A negative gap occurs when there is a mismatch between a financial institution’s interest-sensitive assets and liabilities. Changes in the average interest rate can cause the gap to widen, creating a positive or negative gap. Decreases in the average interest rate can help narrow the negative gap, while increases can increase it. Financial institutions monitor interest rates to reorganize assets and liabilities for the greatest benefit.
A negative gap is a situation in which there is a mismatch between the interest-sensitive assets owned by a financial institution and the interest-sensitive liabilities that the institution currently owns. This type of situation is not unusual for many institutions, and as long as this gap or disparity stays within a certain range, it will not pose a real threat to that institution. Several factors can cause the gap to widen significantly, with changes in the average interest rate being one of the most important.
The degree of interest rate risk that the bank or other institution carries with its assets and liabilities will have an effect on the degree of negative gap that exists. When the average interest rate is more or less in line with the rates associated with those liabilities and assets, the gap will likely remain within an acceptable range. Sudden changes in that average rate can either benefit the institution or create a host of financial difficulties, depending on which direction the interest rate moves.
When the average interest rate changes significantly, this will create a wider disparity that can lead to a positive or negative gap. For example, if the interest rate change leads to a situation where the value of the institution’s interest-sensitive assets are higher than its current interest-sensitive liabilities, this is considered a gap. positive. If that interest rate change leads to a situation where interest-sensitive liabilities are suddenly much larger than assets, the gap is considered negative. Financial institutions routinely monitor the movement of the average interest rate and even predict the future direction of that movement as a way of reorganizing assets and liabilities in a way that is expected to produce the greatest possible benefit for the institution.
Typically, a decrease in the average interest rate is likely to help narrow the negative gap, or may even be enough to create a positive gap. This is because the interest rate decrease would in turn mean that interest-sensitive liabilities held by the bank would be repaid to be in line with those lower rates. The end result is that the institution can pay lower interest on those liabilities and keep more of its earnings as income. If the average rate increases, this would mean that those same liabilities would be revalued at a higher rate, placing a greater burden on the institution and increasing the amount of the negative gap.
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