Client question:

I'm looking at our gap report and it shows our cumulative gap to be 116% which is asset sensitive, yet when I look at the rates up simulation on the income shock report it shows my net interest margin declining when rates rise.  Is there something wrong with the model?

Answer:

No, you've just observed the biggest weakness of the gap report.  It doesn't capture option risk.  There are several accounts where option risk is likely to show up on a bank's balance sheet today.

The first place is in the securities portfolio.  Many US Agency bonds (and Muni's too) have call options.  When rates fall they are likely to call creating an overall lower return for the portfolio.  When rates rise the portfolio acts more like a fixed-rate bond portfolio and there is less positive change income.  Many people try and solve this problem by adjusting the gap report and placing the bond in a gap bucket which reflects its call date and not its maturity date.  The problem is that then the gap report doesn't reflect what might happen if rates rise.  Hence the problem with the gap report, it doesn't capture option risk.

The second place you commonly find option risk is in the bank's loan portfolio...prepayment risk.  Prepayments cause a change in interest income that is similar to call options.  When rates fall prepayments tend to increase making the bank look more "asset sensitive".  When rates rise, prepayments tend to slow down making the bank look more "liability sensitive".  Again you can't fix the gap report because the cash flow structure of the portfolio changes as rates change.

The third place you commonly find option risk is in the bank's core deposit portfolio.  The rates on these deposits are usually administered by the bank.  The bank may change the way these deposits reprice when market rates rise, and they may change the rate differently if market rates fall.  Once again, you can't "fix" the gap report to reflect this difference, because the timing and amount of repricing changes depending on market rate changes.

Finally, the last place you commonly see option risk in the bank's FHLB advance portfolio.  The FHLB's offer a wide range of "convertible" advances these days.  When rates fall, the bank is stuck with a longer-term fixed rate instrument.  When rates rise, the FHLB decides to convert the debt to a variable rate.  Exactly the opposite behavior of the callable security.  The cash flow timing changes as rates change, and that (again) can't be captured on a gap report.

Here is the sample income shock report: