Mutual Benefits of Bank Intermediation through Diversification

Lending Risk Analysis

An individual lends their entire $10,000 savings to a single friend's new business. The loan has a high probability of being fully repaid with interest, but also a small chance of complete default, resulting in the loss of the entire $10,000. A bank, in contrast, takes in deposits and makes thousands of similar small loans to different businesses. Which statement best analyzes the difference in the variability of returns between the individual lender and the bank?

Lending Portfolios and Return Predictability

Analyze the following lending structures and match each one to the correct description of its risk profile regarding the stability of expected returns.

Evaluating Lending Strategies and Return Stability

A financial institution that pools funds from many depositors to make a large number of loans to different borrowers completely eliminates the possibility of its actual portfolio return being lower than its expected return.

Comparing Lending Strategies and Return Stability

Comparing Loan Portfolio Outcomes

An investor is considering two strategies. Strategy 1: Lend $100,000 to a single business. This loan has a 5% chance of complete default (a loss of $100,000) and a 95% chance of being repaid with 10% interest (a gain of $10,000). Strategy 2: Invest $100,000 in a fund that makes 1,000 separate $100 loans, each with the same individual 5% default risk and 10% interest return.

Which of the following statements provides the most accurate analysis of the variability of returns for these two strategies?

Portfolio vs. Single Loan Return Predictability