Key Concepts
1. Create a simple example of how banks that attempt to maximize returns can be exposed to a high
degree of liquidity risk, interest rate risk, and default risk.
2. Describe liquidity risk, and explain how banks manage it.
3. Describe interest rate risk, and explain how banks manage it.
4. Describe credit risk, and explain how banks manage it.
POINT/COUNTER-POINT:
Can Bank Failures be Avoided?
POINT: No. Banks are in the business of providing credit. When economic conditions deteriorate, there
will be loan defaults and some banks will not be able to survive.
COUNTER-POINT: Yes. If banks focus on providing loans to creditworthy borrowers, most loans will
not default even during recessionary periods.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: Many arguments are possible. A bank may be able to avoid a large amount of loan defaults by
providing loans to only the highest rated firms. However, many banks would not be able to lend all the
funds that they have if they only lend to the highest rated firms. Therefore, they provide some loans to
weaker firms, and are susceptible to loan defaults when economic conditions are weak. There are many
banks competing to give loans and it causes some banks to provide loans that are questionable. The
competition is good for the industry because it ensures that deserving customers can receive funding at a
competitive rate, but it leads to some bank failures.