What it is:
A negative gap occurs when a bank's interest-bearing liabilities exceed its interest-earning assets.
How it works/Example:
Let's assume Bank XYZ has $40 million of interest-rate sensitive assets (mostly loans) and $70 million of interest-rate sensitive liabilities (CDs, savings accounts, etc.). Because the bank’s interest-rate sensitive liabilities exceed its interest-rate sensitive assets by $30 million, the bank has a negative gap.
If market interest rates increase, things could get bad for the bank. In our example, if the interest rate on liabilities increases, the bank has to pay out more in interest. The rate it earns on its assets also increases, which is a good thing, but because the bank has more than twice the amount of liabilities than assets, those benefits are virtually washed away.
But a negative gap is not always detrimental. If interest rates fall, the bank will earn less on its interest-bearing assets, but it will also pay less on its interest-bearing liabilities. In situations such as our example, where a bank has much more liabilities than assets, the bottom line improvement can be dramatic.
Why it matters:
A negative gap in and of itself is neither bad nor good. After all, a bank's assets could be generating plenty of income to cover the interest the bank must pay on its liabilities. But a negative gap can signal that the bank is exposed to interest-rate risk, and the size of a negative gap can indicate the degree to which a bank's net income could change if interest rates change.