Introduction
Interest-rate movements affect a bank because its assets and liabilities do not always reprice at the same time or by the same amount.
When market rates change:
interest earned on loans and investments may change;
interest paid on deposits and borrowings may change; and
the difference between the two affects Net Interest Income (NII).
Under RBI’s current Commercial Banks – Asset Liability Management Directions, 2025, the earnings perspective of Interest Rate Risk is measured through Traditional Gap Analysis (TGA). Banks use TGA to assess the sensitivity of NII to interest-rate movements, normally over a one-year horizon, and compute Earnings at Risk under different interest-rate scenarios.
The current 2026 IIBF BFM syllabus includes Interest Rate Risk Management in Module D, covering its sources, effects, measurement techniques and control.
Learning Objectives
After studying this topic, you should be able to:
explain how interest-rate changes affect NII;
determine the NII direction from a positive or negative repricing gap;
understand the relationship between RSA, RSL and rate movements;
correctly interpret basis-point changes in numerical questions;
understand Earnings at Risk as an earnings-sensitivity measure; and
identify why actual NII changes may differ from a simple gap-based estimate.
Net Interest Income – The Starting Point
Net Interest Income is the difference between the interest earned on interest-bearing assets and the interest paid on interest-bearing liabilities.
NII = Interest Income − Interest Expense
This identifies the bank’s net interest earnings before considering non-interest income and expenses.
Refer to the Formula Section for a detailed explanation, variables, and solved examples.
Interest-rate risk affects NII when asset yields and liability costs respond differently to changing rates.
For example:
loan rates may reset after six months;
wholesale borrowings may reprice next week;
term-deposit rates may remain fixed until maturity; and
savings-deposit pricing may respond according to the bank’s pricing behaviour.
The timing and extent of these changes determine the earnings impact.
The Role of RSA and RSL
Traditional Gap Analysis begins with:
Rate-Sensitive Assets (RSA); and
Rate-Sensitive Liabilities (RSL).
RBI requires rate-sensitive assets, liabilities and relevant off-balance-sheet positions to be slotted according to residual maturity or next repricing period, whichever is earlier. Investments, advances, deposits and borrowings that mature or reprice within the relevant horizon are rate sensitive. Loan principal repayments expected within the horizon are also included.
The basic repricing relationship is:
Repricing Gap = RSA − RSL
This identifies whether assets or liabilities are more exposed to repricing during the selected period.
Refer to the Formula Section for a detailed explanation, variables, and solved examples.
Positive Repricing Gap
A positive gap exists when:
RSA > RSL
The bank is asset-sensitive for that period.
More assets than liabilities will reprice.
If Interest Rates Rise
Asset yields generally rise on a larger amount than liability costs.
Therefore:
Positive Gap + Rate Rise → NII generally increases
If Interest Rates Fall
Asset yields generally decline on a larger amount.
Therefore:
Positive Gap + Rate Fall → NII generally decreases
This assumes broadly similar rate transmission and no major offsetting effect from basis risk, options or customer behaviour.
Negative Repricing Gap
A negative gap exists when:
RSA < RSL
The bank is liability-sensitive.
More liabilities than assets will reprice.
If Interest Rates Rise
Funding costs generally increase on a larger amount than asset yields.
Therefore:
Negative Gap + Rate Rise → NII generally decreases
If Interest Rates Fall
Funding costs generally decline on a larger amount.
Therefore:
Negative Gap + Rate Fall → NII generally increases
Gap and Rate Direction Matrix
Repricing Position | Rates Rise | Rates Fall |
|---|---|---|
Positive Gap: RSA > RSL | NII generally rises | NII generally falls |
Negative Gap: RSA < RSL | NII generally falls | NII generally rises |
Near-Zero Gap | Lower simple gap effect | Lower simple gap effect |
This directional table is central to CAIIB numerical questions.
Simplified Impact of a Rate Change on NII
For a basic gap-based numerical, the directional earnings impact can be estimated using:
Change in NII ≈ Repricing Gap × Change in Interest Rate
This estimates the simplified earnings effect when the relevant RSA and RSL experience the assumed rate change.
Refer to the Formula Section for a detailed explanation, variables, and solved examples.
The sign of the answer carries important meaning:
positive change → NII improves;
negative change → NII declines.
This relationship is a simplified approximation. Actual TGA and EaR analysis can incorporate the timing of repricing, different scenarios and other behavioural assumptions.
Basis Points in NII Calculations
Interest-rate shocks are often expressed in basis points (bps).
Remember:
1 basis point = 0.01 percentage point;
25 bps = 0.25%;
50 bps = 0.50%;
100 bps = 1.00%;
200 bps = 2.00%.
For multiplication in a numerical, the percentage normally needs to be expressed in decimal form.
Therefore:
0.25% = 0.0025;
0.50% = 0.005;
1.00% = 0.01;
2.00% = 0.02.
Why Repricing Timing Matters
The simple relationship between gap and rate change becomes more realistic only when the timing of repricing is considered.
Suppose two assets both have the same amount.
One reprices near the beginning of the year.
The other reprices near the end.
Even if both ultimately experience the same change in rate, the first asset affects NII for a longer part of the year.
Therefore, in a detailed EaR model:
Earlier Repricing → Longer Earnings Impact
Later Repricing → Shorter Earnings Impact within the Horizon
This is why RBI requires RSA, RSL and relevant OBS items to be placed into specific time buckets rather than combining everything into one annual figure.
Current IRS Buckets Relevant to the One-Year Earnings Horizon
The current RBI Interest Rate Sensitivity framework uses multiple repricing buckets. For the usual one-year earnings horizon, the important buckets are:
Time Bucket | Position |
|---|---|
1 | 1–28 days |
2 | 29 days and up to 3 months |
3 | Over 3 months and up to 6 months |
4 | Over 6 months and up to 1 year |
Longer buckets remain relevant to the bank’s overall interest-rate-risk profile and economic-value analysis.
RBI requires the Gap Report to be generated by grouping rate-sensitive positions according to residual maturity or the next repricing period, whichever is earlier.
Periodic Gap and NII Effect
Each time bucket can have its own:
RSA;
RSL;
Periodic Gap; and
sensitivity to an assumed rate movement.
A bank may therefore have:
a positive gap in the first bucket;
a negative gap in the second;
another positive gap later.
The earnings effect can differ across periods.
This means a bank should not look only at one aggregate gap when trying to understand when NII becomes vulnerable.
Cumulative Gap and Overall Earnings Direction
The Cumulative Gap combines Periodic Gaps across successive buckets.
It can help indicate the bank’s net repricing position up to a selected horizon.
However, for NII analysis, simply multiplying an end-of-year Cumulative Gap by a rate shock can be too simplistic because different positions may have repriced at different points during the year.
Therefore:
Periodic Gap → shows where repricing occurs
Cumulative Gap → shows running exposure
EaR → estimates income effect under specified rate scenarios
These concepts are related but not identical.
Earnings at Risk
RBI requires banks to compute Earnings at Risk (EaR) representing the loss of income under different interest-rate scenarios over a one-year horizon.
EaR answers a practical question:
How much income could the bank lose if interest rates move adversely?
RBI also requires the Board or Risk Management Committee to approve appropriate internal limits on EaR based on the bank’s risk-bearing and risk-management capacity.
EaR therefore converts an interest-rate scenario into an earnings-risk measure useful for:
ALCO;
risk management;
pricing decisions;
funding strategy; and
balance-sheet positioning.
Parallel Rate Change – Simplest Numerical Case
A basic CAIIB question may assume that all relevant market rates move by the same amount.
For example, the question may state that interest rates:
rise uniformly by a specified number of basis points; or
fall uniformly by a specified number of basis points.
In such a simplified case, gap analysis can give a clear directional NII estimate.
However, real markets do not always move in parallel.
Different Asset and Liability Rate Changes
Suppose lending rates and deposit rates change by different amounts.
For example:
asset yield increases only moderately;
deposit cost increases more sharply.
A bank may have a positive notional gap and still receive less benefit than the simple gap calculation suggests.
This is because the basic calculation assumes a common rate movement.
When the actual changes differ, the bank must separately assess:
asset yield change; and
liability cost change.
This introduces basis risk.
Basis Risk and NII
Basis risk exists when assets and liabilities reprice using different reference rates.
Assume:
a loan benchmark increases by 40 bps; while
the funding benchmark increases by 80 bps.
Even if the bank has similar amounts of RSA and RSL, its spread can narrow.
Therefore:
Matched Amounts ≠ Matched Earnings Sensitivity
The bank must consider how individual benchmarks actually respond.
Deposit Beta and Sticky Deposits
Deposit rates do not always move one-for-one with policy or market rates.
Some deposits may reprice:
slowly;
partially; or
only after competitive pressure increases.
This can temporarily protect NII when market rates rise.
However, customer behaviour may eventually change, particularly if depositors migrate to higher-yielding products.
Therefore, actual liability repricing can differ from the mechanical contractual assumption.
Floors and Caps
Loan and deposit contracts can contain:
interest-rate floors;
caps; or
other pricing restrictions.
A floor can prevent an asset yield from falling below a specified level.
A cap can prevent a rate from increasing beyond a specified level.
These features make the NII response non-linear.
For example, a floating-rate loan may appear fully rate sensitive, but an active cap can limit the increase in income when market rates rise.
Loan Prepayment and NII
Rate changes can also alter customer behaviour.
When rates fall, borrowers with higher-rate fixed loans may prepay or refinance.
The bank may then:
lose high-yielding interest income;
receive principal earlier than expected; and
reinvest at lower prevailing rates.
Therefore, falling rates can hurt NII not only through contractual repricing but also through option risk.
Premature Withdrawal of Deposits
When interest rates rise, customers may seek to replace lower-rate deposits with higher-rate deposits, subject to contractual terms and penalties.
If withdrawals occur earlier than assumed:
liability cash flows change;
funding may need replacement; and
the replacement cost may be higher.
This can reduce NII beyond the original static gap estimate.
Off-Balance-Sheet Positions and NII
Interest-rate derivatives can materially alter earnings sensitivity.
Examples include:
interest-rate swaps;
Forward Rate Agreements;
futures; and
options.
RBI requires rate-sensitive OBS positions to be included in TGA.
A derivative may:
reduce an existing gap;
create a new gap; or
change the effective fixed/floating nature of an exposure.
Therefore, a CAIIB case that gives a hedge should not automatically calculate NII from physical assets and liabilities alone.
Fixed-Rate Asset Funded by Repricing Liability
This is a classic adverse rising-rate position.
Suppose:
the asset earns a fixed rate; and
the liability reprices frequently.
When rates rise:
asset income remains unchanged in the near term;
liability cost rises;
interest spread narrows; and
NII declines.
This is a typical liability-sensitive earnings-risk structure.
Floating-Rate Asset Funded by Fixed-Rate Liability
Consider the reverse situation:
the asset reprices quickly;
the liability remains fixed for longer.
When rates rise:
asset income increases;
liability cost initially remains unchanged; and
NII can improve.
This is broadly an asset-sensitive structure.
When rates fall, the same structure can reduce NII because asset income adjusts downward while liability cost remains fixed.
Practical Banking Application
Consider a bank with:
floating-rate corporate loans;
fixed-rate housing loans;
short-term wholesale borrowings;
fixed-rate term deposits;
savings deposits; and
interest-rate swaps.
ALCO expects market rates to increase.
A proper NII analysis should ask:
Which Assets Reprice?
Identify floating loans and other assets reaching their reset or maturity dates.
Which Liabilities Reprice?
Identify deposits and borrowings whose cost can change within the horizon.
What Is the Gap?
Determine whether RSA exceeds RSL in each relevant bucket.
How Large Is the Rate Shock?
Convert the stated basis-point movement correctly.
Do All Rates Move Equally?
Check whether lending benchmarks and funding rates are assumed to move by the same amount.
Are Customer Options Important?
Consider:
loan prepayment;
premature deposit withdrawal; and
non-maturity-deposit behaviour.
Are Derivatives Present?
Include their rate-sensitive effect.
Only then should the bank interpret whether NII is likely to rise or fall.
CAIIB Exam Focus
1. NII Means Interest Income Minus Interest Expense
A rate movement can affect either or both components.
2. Positive Gap Generally Benefits from Rising Rates
Because more assets than liabilities reprice upward.
3. Negative Gap Generally Suffers when Rates Rise
Because more liabilities reprice upward.
4. Reverse the Direction When Rates Fall
Positive Gap → NII generally falls.
Negative Gap → NII generally rises.
5. Convert Basis Points Correctly
100 bps = 1%, not 100%.
6. Sign Matters
A negative change in NII represents deterioration in earnings.
7. Timing Matters
A repricing event occurring early in the horizon affects earnings for longer than one occurring near year-end.
8. TGA Usually Uses a One-Year Earnings Horizon
RBI requires NII sensitivity and EaR analysis over a horizon usually of one year.
9. Different Benchmarks Can Break the Simple Gap Result
This is basis risk.
10. Include OBS Positions
A hedge may materially alter effective earnings sensitivity.
Common Exam Traps
Trap 1: “Positive Gap Always Increases NII”
Wrong. It generally increases NII when rates rise, but can reduce NII when rates fall.
Trap 2: “Negative Gap Always Reduces NII”
Wrong. It can benefit NII when rates decline.
Trap 3: “100 bps Means 100%”
Wrong. It means 1%.
Trap 4: “Use the Absolute Gap and Ignore Its Sign”
Wrong. The sign determines whether the bank is asset-sensitive or liability-sensitive.
Trap 5: “All Positions Reprice for the Entire Year”
Wrong. Repricing dates may occur at different points within the one-year horizon.
Trap 6: “Equal RSA and RSL Means NII Cannot Change”
Wrong. Different benchmarks, repricing dates, customer behaviour and options can still alter earnings.
Trap 7: “A Floating-Rate Asset Changes Immediately whenever Market Rates Move”
Not necessarily. It changes according to its contractual reset mechanism.
Trap 8: “Only Balance-Sheet Items Affect NII Sensitivity”
Wrong. Rate-sensitive derivatives and other relevant OBS items must also be considered.
Trap 9: “A Rate Rise Changes Asset Yield and Liability Cost by the Same Amount”
Not necessarily. Basis risk and deposit-pricing behaviour can cause different changes.
Trap 10: “NII Sensitivity and Economic-Value Sensitivity Are the Same”
Wrong. NII belongs to the earnings perspective. Economic-value analysis considers the effect on MVE through Duration Gap Analysis. RBI requires both perspectives.
Memory Technique
Remember:
P + Up = NII Up
A Positive Gap generally benefits when rates go Up.
And:
N + Up = NII Down
A Negative Gap generally suffers when rates go Up.
For falling rates, reverse the direction.
The numerical sequence is:
RSA/RSL → Gap → Rate Change → Direction → NII Impact