Final answer:
Banks face less expected loss from a swap default than from a loan default because swaps involve only the exchange of cash flows and usually have collateral agreements reducing potential losses. Unexpectedly high levels of loan defaults, in contrast, can lead to severe financial issues for banks, exacerbated by asset-liability mismatches where liabilities can be withdrawn faster than assets can be repaid.
Step-by-step explanation:
The expected loss to a bank from a default on a swap is typically less than the expected loss from the default on a loan to the counterparty with the same principal because swaps generally involve the exchange of cash flows rather than the full principal amounts. When a default occurs on a swap, the bank is usually only exposed to the net amount of the cash flows, which represents the difference between what the bank owes and what it is owed. In contrast, for a loan, the entire principal amount is at risk if the borrower defaults.
Additionally, swaps often have collateral agreements or margin requirements that reduce potential losses. Furthermore, a well-run bank will factor in the potential for loan defaults into their planning and will maintain a certain level of riskiness on their balance sheet to account for the possibility that some customers will not repay. Nevertheless, unexpectedly high levels of loan defaults during events like a recession can significantly hurt a bank's assets and net worth, as illustrated by the case of a hypothetical bank in the provided text.
Banks also face the issue of asset-liability time mismatch, where liabilities like customer deposits can be withdrawn quickly while assets like loans and bonds are repaid over a longer term. This mismatch can exacerbate problems for the bank if interest rates rise, leading to a situation where the bank might pay higher interest to depositors than it earns on its loans.