I'm reading "Insights for Bank Directors" (http://www.stlouisfed.org/col/director/reference_view.htm), a good introduction to commercial banks, based on a virtual bank "Insight".

It talks about Gap Analysis, on how a bank is positioned by comparing the values of the assets and liabilities that roll over—or reprice—at various time periods in the future. ( http://www.stlouisfed.org/col/director/Materials/alco_gapanalysis_print.htm )

It says banks shall keep short term gap position low:

... ALCO is recommending that the bank sell \$1.6 million in Treasury notes coming due at the end of October (the coming month) and use the proceeds from the sale to buy higher-yielding, five-year notes issued by the Federal Home Loan Bank. The effect of this transaction would be to increase the bank’s negative gap–that is, the purchase would reduce rate-sensitive assets that will reprice within the next year by \$1.6 million. The \$1.6 million would now move to a 1-5 year time period column of the report. The bank’s negative cumulative gap position at one year would increase to \$3,533. As a result, if rates rise as expected, the bank’s net interest income would decline more than if the notes had not been purchased. The recommendation to buy the notes is not a good one.

However, I don't get it, why short term gap position shall be maintained low?

Basically bank have long term asset (loans, T-Bills) and short term liabilities (Deposits, CDs). Revolvingly taking short term liability to fund long term assets -- this is how banks make profit using the term structure, as short term yield is always lower than long term ones. So why there shall be a problem if the short term gap position is high? in the example, if the \$1.6 million in Treasury note coming due at the end of the next month, is used to buy five-year notes, leaving the short term CD more obvious, what would be the problem?

Is it the problem that if interest rate increases in October, Insight Bank needs pay more interest to CDs? In this case, if the \$1.6m is not used to buy 5-year notes, it could be used to buy short term notes, which would brings high interest to compensate the cost to CDs?

If the above is the concern, could it be another option, that is to use part of the \$1.6m to buy some interest rate options or swaptions?


Very simple answer: Duration, my friend. The notes present much higher interest sensitivity and if rates across the curve rise the investment in the longer duration notes will cause a mark to market loss larger than the outstanding treasury notes. Not always do banks have the luxury to hold all their assets until maturity, especially not when the regulatory environment is about to change (Basel III, ...), when the asset base crumbles due to investors/depositors' risk aversion, and such forth. A bank pays very close attention to what their in-house economists think rates will do across the whole spectrum of the curve because banks generally take exposure to a whole host of very interest sensitive securities.

I cannot comment on the specific recommendation but the above is a general explanation why banks do not blindly lend long-term and finance themselves short-term.


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