A dynamic gap is something that is of great concern to banks which have to deal with ongoing loan obligations and constant withdrawals and deposits from customers. The gap is the space between the assets and liabilities that a bank possesses at any given moment. That gap is always in the process of expanding and contracting, which is why dynamic gap analysis takes into account the fluctuating nature of the gap. Since banks are heavily involved in loans both offered to customers and owed to other financial institutions, managing interest rate exposure is another important part of this process.
Financial institutions like banks are at the core of most economies, as they are responsible for transacting large amounts of money between different entities like other banks, businesses, and citizens. Banks are also businesses themselves, and as such, are interested in making profits. Since they have the dual responsibility of catering to the public and reaping profits for their ownership, banks must make sure that their capital reserves are well-managed. One way to do this is through the process of dynamic gap analysis.
Unlike static gap analysis, which is concerned with the difference between assets and liabilities at one moment in time, dynamic gap analysis attempts to measure the gap as time passes and a bank's financial obligations change. This is necessary to make sure that the balance of assets and liabilities is well-preserved. It is a complicated process for a bank that is making a large amount of transactions with multiple entities.
Performing dynamic gap analysis requires keeping track of all of the loans coming into and going out of a financial institution. These loans may have various interest rates attached to them. For example, the interest rate owed on a loan borrowed from another bank might be substantially different from the interest owed to the bank from a small-business owner. As different loans are opened and others are closed out, following these rates is crucial to keeping assets and liabilities in order.
Another important part of managing the dynamic gap is the anticipation of withdrawals by customers. These withdrawals can have a significant impact on the amount of capital reserves held by a bank at any given time. While it is impossible to judge the timing of withdrawals from different customers, banks should be prepared to withstand the maximum impact of these withdrawals at any time in the future. Judging how these withdrawals may be balanced by new deposits is a crucial part of the gap management process.