Question

Discuss the steps banks can take to reduce risk in the context of effective GAP management.

Answer 1

The steps banks can take to reduce risk in the context of effective GAP management.:-

GAP

Gap analysis is the process companies use to examine their current performance with their desired, expected performance. This analysis is used to determine whether it is meeting expectations and using its resources effectively.

Gap analysis, which is also referred to as a needs analysis, is important for any type of organizational performance. It allows companies to determine where they are today and where they want to be in the future. Companies can reexamine their goals through gap analysis to figure out whether they are on the right track to accomplishing them.

As interest rates have become more volatile and have climbed to historically unprecedented high levels, the degree to which variable-rate assets are different from variable rate liabilities (or, in other words, the amount of variable-rate assets supported by fixed-rate funds) has caused concern. This "gap"really an imbalance measures the exposure of bank net interest margin, that is, interest income less interest expense, to unexpected changes in market interest rates. Such changes can result in gains or losses in a bank's portfolio. Losses result if the bank finances its fixed-rate long-term loans with relatively short-term funds and market interest rates rise. Losses also occur if relatively fixed rate longer-term funds are used and lending rates fall. Gains can be made if interest rates move in the other direction. A bank, then, is exposed to interest rate risk whenever there is a quantitative.

The recent increases and broad fluctuations in interest rates have led many banks to a better understanding of interest rate risk and how to manage it. The use of gap management can be particularly important to bank funds management as a technique to manage interest rate risk. A bank can reduce the risk of loss due to unfavorable changes in interest rates by hedging its duration gap. The use of financial futures and the duration approach to gap management enables the bank to maintain a predetermined spread and to lock in an anticipated rate of return.