What Is a Negative Gap?
A negative gap is a situation where a bank's interest-sensitive liabilities exceed its interest-sensitive assets. A negative gap is not necessarily a bad thing, because if interest rates decline, the bank'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 rates, and income would decrease.
The opposite of a negative gap is a positive gap, where a bank's interest-sensitive assets exceed its interest-sensitive liabilities.
Negative Gap Explained
Negative gap is related to gap analysis, which can help determine a bank or asset manager’s interest-rate risk as it relates to repricing (i.e. the change in interest rate when an interest-sensitive investment matures). The size of a bank'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 a bank'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
Many describe gap analysis as a method of asset-liability management, which can be helpful in assessing liquidity risk. (This generally excludes credit risk.) Gap analysis may be a simple IRR measurement, which conveys the difference between rate-sensitive assets and rate-sensitive liabilities over a given period of time.
IRR, or Internal Rate of Return, is a metric which many entities use to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
In general, the concept of asset-liability management focuses on the timing of cash flows (e.g. a bank’s managers must understand when liabilities are due and when they present risk). 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.
Gap analysis works particularly well if assets and liabilities consist of fixed cash flows. One shortcoming of gap analysis is that it cannot handle options, given that options have more variable cash flows.
The interest rate gap is is another term to describe risk exposure. Many financial institutions and investors use the interest rate gap to develop hedge positions. Interest rate futures often come into play in these cases. Calculations rely on the maturity dates of securities.