The Concept Of GAP Management: Purpose, Method, Application, Strengths, And Weaknesses
To assess interest rate risk, banks use GAP and earnings sensitivity analysis, which emphasizes income statement effects by focusing on how changes in interest rates and the bank’s balance sheet affect NII, or net interest income, and net income. GAP is used as a static measure of risk and NII as the target measure of bank performance. There are three factors that will potentially cause it to rise or fall: unexpected changes in interest rates (rate); changes in the composition of assets and/or liabilities (mix); and changes in the volume of earning assets and the volume of interest-bearing liabilities (volume effects). Sensitivity analysis extends static GAP analysis by making it more dynamic by focusing on the variation in bank earnings across different interest rate environments. Both measures presumably signal whether a bank is positioned to benefit or lose from rising versus falling rates and how big a change in earnings is possible. In the traditional static GAP model, it attempts to measure how much interest rate risk a bank evidences at a fixed point in time by comparing the rate sensitivity of assets (the dollar value of assets that either mature or are expected to reprice within a selected time period) with the rate sensitivity of liabilities (the dollar value of liabilities that either mature or are expected to reprice within a selected time period). Static GAP focuses on managing NII by measuring expected NII and then identifying strategies to either stabilize or improve it. The key assumption being made in the static GAP model is that the balance sheet is assumed not to change so that only interest rate changes affect earnings.
There are several steps to conduct a static GAP analysis. The first step is to develop an interest rate forecast. The second step is selecting a series of sequential time intervals for determining what amount of assets and liabilities are rate sensitive within each time interval. The third step is to group assets and liabilities into time intervals according to the time until the first repricing. The principle portion of the asset or liability that is expected to reprice in each specific time interval is classified as rate sensitive within that interval; the effects of any off-balance sheet positions are added to the balance sheet position according to whether the item effectively represents a rate sensitive asset (RSA) or rate sensitive liability (RSL). The fourth step is to calculate GAP: A bank’s static GAP equals the dollar amount of RSAs minus the dollar amount of RSLs for each time interval.
It is important to note that there are two different GAP values: The periodic Gap (compares RSAs with RSLs within each single time interval) and the cumulative GAP (compares RSAs and RSLs over all time intervals from present through the last day in each successive time interval). The final step is to forecast NII given the assumed repricing characteristics of the underlying instruments and the assumed interest rate environment. Management of banks can alter the size of the GAP to either hedge NII against changing interest rates or speculatively try to increase NII.
The main strength of static GAP analysis is that it is easy to understand: Periodic GAPs indicate the relevant amount and timing of interest rate risk over distinct maturities and clearly suggest magnitudes of portfolio changes to alter risk; they also indicate the specific balance sheet items that are responsible for the risk. In addition, GAP measures can be easily calculated once cash-flow characteristics of each instrument are identified.
However, the static GAP model has many weaknesses. First, is that there are serious ex post measurement errors. Second, is that GAP analysis ignores the time value of money. Third, is that the GAP analysis procedure ignores the cumulative, or long-term impact of interest rate changes on a bank’s risk position. Fourth, is that liabilities that pay no interest are often ignored in rate sensitivity comparisons due to many banks allocating demand deposits as non-RSLs. Finally, static GAP does not capture risk associated with options embedded in the loans, securities, and deposits that banks deal with.
