16 MAY / JUNE 2017 Remember eight-track audio tapes? What about VCRs? Typewriters? These innovative products were game-changers when introduced, but the same technological drive to “find a better way” that created them also made them obsolete. Someone is always coming up with a better mousetrap. There seems to be no facet of life or 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 set by management, not by regulatory edict. Banks’ liabilities were now subject to discretionary repricing determined by the vagaries of credit market conditions, competition and managerial strategy. The analytical tools available at the time to help measure and manage the new repricing risk were limited. 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, for example 12 months, and calculate the dollar amount of earning assets that potentially reprice over that span. We’ll call these “rate-sensitive assets.” 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? It might make sense, 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, and gap management alone could not, with any degree of precision, account for the differences in magnitude and timing that describe how the interest rates that generate income behave differently than the interest rates that incur expenses. 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 misleading at worst. Take, for example, the bank that is negatively gapped. Following “gap logic,” management will perceive that NII will be impaired by rising rates and may feel a need to “fix the problem.” However, gap logic ignores the fact that most of the bank’s liabilities are in the form of non-maturing deposits that are 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 costly and 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. If your bank is one of the many holdouts still clinging to those gap reports, think back to that old eighttrack player you might have had in your car. It’s only a matter of time before it eats the tape. HB GAP Management An idea whose time has gone Lester Murray Associate Partner The Baker Group lester@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. Article author DIRECTORS / SENIOR MANAGEMENT
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