Final answer:
Banks face the problem of adverse selection when high-risk borrowers seek loans more actively than low-risk ones, which can contribute to high default rates. Asset-liability mismatches amplify this risk, but banks can mitigate it by diversifying their loans across various sectors and regions.
Step-by-step explanation:
When borrowers with the most risky investment projects are more likely to seek bank loans in comparison to those with safer investment projects, banks encounter the problem of adverse selection.
Adverse selection occurs because banks may end up lending to borrowers who are more prone to defaulting on their loans, hence increasing the risk of an unexpectedly high level of loan defaults.
This is especially problematic due to the asset-liability time mismatch, where customer deposits can be withdrawn quickly, while the bank's assets, such as loans and bonds, are repaid over a longer term.
Banks protect themselves by diversifying their loans, lending to a variety of customers across different industries and geographic areas. This can help maintain a positive net worth by offsetting those who default with those who do not. However, diversification is not foolproof; widespread recessions affecting multiple industries can still cause significant losses.