The Principle of Diversification in Banking
A bank has a fixed amount of capital to lend. Explain why making 100 small loans to 100 different borrowers is typically a less risky strategy than making one large loan to a single borrower.
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Example of Bank Diversification with Multiple Borrowers
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How Bank Diversification Reduces Return Variability Compared to Bilateral Loans
Principle of Uncorrelated Risks in Portfolio Diversification
Residual Risk in Diversified Loan Portfolios
A bank has $50 million available for lending and is evaluating two strategies. Strategy A involves lending the entire $50 million to a single, large, well-established corporation. Strategy B involves lending $500,000 to each of 100 different small businesses across various unrelated industries. From a risk-management perspective, which statement best analyzes the two strategies?
Evaluating a Bank's Lending Strategy
A bank that successfully diversifies its loan portfolio by lending to a large number of different borrowers across various industries can guarantee it will not suffer a financial loss from its lending operations.
Analyzing the Effectiveness of Diversification Strategies
The Principle of Diversification in Banking
A bank shifts its lending strategy from providing a few very large loans to a handful of clients in the technology sector to providing thousands of small loans to borrowers across many different, unrelated industries (e.g., agriculture, retail, manufacturing, healthcare). Which statement best explains the primary risk management benefit of this new strategy?
Match each lending scenario with its most accurate risk profile description.
A bank provides loans to 1,000 different startup companies. All of these companies operate exclusively within the emerging 'smart home' technology sector. A financial analyst claims the bank's loan portfolio is poorly diversified, despite the large number of borrowers. Which of the following statements best supports the analyst's claim?
A commercial bank aims to minimize its overall lending risk by applying the principle of diversification. It has $100 million to lend. Which of the following lending strategies best achieves this goal?
Evaluating Competing Diversification Strategies