Negative Gap
Candlefocus EditorA negative gap occurs when an entity’s interest-sensitive liabilities exceed its interest-sensitive assets. This means that when interest rates decline, the entity experiences an increase in income as the lower prices for their liabilities make them more competitive for their services. At the same time, when interest rates increase, the reverse is true as the cost of providing services through their liabilities increases.
The size of the gap is an indication of how sensitive the entity's net interest income is to changes in interest rates. A larger gap signal increased volatility. If a financial institution has a large negative gap, they are more likely to experience larger swings in income when rate changes occur. On the other hand, if the gap is small, the entity is more protected against shifts in the market. A zero duration gap is when the sum of the of the interest rate-sensitive assets and liabilities are the same, which means that the institution is better protected against movements in interest rates.
Overall, negative gaps can be a useful tool in asset-liability management. By understanding the impact of changes in interest rates, financial institutions can make more informed decisions with their investments, liabilities and cash flows to keep their institution’s financial health secure in the long term.