DEFINITION of Dynamic Gap
Dynamic gap refers to a method of measuring the gap between a bank’s assets and liabilities. The gap is always in the process of expanding and contracting due to deposits being made and redeemed. Dynamic gap attempts to account for the fluctuating nature of the gap.
BREAKING DOWN Dynamic Gap
Dynamic gap is the opposite of static gap. Whereas static gap is a measure of the gap between a bank’s assets (money held) and liabilities (money loaned or sensitive to interest) at a set moment in time, dynamic gap attempts to measure the gap as time passes. That gap is always expanding and contracting, which is why dynamic gap analysis takes into account its fluctuating nature. Because banks are heavily involved in loans both offered to customers and owed to other financial institutions, managing interest rate exposure is an important part of this process.
How Dynamic Gap Analysis Works
Dynamic gap analysis requires keeping track of all loans coming into and going out of a financial institution. The interest rate owed on a loan borrowed from another bank might be substantially different from the interest owed to the bank from a small-business owner. As different loans are opened and others are closed out, following these rates is crucial to keeping assets and liabilities in order.
Anticipating withdrawals by customers is also important. Withdrawals affect capital reserves held by a bank at any given time. It is impossible to judge the timing of withdrawals from different customers, but banks should be prepared to withstand the maximum impact of these withdrawals at any time.
Limitations of Dynamic Gap Analysis
One limitation of interest rate gaps is the result of options embedded in banking products. These options include items such as floating-rate loans that have a cap on the interest paid by the client. Other options are more implicit, notably the ability of a client to renegotiate the fixed rate of a loan when interest rates decline. In competitive environments, banks tend to comply with the clients’ requests because they are reluctant to give up the revenues from other products.
Embedded options, whether explicit or implicit, change the nature of interest rates. For example, if a rate hits a cap, the rate, which was previously variable, becomes fixed. In the renegotiation of the rate of a fixed-rate loan, the rate was initially fixed and becomes variable. Because interest rate gaps are based on the nature of rates, they do not account for changes of variable to fixed rates and vice versa.