Final answer:
A negative income gap indicates that a bank has more rate-sensitive assets than liabilities, which can result in financial distress if interest rates rise, as the bank may end up paying more in deposit interest than it earns from its loans.
Step-by-step explanation:
A negative income gap shows that the bank has more rate-sensitive assets than liabilities, and it will suffer from an increase in interest rate.
Banks face a risk called asset-liability time mismatch, where a bank's liabilities can be withdrawn quickly by depositors while its assets, like loans and bonds, are repaid over longer periods. If interest rates rise significantly, a bank that has issued loans at lower interest rates can find itself at risk. Depositors may move their funds to other institutions offering higher rates if the bank does not adjust its interest rates accordingly. Consequently, if the bank raises the rates it pays to depositors, it may end up paying more in interest than it receives from fixed-rate loans issued earlier, leading to financial distress.