What Is the Interest Rate Gap?
The interest rate gap measures a firm's exposure to interest rate risk. The gap is the distance between assets and liabilities. The most commonly seen examples of an interest rate gap are in the banking industry. A bank borrows funds at one rate and loans the money out at a higher rate. The gap, or difference, between the two rates represents the bank's profit.
- The interest rate gap helps determine a bank or financial institution’s exposure to interest rate risk.
- A negative gap, which is an interest rate gap that is less than one, is when rate-sensitive liabilities are greater than rate-sensitive assets, while a positive gap, which is greater than one, is the opposite.
- Hedging can be used to reduce the risk of a large interest rate gap.
Formula and Calculation of the Interest Rate Gap
IRG=Interest Bearing Assets − IBLwhere:IRG = Interest rate gapIBL = Interest bearing liabilities
The interest rate gap is calculated as interest rate sensitive assets minus interest rate sensitive liabilities.
What the Interest Rate Gap Can Tell You
The interest rate gap shows the risk of rate exposure. Typically, financial institutions and investors use it to develop hedge positions, often through the use of interest rate futures. Gap calculations are dependent on the maturity date of the securities used and the period remaining before the underlying securities reach maturity.
A negative gap, or a ratio less than one, occurs when a bank's interest rate sensitive liabilities exceed its interest rate sensitive assets. A positive gap, or one greater than one, is the opposite, where a bank’s interest rate sensitive assets exceed its interest rate sensitive liabilities. A positive gap means that when rates rise, a bank’s profits or revenues will likely rise.
There are two types of interest rate gaps: fixed and variable. Each measures the difference between rates on assets and liabilities and is an indicator of interest rate risk. Determination of the differential spans a given period for both fixed and variable interest rate gaps. Interest rate gaps can also apply to the difference in interest rates on government securities between two different countries.
Who Uses the Interest Rate Gap?
Institutions that profit from interest rate differentials or fund their activities with loans must keep track of the gap. A bank, which hopes to borrow low and loan high, must be keenly aware of the yield curve. The yield curve is the difference among interest rates across the maturity spectrum.
A flat yield curve indicates there is a low differential between liabilities and assets. A flat yield can be harmful to profitability. In an extreme negative instance, a yield curve may become inverted. In this case, short rates are above long rates, and loan business is entirely unprofitable.
For firms that fund large projects, such as building a new nuclear power plant, the interest rate gap lets them know how to secure funding. If they borrow in short-term maturities for a project that is of a long-term nature, they risk that the rate of continuing funding needs will rise, thereby increasing costs. A hedging strategy may be useful to reduce the risk of a sizable interest rate gap.
Example of How to Use the Interest Rate Gap
For example, Bank ABC has $150 million in interest rate sensitive assets (such as loans) and $100 million in interest-rate sensitive liabilities (such as savings accounts and certificates of deposit). The gap ratio is 1.5, or $150 million divided by $100 million.
Or consider Bank of America and its 2020 year-end balance sheet. Bank of America had $1.39 billion in interest-bearing assets, which includes loans and leases, and debt securities. Alternatively, it has some $1.63 billion in interest-related liabilities, such as deposits, short-term borrowings, and debt. In this case, Bank of America’s interest rate gap is -$240 million, or $1.39 billion - $1.63 billion.
The Difference Between the Interest Rate Gap and Earnings Sensitivity
Interest rate gap analysis looks to determine interest rate risk by looking at assets versus liabilities. Meanwhile, earnings sensitivity takes gap analysis a step further. It looks beyond the balance sheet to how interest rates impact a bank’s earnings.
Limitations of Using the Interest Rate Gap
A negative gap may not always be a negative for a financial institution. That is, as interest rates fall, banks earn less from interest-rate-sensitive assets; however, they also pay less on their interest-related liabilities. Banks that have a higher level of liabilities than assets are the ones that see more of a strain on their bottom line from a negative gap.