Question

When the duration gap is negative, it means that the duration of assets < duration of liabilities, so liabilities are more sensitive than assets to interest rate changes. My understanding of this is, that if interest rates fall, you pay less on liabilities, and so income would increase....but then why would equity decrease? Wouldn't equity increase?

I'm also confused as to why a negative gap would mean that a rise in interest rates makes equity increase and why a positive gap would mean a decrease in equity with interest rate increases

Answer 1

It is true that when interest rates falls and the bank has negative gap (Value of interest paying liabilities is greater than interest earning assets), the income of the bank will rise but it is also true that the value of equity will fall since analysts do their valuations considering many factors and taking into account the risk component as well. some of the reasons are:

1. A negative gap rate implies that the core banking operations of earning through loans and paying through deposits accepted is not working correctly and if at the current rate in the future due to consistently negative gap the bank will become bankrupt.

2. If in the future the interest rate rises then things could go worse for the banks as interest rate increases and since under negative gap the bank has more interest paying liabilities than interest earning assets the impact of interest increase would be worse.

The companies which are performing well with their core operations are always considered to be good bet for long term future purposes (as per value analysis).

In case of a positive gap Interest rate rises but with that also rises the value of liabilities, now assuming that interest rate keeps on rising then the situation will be that since rate of interest in case of deposits increase people will stop taking loans since depositing money will give them high yield without taking any risk and eventually the profits of the banks will decrease.