Final answer:
Banks can mitigate risk by diversifying their loans across various sectors and locations, which helps balance out the defaults. However, during a widespread recession, diversification is less effective. Other strategies include hedging, insurance policies, and credit derivatives.
Step-by-step explanation:
Banks can protect themselves against a variety of risks through multiple strategies. Diversifying loans is a key method, as it spreads the risk across various borrowers from different industries and geographic locations.
In case of a downturn affecting a niche market, having loans dispersed among a variety of sectors helps in offsetting the defaults from one particular segment. However, this method has its limitations during widespread recessions that affect multiple sectors simultaneously.
In addition to diversifying their loan portfolio, banks can engage in several other strategies to mitigate their risks.
These may include utilizing financial instruments to hedge against interest rate fluctuations, purchasing insurance policies to protect against specific risks like natural disasters, and using credit derivatives to transfer credit risk to other parties.