Sometimes banks invest in attractive instruments with higher risk in order to earn higher profit. To mitigate such risks banks use risk transfer strategy where it transfers the credit risk to another party that is willing to take the risk.
This strategy has become very popular in USA just before the subprime crisis where banks had transferred their subprime credit risk and mortgage risks to other insurance companies at certain premiums. They have used complex financial instruments like Asset based securitization and Mortgage based securitization and credit default swap etc. to transfer the risk to third parties. Too much risk exposure in subprime and mortgage loans of some insurance companies like US Insurance giant AIG proved as disastrous for those companies when much higher than expected number of borrowers went default and they had to pay the entire insured amount to the banks.
Credit default swap is one of the most popular risk transfer strategy that is being used by most of the banks and financial institutions even now as well.
Banks can also hedge risks on their own by using different derivative instruments such as forward, futures, options and swaps etc. Currency swap helps them to transfer currency risk and interest swap helps them to transfer interest rate risk to counter parties. All these are explained in the derivatives segment.