Communicator Archives: May 2002

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Is GAP Analysis Enough?

Identify, measure, monitor and control are the key elements of an effective risk management process. When dealing with interest rate risk, is Gap analysis enough of a tool to effectively manage a bank's interest rate risk?

Gap analysis has been a widely used tool used for communicating some information about interest rate risk characteristics and has paved the way for focusing attention on the subject. As a current replacement for Gap analysis, bankers are now using two measurement tools: Earning at Risk measurement, and Economic Value of Equity at Risk measurement.

Gap analysis attempts to take a look at the cash flows inherent in a bank's balance sheet resulting from varying maturity and re-pricing structures. Dollars are slotted into five or six "buckets" representing timing of maturities and re-pricing. Positive or negative net cash flows in the various "buckets" or time frames may give an overall sense of whether the bank is assets sensitive or liability sensitive to interest rate movements.

Some problems with using Gap analysis for interest rate risk are:

• Gap analysis is a point in time snapshot of cash flows and therefore does not take into account changes in the interest rate environment.
• Gap analysis may slot cash flows by final maturity or amortize loan payments over the life of the loan. There is no "standard" format and therefore makes peer comparisons difficult.
• Most gap report show historical cost of an instrument while the balance sheets shows the fair value of an instrument.
• A gap analysis typically does not take in to account callable securities/FHLB advances, prepayment speeds or early withdrawals.
• Probably most importantly, a gap analysis does not address the amount of impact on earnings and economic value of equity due to a change in interest rates.

Despite the issues mentioned above, a gap analysis may be an adequate tool for small banks with a very simple balance sheet; with well-matched maturities and re-pricing; with no optionality from prepayments or security call provisions; and no need to compare performance with other banks.

An Interest Rate Risk management system must be robust enough to adequately measure the risk associated with all of the financial instruments on the balance sheet. A/L Benchmarks offer clients an income shock simulation to measure Earnings-at- Risk and a balance sheet shock simulation to measure Economic Value of Equity-at-Risk. A/L Benchmarks also presents a version of a Gap Report to give some information about the balance sheet cash flows.

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"Community Banks Face Challenges, Opportunities in Changing Economic Times"
Item Processing Report (04/11/02) Vol. 13, No. 7,

Two Federal Reserve governors, Mark Olson^* and Susan S. Bies, recently said making better use of technology and adopting effective risk management practices would help community banks continue doing as well as or better than large banks measured by return on assets. According to Olson, product delivery, creation of new financial instruments, and increasing efficiencies of operation will all be affected by technological innovations during the next decade. Bies noted that community banks weathered the recent recession well, because the dip was mild and many banks were not as exposed to the weakness in commercial and industrial loan portfolios as larger institutions were. However, community banks' market share of industry assets have dropped from 25 percent 10 years ago to its current 16 percent, Bies said. Improvements in risk management, such as more extensive use of credit scoring, have helped strengthen the banking industry, but management and auditors must work harder to identify, characterize, and fairly disclose key risk exposures. According to Bies, community banks should continue providing the personal touch they are known for, but their success depends on sound market research; pricing that reflects competition, customer value, and risk; and the development of new revenue streams.

   ^*Governor Mark W. Olson is not affiliated with ORA

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For those clients that submitted an investment download from a securities dealer, we found an inconsistency with the calculation between the A/L Benchmarks model and the calculations of many security-pricing systems. For security pricing purposes, many calculate prices for callable securities by assuming re-pricing at a call date as a base scenario when rates are generally trending downward. The A/L Benchmarks base case is now consistent with most security downloads.

Although you may have seen some slight reductions in the duration of securities in the 4th quarter 2001, we feel that the changed calculation procedure presents a realistic view of the cash flows of your institution.

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