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U.S. Banks’ Vulnerability to Rising Short-Term Interest Rates

April 15, 2011

With short-term interest rates at historic lows, the European Central Bank raising its rates, and ongoing speculation about when they will rise in the U.S., Weiss Ratings analyzes how well positioned the nation’s banks are to handle a rise in interest rates.

The gap ratio measures an institution’s re-pricing sensitivity, which is the amount that interest-sensitive assets differ from interest-sensitive liabilities in a given time period.  For example, if liabilities (deposits and borrowings) exceed assets (loans and investment securities) for that time period, the result is a negative gap.  This is a disadvantage in a rising interest rate environment, since the deposit rates a bank must pay will be increasing faster than the interest rates the bank receives on loans and investments. In contrast, a negative gap will be an advantage as rates are declining.  Of course, the opposite is true for a positive gap.

The 1-year gap ratio is defined as assets with maturities of one year or less, minus liabilities with maturities of one year or less as a percentage of total assets (which are exposed to changing interest rates).  The level of exposure can be explained with the following range of ratio results:

1-Year Gap Ratio Range	Potential Rate-Risk Exposure	Explanation
-10% to + 10%	Low	Good job matching interest rates charged on loans or paid on deposits
-10% to -20% or +10% to +20%	Moderate	Fair job in matching interest rates on loans and deposits
< -20% or > +20%	High	Poor job matching interest rates charged on loans or paid on deposits

The more positive a gap ratio is the better equipped the bank is to withstand rising interest rates and to profit on the spread, or difference, between the interest rate it charges for loans and the rate it pays on deposits. 

For example, if most of an institution’s loans (or assets) are set to reprice within one year at higher rates and it has less deposits (or liabilities) that must reprice at the higher rates then it will be more profitable, because its cost of funds will be lower.  The table below demonstrates the relationship between the gap ratio and the interest rate spread during rising and falling interest rate environments. 

	When Short Term Rates are:
Gap Ratio	Falling	Rising	Explanation
Positive	Lower Spread	Higher Spread	In a rising rate environment it is better to have a higher gap
Negative	Higher Spread	Lower Spread	In a falling rate environment it is better to have a lower gap
Zero (matched)	No Effect	No Effect	Matched. Effect is neutral or none

1-Year Gap Ratios of the Nation's Largest Institutions
(with assets of $10 billion or more)

Regions Most Vulnerable to Rising Short-Term Interest Rates

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