Construction of a Gap Report

As a general rule all assets, liabilities and off-balance-sheet items should be included in a banks gap report. Less complex banks should at a minimum include all earning assets and interest-paying liabilities in their gap reports.

A bank also should consider including potential repricing or maturities of all non-earning assets and non-interest bearing liabilities in its reports. Non-earning assets such as non-accrual loans, for example may at some point be collected or renegotiated, and then become repricable. Non-interest bearing liabilities (demand deposit account balances) also should be included in a banks gap report even though such deposits do not bear an explicit rate of interest. Such deposits are included because, their maturity or run-off exposes the bank to interest rate risk. (The bank may need to replace the deposits with interest bearing sources of funds such as NOW accounts, certificates of deposits or federal funds purchased.)

If the bank operates significant books in currencies other than the dollar, it should prepare a separate gap report for each book. Why? Interest rates in different countries can move in different directions, and the volatility of such interest rates can differ considerably as well. A significant currency book would be one that represents atleast 10 % of total business. Many banks avoid open positions or repricing imbalances in their foreign currencies may not be needed.

Number of Time Bands

A bank must decide how many time bands it will use in its gap report. In general, the narrower the time bands, the more accurate the risk measure. To measure risk to earnings, the report should have at least monthly detail over the first year and quarterly over the second. If a gap report is used to capture long-term exposures and risk to economic value time bands should extend to the maturity of the last asset or liability.

Time bands for distant periods, say beyond 10 years, may be relatively wide-five years for example. These wider time frames are justified because the change in interest rate sensitivity is small in maturities beyond 10 years. In other words a banks use of wide time bands beyond 10 year will not usually cause it to misestimate its interest rate risk exposure for items in those time bands.

Reporting of Off-Balance Sheet Items

A gap report that does not include off-balance sheet interest rate positions does not fully measure a bank’s interest risk profile. All material positions in off-balance sheet instruments whose value can be affected by interest rates should be captured in a gap report. Such instruments include interest rate contracts, such as swaps, futures; and firm forward commitments to buy or sell loans, securities, or other financial instruments.

Off-balance sheet instruments are often reported in a gap report using two entries to reflect how the instruments alter the timing of cash flows. The two entries of the contract are offsetting: one entry is the notional principal amount of the contract reported as a positive dollar value, and the other is an off-setting negative entry. If the off-balance sheet position generally increases in value when interest rates fall (e.g. long futures, pay-floating swap, long call option, and short put option positions), the first entry is reported with a negative value and the second entry is reported with a positive value when interest rates rise (e.g.; short futures, pay-fixed swap, short call option and long put option positions), the first entry is positive and the second is negative. The slotting reflects the impact of an off-balance sheet instrument on the effective maturity of an asset on the balance sheet.

For example, if a bank has a $100 million five-year interest swap in which it receives a fixed rate and pays three month Libor, the bank would report a positive $100 million in the five-year time band and a negative $100 million in the three-month time band. This treatment reflects the fact that the bank is ‘long ‘a fixed rate payment (as it owned a fixed rate asset) and ‘short’ a floating-rate payment (as if it had a floating-rate liability).

A long futures position would increase a bank’s asset maturity, while a short futures position would decrease its asset maturity. Hence, along position in a 10-year Treasury note future that expires in five months would be reported as a negative entry in the time band that covers five-month maturities and a positive entry in the time band that covers a 10-year instrument.

As discussed in the next post, option instruments such as caps and floors pose special problems for gap reports. Because most gap reports usually assume a static interest rate environment at the current level of interest rates hey ignore caps and floors until the strike rate is hit. Suppose a bank has a long position in the 10-yr interest rate cap. Before the strike rate is hit, the report would show the position as a floating rate liability and would ignore the cap; after the strike rate is hit, the position becomes a 10-year fixed rate liability.