What Is a Negative Gap?
Let me explain what a negative gap is: it's a situation where a financial institution's interest-sensitive liabilities exceed its interest-sensitive assets. You should know that a negative gap isn't automatically a bad thing, because if interest rates decline, the entity's liabilities get repriced at lower rates, which would increase income. However, if interest rates go up, those liabilities would be repriced at higher rates, and income would decrease.
The opposite is a positive gap, where interest-sensitive assets exceed liabilities. These terms—negative and positive gaps—are part of analyzing interest rate gaps, also known as duration gaps.
Key Takeaways
- A negative gap is when an entity's interest-sensitive liabilities exceed its interest-sensitive assets.
- If interest rates decline, liabilities are priced at lower rates, increasing income; if rates increase, the opposite happens.
- The size of a financial institution's gap indicates how interest rate changes will impact its net interest income.
- A negative gap is part of asset-liability management, which involves managing cash inflows to cover liabilities.
- A zero duration gap means no positive or negative gap, protecting the firm against interest rate movements.
Understanding a Negative Gap
Negative gap ties into gap analysis, which helps determine a financial institution's interest-rate risk related to repricing—that's the change in rates when an interest-sensitive investment matures.
The size of an entity's gap shows you how much impact interest rate changes will have on a bank's net interest income. Net interest income is simply the difference between revenue from assets like loans, mortgages, and securities, and expenses like interest paid on deposits.
Negative Gap and Asset-Liability Management
A negative gap isn't inherently good or bad, but it measures how exposed a bank is to interest-rate risk. You need to understand this as part of asset-liability management, which banks incorporate into their operations.
Gap analysis, as a tool in asset-liability management, can assess liquidity risk. Overall, asset-liability management focuses on the timing of cash flows—it examines when cash comes in versus when liabilities are due and the risks involved. The goal is to ensure cash inflows from assets always cover liability payments.
This management also concerns the availability of assets to pay liabilities and when assets or earnings can be converted to cash. You can apply this to various balance sheet asset categories.
When the duration gap is zero—no positive or negative gap—the firm's equity is protected from interest-rate risk, as rate changes won't affect it. But achieving a zero gap is tough because not all assets and liabilities match in duration, customer prepayments and defaults alter cash flow timing, and some items have inconsistent cash flow patterns.
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