Dynamic gap transformations: Are banks asset – transformers or brokers? or both?

We study the sensitivity of bank stock returns to interest rates, by extending existing tests in two important directions. We incorporate dynamic gap adjustments and extend the traditional duration gap measure to new gap measures based on the general equilibrium term structure model developed by Longstaff and Schwartz [Longstaff, F. A., & Schwartz, E. S. (1992). Interest-rate volatility and the term structure: A two-factor general equilibrium model. Journal of Finance, 47(4), 1259–1282]. Consistent with previous studies, the results indicate that banks hedge against changes in interest rate levels, when the levels are low, and speculate when the levels are high, but the volatility is low.