that come due over a given time interval and subtracting the liabilities that come due during the same interval. (Only earning assets and interest-bearing liabilities are used, because other balance-sheet categories usually do not have meaningful maturities or repricing schedules.)

The gap analysis report for Insights Bank helps clarify these points. An extract of this report is shown below. For simplicity’s sake, columns for intervals beyond one year are not shown.

For more information about the summary worksheet, move your mouse pointer over the chart below.

Insights’ Gap Report

In her report, Madison noted the ALCO is recommending that the bank sell $1.6 million in Treasury notes coming due at the end of October and use the proceeds from the sale to buy higher-yielding, five-year notes issued by the Federal Home Loan Bank. The effect of this transaction would be to increase the bank’s negative gap–that is, the purchase would reduce rate-sensitive assets that will reprice within the next year by $1.6 million. The $1.6 million would now move to a 1-5 year time period column of the report. The bank’s negative cumulative gap position at one year would increase to $3,533. As a result, if rates rise as expected, the bank’s net interest income would decline more than if the notes had not been purchased. The recommendation to buy the notes is not a good one.

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Gap Ratios in the ALCO or Investment Policy

Many times, the Rate-Sensitive Assets/Rate-Sensitive Liability ratio (RSA/RSL) is incorporated into a bank’s ALCO or investment policy. For example, “It is the policy of Insights Bank to keep its rate-sensitive assets to rate-sensitive liabilities between 0.9 and 1.1.” Banks often state their goal as trying to keep RSA/RSL close to one. At one, interest-sensitive assets equal interest-sensitive liabilities. Deviations from one indicate more interest rate risk exposure.

Another gap measure you may see is gap-to-earnings assets. Half of the banks responding to one survey had policies to keep this ratio below 10 percent in absolute value, meaning that it could be -10 or +10. Few banks tolerated a ratio above 20 percent in absolute value. Thus, if your bank's policies permits exposure in excess of 20 percent, the board may be permitting a level of earning exposure that few other banks would tolerate.

Once you have reviewed the Gap Analysis lesson, complete the Try This at Your Bank exercise: Gap Analysis.