We can determine a bank’s balance sheet type by learning how the bank’s net interest income responds to changes in interest rates.
But how can we assess the rate sensitivity of net interest income?
We can use the earning gap. It’s calculated as follows:
earning gap = (rate-sensitive assets) – (rate-sensitive liabilities)
Note that rate-sensitive assets and rate-sensitive liabilities are assets and liabilities whose value changes in response to interest rates.
Once you know the earning gap, you can predict the change in net interest income for a given change in the interest rate:
change in net interest income = earning gap * change in interest rate
This is a simplified example. In practice, banks group financial instruments into buckets based on their time to maturity (for fixed-rate instruments) and the time until the next rate-reset date (for floating-rate instruments).
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