Final answer:
Diversification of loans helps banks protect themselves against loan defaults and asset-liability time mismatch by reducing exposure to risk. However, diversification may not be effective during widespread economic downturns. Banks can use other strategies to further reduce risk.
Step-by-step explanation:
When it comes to protecting themselves against an unexpectedly high rate of loan defaults and asset-liability time mismatch, banks can employ several strategies. One of these strategies is diversifying their loans by lending to a variety of customers. By doing so, banks can reduce their exposure to risk. For example, if a bank lends to both consumers purchasing homes and cars as well as a wide range of firms in different industries and geographic areas, the bank is less likely to suffer significant losses if one particular category of borrowers defaults on their loans. This is because the borrowers who default will tend to be balanced out by other borrowers who have fewer defaults.
Diversification of loans allows banks to keep a positive net worth. However, it's important to note that diversification may not offer much protection during widespread economic downturns that affect multiple industries and areas.
In addition to diversification, banks have other strategies to reduce risk, which they can employ alongside diversifying their loans.