Term Deposits (9) - Risk of Default

Matching the term of the loan to the term of the deposits does not eliminate all risk. The person who borrowed the money may abscond or make bad business decisions. They might not be able to repay the money they have borrowed when the term is complete. The bank is to should be skilled in assessing the creditworthiness of borrowers and putting appropriate security measures in place.

The more risky the loan, the higher the interest rate will have to be. Depositors should be able to choose the level of risk they want to take on, but I suspect that most depositors would specify that their money only be lent to creditworthy borrowers.

The bank could also provide insurance against the borrower defaulting. This does not eliminate the risk, but it spreads the cost across all depositors, rather than leaving all the risk with the few depositors affected by the bad loan. Most depositors would prefer a slightly lower interest rate, if they new that the cost of any default would be spread across many depositors.