Gap Reports - What they are

Gap Reports – What they are

A method of measuring interest rate risk

Gap reports are frequently used in firms to show the extent of the interest rate risk that is being run. They are sometimes referred to as interest rate repricing reports.

If you look at the assets (investments) and the liabilities (funding) in a bank or building society balance sheet it is most unlikely that they will all be on the same interest basis. 

Some assets and liabilities are floating or variable rate. This means they are linked to Libor or Base rate. Some assets and liabilities are fixed rate. As a result the balance sheet will have a mixture of fixed rate and floating rate interest payments and receipts.

When this happens the firm is exposed to a type of market risk called interest rate risk. 

When interest rates change the value of the balance sheet can alter. It may work in your favour it may work against you. The main difficulty is the uncertainty you face and that’s something you need to manage. A gap report measures this risk. Let’s see how.

A simple example

Suppose a bank or society lends money for mortgages which pay a fixed interest rate. Furthermore the bank borrows money either from retail depositors or wholesale markets on a variable or floating rate basis:

If interest rates increase the funding cost will exceed the interest income.

If funding costs 6% and the interest income is 5% the net interest margin is -1%. The firm loses money. To stop this happening it is important that interest rate risk is measured and controlled.

A gap report puts all the assets and liabilities into time buckets that reflect their repricing.

It means that if you make a 3 month loan this is your asset. It would be recorded as a cash repayment or inflow of money on the maturity date. The loan would fall into the 3 month time bucket because in three month's time the loan is repaid.

If you took a matching deposit for 3 months (your liability) this would be recorded as a cash outflow on the maturity date:

By determining when the asset or liability is repriced (has its interest rate refixed or renewed) you can see what different products look like using this simple graph.

A few more familiar products

Here is a 3 year bond or 3 year loan at a fixed rate of interest

Now a 3 year floating rate note with Libor refixings every 3 months

What about a 3 month repo?

This is like taking a deposit. You "borrow" money against collateral.

And a 3 month reverse repo?

This is just like lending money, you get your cash returned in 3 months.

It’s simple and even derivatives like swaps can be put into time buckets. You just treat them as if they are loans and deposits. Let's look at a 5 year interest rate swap. Where you pay fixed interest and receive 3 month Libor. This is just like borrowing 5 year money, paying a fixed rate of interest and lending 3 month money where you receive Libor.

Here is what it looks like:

How does interest rate risk show up?

It shows up when there is a gap between the buckets containing the assets and the buckets containing the liabilities. In order to see this all the assets and liabilities need to be put on the same graph or report.

Earlier we looked at a bank that had lent on a fixed interest basis and borrowed on a floating rate basis.

Let's now add that the loan is for £100m  maturing in 5 years time and the deposit is £100m maturing in 3 months time.

If this was the entire balance sheet what does it look like on our time bucketed graph? Let’s see:

This is the gap report. It shows an interest rate mismatch between the assets and liabilities on the balance sheet. The liabilities reprice before the assets. This means there is an interest rate risk. If interest rates increase the liability will reprice first and it will reprice upwards. This will be detrimental. The interest expense will rise relative to the interest income.

If interest rates fall the reverse occurs. The interest expense falls whilst the interest income remains unchanged. If the bank wants to reduce this risk it must find ways of closing the gap. Of course the simplest (but not the only) way is to match the repricing maturities of both assets and liabilities.

First Published by Barbican Consulting Limited 2009