Dynamic Gap

What Is a Dynamic Gap?

Understanding Dynamic Gaps

Because banks are heavily involved in loans both offered to customers and owed to other financial institutions, managing interest rate exposure is an important part of this process.

How Dynamic Gap Analysis Works

Dynamic gap analysis requires keeping track of all loans coming into and going out of a financial institution. 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.

Anticipating withdrawals by customers is also important. Withdrawals affect capital reserves held by a bank at any given time. It is impossible to judge the timing of withdrawals from different customers, but banks should be prepared to withstand the maximum impact of these withdrawals at any time.

Limitations of Dynamic Gap Analysis

One limitation of interest rate gaps is the result of options embedded in banking products. These options include items such as floating-rate loans that have a cap on the interest paid by the client. Other options are more implicit, notably the ability of a client to renegotiate the fixed rate of a loan when interest rates decline. In competitive environments, banks tend to comply with the clients’ requests because they are reluctant to give up the revenues from other products.

Embedded options, whether explicit or implicit, change the nature of interest rates. For example, if a rate hits a cap, the rate, which was previously variable, becomes fixed. In the renegotiation of the rate of a fixed-rate loan, the rate was initially fixed and becomes variable. Because interest rate gaps are based on the nature of rates, they do not account for changes of the variable to fixed rates and vice versa.