Final answer:
By replacing long-term securities with floating rate loans, a bank's default risk would likely increase because borrowers may struggle to pay if interest rates rise. Additionally, liquidity risk may also increase as loans are less easily sold than marketable securities.
Step-by-step explanation:
If a bank attempts to reduce exposure to interest rate risk by replacing long-term marketable securities with more floating rate commercial loans, it is likely that the bank's default risk would increase (option B). This is because floating rate loans are more likely to adjust to current interest rates, which reduces the interest rate risk for the bank but may increase the risk of borrowers not being able to afford higher payments if rates increase, leading to higher default risk. Additionally, the bank's liquidity risk could increase (option C) because commercial loans are not as liquid as marketable securities, which can usually be sold more easily and quickly.
The asset-liability time mismatch is critical here. Banks are in danger when they cannot adjust the interest rates on assets quickly enough to match the changes in the rates they pay on liabilities. By replacing long-term fixed assets with assets that adjust their interest rates—like floating rate loans—they seek to align the interest income with the interest paid to depositors, but in the process, may take on more risk that borrowers default during times of rising interest rates.
It is important to recognize the complex trade-offs banks face between different types of risks, and that reducing one form of risk might increase another. Therefore, the answer is option E; both default risk would increase, and liquidity risk would increase.