Community Bank & Trust: Dollar Gap Analysis

Jack Brothers had recently taken over the management of the securities portfolio at Community Bank & Trust, a $100 million asset-size bank in a suburb of a large U.S. city. Previously, Jack worked in the loan portfolio of a bank in another state. He had gained favorable recommendations from his prior employers in large part due to his innovative work in securitizing loans, a growing area of management in the banking industry involving the issuance of mortgage backed securities on home loans. A meeting with CEO George Willis the day before had raised some unsettling evidence concerning the gap management of the bank. The accounting department reported that, while the dollar gap of the bank over the past year was zero, with equal dollar holdings of interest rate sensitivity of assets and liabilities, the bank had lost $500,000 in interest income over the last year as interest rates had rapidly fallen 300 basis points. Mr. Willis asked Jack to identify the "missing gap" problem that appears to exist and make recommendations in the securities portfolio that would help solve the problem. He wanted a fast turnaround on these questions, with a preliminary report due tomorrow afternoon. He also made clear that, according to investment policy, securities portfolio management was a means to effective and efficient asset/liability management. The recommendations made by Jack to Mr. Willis would be forwarded to the Asset/Liability Management Committee in order to coordinate activities in the bank.
Jack reviewed asset/liability materials that evening in his study at home and decided to go forward with a standardized gap analysis (see Chapter 5). The short period of time allowed for the preliminary report required that only a general analysis of the problem be attempted at this stage.
In the morning he visited the accounting department staff, who helped him obtain some rough historical figures from the past year on the interest rate sensitivity of broad asset and liability accounts in response to a change of 100 basis points in the prime rate of interest.
It occurred to Jack that the rapid decline in interest rates this past year may imply that interest rates will increase in the future. Consequently, he also checked the financial newspaper in the morning and found that the two-year Treasury bond rate was 5.0 percent and the one-year Treasury rate was 4.0 percent. He estimated that approximately a 50 basis point liquidity premium likely exists in the two-year bond rate to compensate investors for the added price risk of these bonds relative to the one-year bonds.
Based on standardized gap analysis, why did the 300 basis point drop in interest rates so adversely affect the bank's net interest earnings in the past year?
How could securities management have reduced or eliminated the recent loss of $500,000?
What is the interest rate forecast using expectations and liquidity premium theories of the yield curve?
What are the implications of anticipated future interest rate movements for net interest earnings, the bank's gap position, and securities management in the near future?