In terms of ALM, what does credit risk imply?

In the context of Asset Liability Management (ALM), credit risk refers to the potential for losses due to a borrower's failure to repay a loan or meet contractual obligations. This inherent risk is particularly relevant in lending activities, where financial institutions extend credit to individuals or businesses.

The notion that loans have higher potential profitability but also greater risk aligns with the nature of credit transactions. Loans typically offer higher interest rates compared to securities, which can lead to increased profitability for lenders. However, this comes with the caveat of increased exposure to credit risk; borrowers may default on their payments, leading to financial losses for the lender.

Investing in securities, while generally considered to have a lower risk of credit default, may not yield the same level of returns. Therefore, the balance between potential profitability and risk is critical for financial institutions when deciding their asset allocations in relation to loans versus securities.

Understanding this trade-off is essential for effective ALM, as managing credit risk is a key component of ensuring the stability and profitability of a financial institution.