Negative Gap

Negative Gap

Key takeaways

• A negative gap occurs when an institution’s interest-sensitive liabilities exceed its interest-sensitive assets.
• If interest rates fall, liabilities reprice lower before assets, which can increase net interest income; if rates rise, income can decline.
• Gap size indicates exposure of net interest income to interest-rate movements.
• Managing negative (and positive) gaps is part of asset-liability management (ALM) and gap analysis.
• A zero (duration) gap seeks to neutralize interest-rate risk, but is difficult to achieve in practice.

What a negative gap means

A negative gap means more of a bank’s or financial institution’s liabilities (for example, deposits or short-term borrowings) reprice with changes in interest rates sooner than its assets (such as loans or securities). Because liabilities are more rate-sensitive than assets, changes in market rates affect the institution’s net interest income (interest earned on assets minus interest paid on liabilities).

How it works

• If interest rates decline: Liabilities reprice downward more quickly, reducing interest expense and typically increasing net interest income.
• If interest rates rise: Liabilities reprice upward first, increasing interest expense and typically reducing net interest income.

The magnitude of the gap determines how strongly net interest income responds to rate changes. A larger negative gap implies greater sensitivity to rising rates (more downside) and larger potential upside if rates fall.

Role in asset-liability management (ALM)

Gap analysis is a core ALM tool used to measure timing mismatches between asset and liability repricing. ALM focuses on:
* Timing of cash inflows versus outflows.
Liquidity risk — ensuring assets and incoming cash flows are available to meet liability payments.
Interest-rate risk — understanding how repricing timing affects earnings.

Managers use gap measures to align repricing windows, hedge risk, or adjust product mixes to alter sensitivity to rate movements.

Duration gap and zero gap

Terms like “duration gap” extend the concept by measuring the weighted-average timing (duration) of cash flows. A zero duration gap means assets and liabilities have equal interest-rate sensitivity, so changes in rates have minimal effect on a firm’s equity or net interest income. In practice, achieving a true zero gap is difficult because of:
* Mismatched maturities and cash-flow patterns.
Customer behaviors (prepayments, early withdrawals, defaults).
Assets and liabilities that don’t repricing symmetrically.

Conclusion

A negative gap isn’t inherently good or bad; it signals how exposed a financial institution is to changes in interest rates. Understanding and managing gap exposure through ALM practices helps institutions protect net interest income and liquidity as market rates move.