how do banks diversify their risk?

Answer 1

A lot of time, they just "sell" their risk to others.

I loan company XXX $100. I then buy an otion from YYY to pay me $100 if XXX goes out of business. No matter what happens, I get my $100 (unless XXX AND YYY go out of business). Ideally I make enough on the XXX loan to cover what I have to pay to YYY

Answer 2

Banks diversify their risk by not making loans to all of the same type of loans (i.e. business loans, personal loans, auto loans, mortgage loans). Each type of loan carries its own level of risk and level of return on investment. Banks may also invest their money into various types of investments (government bonds, etc.). By being diversified, this lessens the chance that a downturn in one area (i.e. real estate slump) will negatively affect their earnings.

Answer 3

So that even if one type fails, the others are OK and the bank can go on. If you put all your eggs in one basket and it goes bad you are finished .
This rule is advised for regular people / investors also, not just banks . . . diversify, diversify, diversify . . .

Answer 4

For banks, hedging risk is just as important as diversifying risk. Commercial banks often use derivative securities (i.e. options) to hedge risk. For example, banks typically will use swaps (a type of derivative) to hedge interest rate risk because they typically hold long-term assets (i.e. loans given to borrowers) and short-term liabilities (i.e. deposits accepted which bear interest payable). Since banks therefore typically "want" or "need" ST assets and LT liabilities, they will often enter into a swap to pay fixed rates and receive variable rates (often tied to Tbills or LIBOR). Insurance companies are typically the exact opposite in capital structure and will typically enter into the other end of the swap agreement.

Answer 5

investment paths