This latest installment in the “D’oh! the gap report” category was motivated by a client call I received late last week. The bank’s CFO related to me examiner “concerns about how our model is handling core deposits” because……wait for it……the gap report is wrong. D’oh!
Here’s the essence of their “concern”:
They feel that we are not properly representing money market accounts on the gap report. The reason is that 100% of these accounts can reprice and therefore the entire amount should be slotted in the first bucket.
While I’ll recognize that 100% of these accounts may reprice immediately, it’s the nature of their repricing that causes problems on the gap report. In fact it highlights two significant problems with the gap report.
#1 - Pricing Lag or Beta
While these money market accounts reprice immediately they don’t reprice to “market” rates. When the gap report was originally conceived back in the early ‘70s it was supposed to capture when balances matured or repriced back to market. These money market accounts don’t necessary behave that way (for some banks they do, but not for this bank). To illustrate the difference think about a simple variable rate loan that is tied to Prime and resets at the beginning of every month. I think we’d all agree that this loan should be slotted in the first gap bucket. If Prime changes by +25bp or say +100bp the loan rate would change by that same amount.
The same can’t necessarily be said for money market accounts with administered rates. If Fed Funds moved by 100bp how much would the bank change its rate? Typically a bank’s change will lag or only be a portion of the market change. How much will that change be if fed funds moves 100bp? Will the bank move its rates only 50bp or 5bp? In A/L BENCHMARKS we model this behavior using a beta factor. If the bank only moves 5bp then the beta factor would be 5%. The impact of this beta factor is shown easily on the Income Shock report (i.e. in the earnings simulation). It’s less clear how to represent this behavior on the gap report. We show it on the gap report by placing only a portion of the balance in the first bucket and the remainder of the balance beyond one-year.
Even this treatment can be “wrong” because there’s another problem with the gap report – it only shows behavior in a base case rate environment.
#2 - Gap only represents one point in time, and one rate scenario
Another significant repricing behavior for these money market accounts is that the change in rates may not be the same rates-up versus rates-down. If the Fed moves the fed funds rate down a bank is likely to be very quick to move their administered rates down also. Whereas if the Fed moves the fed funds rate up a bank may not move their rates up as quickly (or by as much). In many cases a bank may have different beta factors for different rate environments. It is unclear how to represent this behavior on the gap report. The loan example above doesn’t have this problem. If rates move up or down the loan will reprice by the same amount (remember I’m talking about a simple Prime-based variable rate loan…no caps or floors).
Essentially the rates (and cash flows) of your core accounts change when interest rates change. This is the classic definition of optionality, and the gap report is an inadequate tool to measure optionality. That’s the reason why we don’t use it to try and measure your bank’s interest rate risk. We use earnings and economic value of equity simulation.
We’ve only included the gap report to show you a base case representation of your cash flows. However, the two problems with the report that I’ve highlighted here are just the tip of the iceberg. You can have a similar discussion about the “right” or “wrong” way to represent calls, prepayments, caps, floors, conversions, etc. In the end any discussion is academic only. The better way to measure interest rate risk is using simulation because it’s capable of capturing the dynamic behavior of your balance sheet…a gap report is not.