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GAP MANAGEMENT: AN IDEA WHOSE TIME HAS GONE Remember 8-track audio tapes? What about VCRs? Typewriters? These were all innovative products that, at the times they were introduced, were game-changers for many. But, someone is always coming up with a better mousetrap. Cameras don’t even need film anymore. There seems to be no facet of human endeavor that hasn’t been affected by technological advancement. The management of interest rate risk is no exception. Banking deregulation during the 1970s removed governmental restrictions over what banks could pay depositors, allowing for new and innovative deposit products. Modern-day asset/ liability management became necessary because, for the first time, the rates paid to depositors would be influenced by market conditions and not by regulatory edict. Banks’ liabilities were now subject to discretionary repricing determined by the vagaries of credit market conditions, competition, and managerial strategy. Technology had some catching up to do.
Something Is Better Than Nothing In the meantime, a tool was developed that was easy to use and simple to understand. Pick a time period, say twelve months, and calculate the dollar amount of earning assets that potentially reprice over that span. Then, compare that dollar amount to the dollar amount of rate-sensitive liabilities that could reprice over the same period. The difference came to be known as “the gap”; thus, gap management was born. On the surface, the reasoning behind gap management’s utility seemed pretty sound. If bank management knew that it had a greater volume of assets repricing than it did liabilities, a condition known as “positive gap,” it could conclude that net interest income (NII) would increase in a rising rate environment. Conversely, if the volume of repricing liabilities was greater than the volume of repricing assets, the bank was “negatively gapped,” and earnings would suffer if rates rose. Makes sense, right? Well, it might if the rates on assets that earn money and the rates on liabilities that cost money all moved at the same time by the same amount. But, the world doesn’t work that way.
Live in the Now While not totally without use, gap-driven estimates of how earnings might be impacted by changing rate environments have always been inaccurate at best, and downright 3 4 | ww w.cbaofga.co m | Summer 2017
misleading at worst. Take, for example, the bank that is negatively gapped. Following “gap logic,” management will perceive that net interest income (NII) will be impaired by rising rates and may feel a need to “fix the problem.” But, “gap logic” ignores the fact that most of the bank’s liabilities are in the form of non-maturing deposits (NMDs) that are very rate insensitive and significantly lag the market in rising rate environments. Under these commonly occurring circumstances, a negatively-gapped bank can, and probably will, still benefit from rising rates. Management’s efforts to fix a problem that doesn’t exist can prove counterproductive. Thankfully, there are now computer models that can, account by account, recognize that rates charged to loan customers will behave differently than rates paid to depositors. The ability to factor in pricing betas along with time lags gives the whole measurement and management process a greater degree of reliability and precision. So, if your bank is one of the many holdouts still clinging to those gap reports, think back to that old 8-track player you might have had in your car. It’s only a matter of time before it eats the tape. Lester Murray joined The Baker Group in 1986 and is an Associate Partner within the firm’s Financial Strategies Group. He helps community financial institutions develop and implement investment and interest rate risk management strategies. Before joining The Baker Group, he worked at two broker/dealer banks in Oklahoma City and was also an assistant national bank examiner. A graduate of Oklahoma State University, he holds Bachelor of Science degrees in finance and economics. For more information, contact Lester at 800-937-2257 or lester@GoBaker.com.
Lester Murray Associate Partner The Baker Group A CBA Endorsed Member Company