Negative Gap

What Is a Negative Gap?

A negative gap is a situation where a financial institution's interest-sensitive liabilities exceed its interest-sensitive assets. A negative gap is not necessarily a bad thing, because if interest rates decline, the entity's liabilities are repriced at lower interest rates. In this scenario, income would increase. However, if interest rates increase, liabilities would be repriced at higher interest rates, and income would decrease.

The opposite of a negative gap is a positive gap, where an entity's interest-sensitive assets exceed its interest-sensitive liabilities. The terms of negative and positive gaps, which analyze interest rate gaps, are also known as duration gap.

Key Takeaways

  • A negative gap is when an entity's interest-sensitive liabilities exceed its interest-sensitive assets.
  • If interest rates decline, the liabilities are priced at lower rates, increasing income. If interest rates increase, the opposite is true.
  • The size of a financial institution's gap is an indicator of the impact interest rate changes will have on its net interest income.
  • A negative gap is a component of asset-liability management; managing cash inflows to pay for liabilities.
  • A zero duration gap is when there is no positive gap or negative gap and a firm is protected against interest rate movements.

Understanding a Negative Gap

Negative gap is related to gap analysis, which can help determine a financial institution's interest-rate risk as it relates to repricing, i.e. the change in interest rates when an interest-sensitive investment matures.

The size of an entity's gap indicates how much of an impact interest rate changes will have on a bank's net interest income. Net interest income is the difference between an entity's revenue, which it generates from its assets, including personal and commercial loans, mortgages and securities, and its expenses (e.g., interest paid out on deposits).

Negative Gap and Asset-Liability Management

A negative gap is not necessarily either good or bad, but it is a measure of how much a bank is exposed to interest-rate risk. Understanding this metric is a component of asset-liability management, which banks must consider in their operations.

Gap analysis, as a method of asset-liability management, can be helpful in assessing liquidity risk. In general, the concept of asset-liability management focuses on the timing of cash flows. It looks at when cash inflows are received versus when payments on liabilities are due and when the liabilities present a risk. It aims to ensure that the timing of liability payments will always be covered by cash inflows from the assets.

Asset-liability management is also concerned with the availability of assets to pay the liabilities, and when the assets or earnings may be converted into cash. This process can be applied to a range of categories of balance sheet assets.

When the duration gap is zero, meaning there is no positive gap or negative gap, a firm's equity is thought to be protected against interest-rate risk because any increases or decreases in interest rates won't affect the firm. However, achieving a zero gap is difficult as not all assets and liabilities have matching durations, customer prepayments and defaults will affect the timing of cash flows, and some assets and liabilities will have cash flow patterns that are not consistent.