Final answer:
Banks manage risk and protect against high loan defaults through loan diversification and risk transfer strategies, such as purchasing insurance and using financial derivatives, to maintain a positive net worth and stability.
Step-by-step explanation:
Banks can protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch through a strategy known as risk transfer. This is often achieved by the diversification of loans. By not placing all their financial resources into one type of investment or sector, banks reduce their vulnerability to specific economic changes or downturns. Diversifying loans means lending to a variety of customers across many industries and geographic areas, which allows for a balance between those with high defaults and those with low defaults. Hence, diversification can help maintain a positive net worth for the bank.
However, banks also engage in other methods of risk management, such as purchasing insurance, using derivatives like credit default swaps, or creating securitized products, which can spread the risk even further. These strategies are crucial for banks to manage potential financial losses and maintain stability in the face of economic fluctuations.