Liquidity Gap Analysis

Liquidity gap analysis is a method of measuring liquidity risk by setting out an institution's expected cash inflows and outflows in a series of time bands and calculating the difference in each. A band in which outflows exceed inflows shows a negative gap, meaning that the institution would need to find funding or sell assets to meet its obligations in that period. The table of bands is known as a maturity ladder.

The technique is one of the oldest tools of asset liability management and is used by banks, insurers and corporate treasuries. It makes visible the mismatch created by maturity transformation, in which a bank funds long-term loans with short-term deposits. It should be distinguished from the repricing gap, which uses a similar layout to measure exposure to interest rate changes by the dates on which rates reset.

Assets, liabilities and off-balance-sheet items are sorted by the date on which cash is expected to move. Time bands are narrow at the short end, typically overnight, two to seven days, eight days to one month, and then monthly or quarterly, widening to years. For each band:

The cumulative gap up to a band is the sum of the gaps of that band and all earlier ones:

• $\text{Inflows}_t$ are loan repayments, maturing securities, interest and fees receivable and other cash due in band $t$.
• $\text{Outflows}_t$ are maturing deposits and borrowings, interest payable, operating costs and expected drawings on commitments in band $t$.

As an example, a bank expects inflows of 400 and outflows of 550 in the first month, and inflows of 300 and outflows of 250 in the second. The gap is minus 150 in the first month and plus 50 in the second, and the cumulative gap after two months is minus 100. If the bank holds liquid assets of 180 that can be sold or pledged, it can cover the shortfall with 80 to spare.

A contractual gap uses legal maturity dates. Current accounts and other deposits repayable on demand are placed in the first band, and loans at their final maturity. This is objective but unrealistic, since most demand deposits stay for years while overdrafts and credit lines are rolled over.

A behavioural gap replaces contractual dates with expected ones. Stable deposits are spread over longer bands according to an assumed deposit run-off rate, mortgages are adjusted for prepayment, and expected drawings on undrawn facilities are added. Institutions usually produce both views, and repeat the behavioural view under stressed assumptions, which links the method to liquidity stress testing.

A further distinction is between a static analysis, which considers only the existing balance sheet as it runs off, and a dynamic one, which adds planned new lending and funding from the bank funding plan. Gaps are also prepared separately for each significant currency and for each legal entity, since surplus liquidity in one cannot always be moved to another.

Treasury and risk functions use the ladder to set limits on the size of negative gaps, particularly in the short bands, and to determine the survival horizon, which is the period for which the institution could continue without new funding. Asset and liability committees review it regularly. It informs the size and maturity profile of wholesale funding, the amount of liquid assets held, and the actions listed in the contingency funding plan. The cost of closing gaps is charged to business lines through funds transfer pricing.

Supervisors also rely on it. The Basel Committee's liquidity principles of 2008 expect banks to project cash flows over a range of horizons, and the Basel III framework includes a contractual maturity mismatch report among its monitoring tools, alongside the liquidity coverage ratio and the net stable funding ratio. Those two ratios can themselves be read as standardised gap measures, over 30 days and one year.

The result depends on behavioural assumptions that may fail when they matter most; deposits considered stable have left banks within days during runs. A ladder shows the position at one date and can miss intraday needs and flows within a band. Contingent outflows, such as collateral calls on derivatives or drawings on committed lines, are hard to place. The value of assets counted as available may fall under stress. For these reasons gap analysis is used together with stress tests, concentration limits and early warning indicators, and not as a single measure. A related entry on the funding side is funding gap analysis.

• Basel Committee on Banking Supervision