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A negative gap is a situation in which there is disparity between the interest sensitive assets that are owned by a financial institution and the interest sensitive liabilities that the institution currently carries. This type of situation is not unusual for many institutions and, as long as this gap or disparity is kept within a certain range, will not pose any real threat to that institution. A number of factors can cause the gap to widen significantly, with shifts in the average interest rate being one of the more important.
The degree of interest rate risk that the bank or other institution carries with both 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 rates associated with those liabilities and assets, the gap will likely remain within an acceptable range. Sudden changes in that average rate may benefit the institution, or create a great deal of financial hardship, depending on the direction that the interest rate happens to move.
When the average interest rate changes significantly, this will create a wider disparity that may lead to a positive or a negative gap. For example, if the shift in interest rate leads to a situation in which the value of the institution’s interest sensitive assets are higher than the interest sensitive liabilities currently held, this is considered a positive gap. Should that change in interest rate lead to a situation in which the interest sensitive liabilities are suddenly much greater than the 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 to rearrange assets and liabilities in a manner that is expected to produce the most possible benefit to the institution.
Typically, a decrease in the average interest rate is likely to help narrow the negative gap, or may even be sufficient to create a positive gap. This is because the decline of the interest rate would in turn mean that the interest-sensitive liabilities held by the bank would be repriced in order to be in line with those lower rates. The end result is that the institution is able to pay lower interest on those liabilities and keep more of its proceeds as income. Should the average rate increase, this would mean those same liabilities would be repriced at a higher rate, which would place a greater burden on the institution and increase the amount of the negative gap.