Understanding Duration Gap Analysis from the FRR Perspective

In the world of banking and financial management, managing interest rate risk is crucial. One of the most important tools used by banks for this purpose is the Duration Gap (DG) Analysis. This analysis helps banks understand how sensitive their assets and liabilities are to changes in market interest rates and how those changes impact both their Net Interest Income (NII) and the Economic Value of Equity (EVE).

✅ What Is Duration Gap Analysis?

Duration Gap measures the difference between the average duration of a bank’s assets and liabilities.

  • Duration of Assets (DA) refers to how long it takes for the bank to recover its invested funds through interest payments and principal repayments.

  • Duration of Liabilities (DL) refers to the time period over which the bank pays interest and repays its borrowed funds.

The formula is simple:

  Duration Gap (DG) = Duration of Assets (DA) − Duration of Liabilities (DL)

A positive duration gap indicates the bank is asset sensitive (DA > DL), while a negative duration gap shows liability sensitivity (DL > DA).

✅ Why Is It Important?

From an FRR (Financial Risk & Regulation) perspective, duration gap analysis helps to:

  • Measure interest rate risk exposure of the bank.

  • Assess the impact of interest rate changes on the bank’s Net Interest Income (NII) in the short term.

  • Evaluate the effect on the Economic Value of Equity (EVE) in the long term.

✅ Four Scenarios of Interest Rate Changes

1️⃣ Interest Rates Rise Sharply

In this scenario, a sudden increase in market interest rates impacts assets and liabilities differently.

  • Positive Duration Gap (Asset Sensitive):

    • NII Impact: May rise in the short term because assets reprice faster than liabilities, leading to higher income.

    • EVE Impact: Declines sharply. Long-term value of assets (which have longer durations) falls more than liabilities, reducing the bank’s economic equity.

2️⃣ Interest Rates Fall Sharply

When market rates suddenly drop:

  • Positive Duration Gap (Asset Sensitive):

    • NII Impact: Likely to fall, since assets yield less and liabilities may not adjust as quickly.

    • EVE Impact: Increases as the market value of assets rises faster than liabilities, improving the bank’s economic position.

3️⃣ Interest Rates Rise Slowly

A gradual increase in rates causes smaller shifts in asset and liability values.

  • Positive Duration Gap (Asset Sensitive):

    • NII Impact: Improves slowly over time as asset yields adjust faster than liabilities, helping short-term profitability.

    • EVE Impact: Decreases gradually, reflecting the slower but consistent erosion of asset values relative to liabilities.

4️⃣ Interest Rates Fall Slowly

A gradual decline in rates also leads to milder effects.

  • Positive Duration Gap (Asset Sensitive):

    • NII Impact: Slowly declines as asset yields reduce over time.

    • EVE Impact: Increases steadily as asset values appreciate more than liabilities, strengthening the bank’s economic equity.

✅ Key Insights

  • A Positive Duration Gap is beneficial for rising rate environments in terms of NII but poses a long-term risk to EVE.

  • A Negative Duration Gap (where liabilities have longer duration than assets) may protect EVE when rates fall but could weaken NII if liabilities reprice slower.

✅ Conclusion

Duration Gap Analysis is a powerful tool in the bank's arsenal for managing interest rate risk.
From the Fundamental Risk and Regulation (FRR) perspective, it helps balance short-term profitability (via NII) and long-term financial stability (via EVE).

Banks must strategically manage their duration gap according to interest rate forecasts and risk tolerance. An optimized duration gap helps the bank remain profitable while safeguarding its economic equity against unexpected market movements.


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