Chapter 7
Managing Interest Rate Risk: GAP and Earnings Sensitivity
Chapter Objectives
1. Identify factors that cause a bank’s net interest income and net interest margin to
change.
2. Describe the traditional static GAP model used to assess a bank’s interest rate risk.
3. Identify the strengths and weaknesses of the static GAP model.
4. Describe how embedded options in assets and liabilities make it difficult to assess
actual repricing frequencies and the ultimate impact on expected cash ‘ows.
5. Explain why bank managers do not change loan rates by the same amounts and at
the same time that they change rates paid on liabilities.
6. Demonstrate the basic features of earnings sensitivity analysis.
7. Introduce a rate sensitivity report and earnings at risk report.
8. Analyze strategies to manage interest rate risk. Address whether banks can vary
GAP to take advantage of perceived movements in interest rates.
Key Concepts
1. Asset and liability management involves managing a bank’s entire balance sheet as
a dynamic system of interrelated accounts and transactions. A bank’s asset &
liability management committee (ALCO) considers decisions related to the
composition of assets and liabilities, the pricing of loans and deposits, meeting
liquidity needs, capital management, and controlling noninterest expense or
generating noninterest income. The term, asset and liability management, has
come to refer generally, however, to managing interest rate risk.
2. Banks typically focus on either net interest income or the market value of
stockholders’ equity as a target measure of performance. GAP models are
commonly associated with net interest income (margin) targeting.
3. Many factors can cause a bank’s net interest income to vary over time. The most
prevalent include a change in 1) the level of interest rates, 2) the slope of the yield
curve, 3) the volume of earning assets and interest-bearing liabilities, and 4) the
composition of assets and liabilities, and 5) the exercise of embedded options,
which alters the cash ‘ows of underlying assets and liabilities.
4. Rate sensitive assets and liabilities are those than can be repriced within a <xed
time interval. They include maturing instruments, ‘oating and variable rate
instruments, and any full or partial principal payments. A bank’s GAP is de<ned as
the difference between a bank’s rate sensitive assets and rate sensitive liabilities. It
is a balance sheet <gure measured in dollars for U.S. banks over a speci<c period of
time.
5. A rate sensitivity report classi<es a bank’s assets and liabilities into time intervals
according to the minimum number of days until each instrument can be repriced. It
then reports GAP values on a periodic basis for each time interval, and on a
cumulative basis through each time interval. The be0er reports incorporate a
speci<c interest rate forecast and assign cash ‘ows to time intervals based on when
assets and liabilities are expected to reprice given the rate environment.
6. A positive GAP indicates that a bank has more rate sensitive assets than liabilities,
and that net interest income will generally rise (fall) when interest rates rise (fall). A
negative GAP indicates that a bank has more rate sensitive liabilities than rate
sensitive assets, and that net interest income will generally fall (rise) when interest
rates rise (fall).
7. A bank that is positioned to gain when rates rise and lose when rates fall is labeled
asset sensitive. A bank that is positioned to gain when rates fall and lose when
rates rise is labeled liability sensitive.
8. There is no general optimal value for a bank’s GAP in all environments. GAP is a
measure of interest rate risk. The best GAP for a bank can be determined only by
evaluating a bank’s overall risk and return pro<le and objectives. Generally, the
farther a bank’s GAP is from zero, the greater is the bank’s risk. Many banks
establish GAP policy targets to control interest rate risk by specifying that GAP as a
fraction of earning assets should be plus or minus 15%, or the ratio of RSAs to RSLs
should fall between 0.9 and 1.1. Generally, these static measures of risk are bad
because they ignore the dynamic nature of rate sensitive assets and liabilities.
9. The primary advantage of GAP analysis is its simplicity. The primary weakness is
that it ignores the time value of money. GAP analysis typically assumes that all
rates change at the same time in the same direction and by the same amount,
which never happens. GAP further ignores the impact of embedded options. For
this reason, most banks conduct earnings sensitivity analysis, or pro forma analysis,
to project earnings and the variation in earnings under different interest rate
environments.
10. Earnings sensitivity analysis consists of six general steps: forecasting interest rates,
identifying changes in the composition of assets and liabilities in different rate
environments, forecasting when embedded options will be exercised, identifying
when speci<c assets and liabilities will reprice given the rate environment,
estimating net interest income and net income, and repeating the process to
compare forecasts of net interest income and net income across rate
environments.
11. The concept of earnings at risk indicates the potential variation in net interest
income and/or net income across different interest rate environments, given
different assumptions about balance sheet composition, when embedded options
will be exercised and the timing of repricings. It demonstrates the potential
volatility in earnings across these environments.
12. The greater the potential variation in earnings (earnings at risk), the greater the
amount of risk assumed by a bank. Alternatively, some banks focus on the risk of
loss. As such, the greater the potential reduction in earnings from target, the
greater the amount of risk.
13. Many bank managers a0empt to adjust the interest rate risk exposure of a bank in
anticipation of changes in interest rates. This activity is speculative because it
assumes that management can forecast rates be0er than forward rates embedded
in the yield curve.
14. A bank’s asset and liability management committee (ALCO) coordinates all policy
decisions and strategies that determine a bank’s risk pro<t and pro<t objectives.
Interest rate risk management is the primary responsibility of this committee.
Teaching Suggestions
This chapter is highly technical, but extremely important to understand the most popular
procedures to assess a bank’s interest rate risk. Many students will need to review
Chapter 6, which provides background information about interest rates and bond prices.
Static GAP analysis is best introduced by reference to the examples in Exhibits 7.2 to 5.4.
The rate sensitivity reports in Exhibits 7.5 and 7.6 follow closely those provided in the
soGware used by many community banks. Students should fully understand the
construct and implications of this report before leaving the topic. It is important to
differentiate between a bank’s periodic GAP and cumulative GAP and to note that this is
a static snapshot of a bank’s pro<le at a <xed point in time. The cumulative GAP <gure is
the more useful one because it measures the difference in rate sensitivity from the
present (date of the report) through the last day in each time bucket.
A key point is that there is a different GAP pro<le or rate sensitivity pro<le that applies in
each different rate environment. This result arises because which assets are truly rate
sensitive depends on the underlying interest rate environment. The embedded options
inherent in bank assets and liabilities are exercised in different rate environments. Spend
time discussing prepayments on mortgages and when bonds with call options are
exercised. What do these ‘events’ do to the effective rate sensitivity of bank assets and
liabilities? In addition, banks do not change asset yields at the same time, in the same
direction and by the same amount. Hence, spreads adjust depending on whether rates
are rising or falling.
Spend some time discussing GAP-based targets for policies on how much interest rate
risk is acceptable. The measures RSAs/RSLs and GAP/Earning assets have many
weaknesses for banks with signi<cant embedded options. Importantly, what’s rate
sensitive changes when rates change such that GAP changes across rate environments.
Have students collect rate sensitivity report data from current annual reports of large
banking organizations. Many of these describe the problems in interpreting GAP data
and introduce the concept of earnings sensitivity and earnings at risk. Use this
information to lead a discussion of embedded options. Ask students to identify which
assets and liabilities of a bank contain embedded options, is the bank a buyer or seller of
the option, in what environment will the option be exercised, and what will option
exercise do to the rate sensitivity of the bank’s assets and liabilities. It is bene<cial to
work through the example for ABC bank. The earnings sensitivity data in Exhibit 7.8
demonstrate the process and describe the bank’s aggregate risk exposure. It is important
to understand the basic assumptions underlying the analysis. What is the benchmark
interest rate? What is the most likely (base case) rate forecast? What does a rate shock
of +1% or –1% mean? Refer also to the data in Exhibit 7.9, which reflect one of the
popular effective GAP reports used by community banks. Finally, students will want to
discuss how banks manage GAP to either hedge or speculate. Use the information in the
text to work through alternative strategies that seem appropriate in adjusting a bank’s
GAP exposure.
To demonstrate pro<ciency, students should answer the questions and problems at the
end of the chapter. The emphasis should be on interpreting the information and not the
calculations. Finally, it is important to clarify that GAP and earnings sensitivity models
simply provide methods for assessing risk. There are many weaknesses to each model,
but managers can use the models to track when and how risk is changing over time and
how much relative risk a bank has assumed.