GAP vs Income Simulation

By Sean Doherty


We have had several instances, just in the last few months, where certain field examiners have either verbally criticized or written up clients for "inconsistencies" in their GAP reports. Although recent FFIEC guidance suggests that banks currently using GAP will be required to use the more accurate Income Simulation and Market Value of Equity models, we wanted to take a minute to review the arguments against using GAP analysis so that you can be prepared should this come up in a future examination.
GAP analysis cannot accurately measure interest rate risk, and should not be used if there is a better alternative being used by the bank.
As a reminder, gap is a "static" view of the balance sheet, in that it can only pick up repriceable assets or liabilities ONCE. Therefore if you have a loan that reprices each month, it cannot account for that fact.
GAP is also ignorant of optionality, so if you have a callable bond (or FHLB Advance on the liability side), and assuming you have the current optionality properly identified, you will only be able to measure this with the current option. If rates increase or decrease the exercise of that option remains static. 
One of the MAJOR flaws in GAP analysis is the underlying assumption that the pricing of Assets and Liabilities move in tandem, when our experience (and yours) shows that is far from accurate. In fact when comparing a gap report to a well-run simulation analysis you will often see opposing interest rate risk profiles. Try this out on your own bank, look at the GAP ratio in the gap report for the 181-365 day bucket, and compare this to the income simulation results. Oftentimes, the gap report will show a balance sheet that is "negatively gapped" (indicating the bank will make less income when rates move up) and the simulation analysis will show the same balance sheet actually makes MORE income in a rising rate environment. When this is properly explained to your field examiner, they will usually defer to the more accurate income simulation. Be prepared to defend this analysis and it will serve you well in your exam.
One last note about GAP, if you are still using any reference to GAP ANALYSIS in your policies, or in the information you are presenting to your board, we strongly recommend you purge this information, as this could provide all the evidence needed to make the case that the balance sheet is being managed using these Gap rules, and should therefore be subject to these rules. If your examiner suggests that these ratios be included in the board approved policy, make sure this recommendation is part of the WRITTEN exam so you can explain in future exams why you are still using this outdated approach.