Credit derivatives design to facilitate loan purchase agreements in the secondary loan market in Thailand

Date15 April 2020
Publication Date15 April 2020
AuthorKittiphod Charoontham,Kessara Kanchanapoom
SubjectStrategy,International business
Credit derivatives design to facilitate loan
purchase agreements in the secondary
loan market in Thailand
Kittiphod Charoontham and Kessara Kanchanapoom
Purpose This paper aims to studya strategic decision of banks in Thailand to signal theirtypes to the
market andderive the optimal credit derivativescontract to guarantee their loans and crediblysignal their
quality under different economic determinants, namely, the maximum credit risk investment constraint,
opportunitycost and opaqueness of the credit derivative market.
Design/methodology/approach Contracttheory is deployed to derive the expected payoff of different
bank types under different economic and financial constraints. Hence, different bank types offer
derivatives contracts to signal their loan quality and resell their loans in the secondary loan markets of
Findings The optimal derivatives contract is constructed on a basis of asymmetric information when
banks have more privateinformation concerning quality of their loans. A digitalcredit default swap is an
optimal derivatives contract to send credible signal when banks are restricted to the maximum
investment constraint. Moreover, profit of banks is reduced, as the optimal derivatives contract is more
costly whenbanks are subjected to positive opportunitycost and opacity of the credit derivativesmarket.
These results depict impact of changesof the maximum credit risk investment constraint on Thai credit
Originality/value The optimal credit derivatives design that signifies bank types and facilitates loan
purchase agreementhas not been studied in Thai secondary loan marketsbefore. In addition, this study
provides insightsof banksstrategic decisions to signal their types and transferrisk to risk buyers in Thai
Keywords Optimal credit derivatives contracts, Maximum credit risk investment constraint,
Opportunity cost, Credit derivatives market opacity
Paper type Research paper
1. Introduction
Broad demand for many types of consumer loans in the primary loan market has been a
major growth area for the bankingindustry in Thailand. After the 1997 financial crisis hit, the
Secondary Mortgage Corporation (SMC), a state enterprise financial institution under the
Ministry of Finance, was established as a non-depository financial institution with the main
objective of developing the secondary market for housing mortgage loans under the
principal of asset securitization for fund-raising activities. After purchasing quality housing
loan portfolios, the SMC would securitize them as asset-backed securities or mortgage-
backed securities to sell in the secondary loan market. This, therefore, gives commercial
banks more options to manage their portfoliosand adapt to changes of the maximum credit
risk investment constraint under the Basel III framework. With such objectives, the SMC
should significantly help commercial banks in Thailand to adopt an off-balance-sheet
strategy to expand lending activities and establish mortgage stability in the real estate
sector. By selling housing loan portfolios to the SMC, banks could immediatelyrealize profit
Kittiphod Charoontham is
based at Khon Kaen
University, Khon Kaen,
Kessara Kanchanapoom is
based at the NIDA
Business School, National
Institute of Development
Administration, Bangkok,
JEL classication G21, D82
Received 12 February 2019
Revised 8 August 2019
17 December 2019
Accepted 24 December 2019
This research has been
supported by the Khon Kaen
University International College
Research Grant.
The authors would like to thank
Matthew Foley and Martin Baier
for their helpful feedback
during the initial development
of the manuscript. The authors
are grateful to the editor and
anonymous referees for their
insightful comments and
suggestions which significantly
helpedimprove the manuscript.
Conflictof Interest: The authors
declarethat they have no
conflictof interest.
DOI 10.1108/JABS-02-2019-0050 VOL. 14 NO. 5 2020, pp. 561-580, ©Emerald Publishing Limited, ISSN 1558-7894 jJOURNAL OF ASIA BUSINESS STUDIES jPAGE 561
and transfer their risk to the SMC, after which the realized profit could be used to extend
lending activities to new borrowers. As a result, borrowers who might not have access to
credit due to credit rationing could have better access to housing finance from banks,
which would result in financial development in Thailand. The SMC, a risk buyer, would
selectively purchase quality housing loans from financial institutions, in particular
commercial banks in Thailand, and hold these loans to maturity. In the current situation, it
seems that the SMC and Thai commercialbanks should simply reach Pareto optimum.
However, the SMC has encountered difficulty in settling purchasing-loan agreements with
Thai commercial banks for many years because the SMC offers to purchase recourse loans
from banks to guarantee the qualityof housing loans and to secure its investment. Recourse
loans have become the only financial instrument that the SMC uses to prevent banks from
dumping toxic loans. Regarding this point, the financial products offered by the SMC in the
secondary loan market have expanded at a much slower pace compared to the growth of
bank loan portfolios in the real sector. With an aim to increase the credit supply for housing
loans and expand the size of the secondary loan market in June 2013 (Hachaiyaphum,
2013), the SMC started implementing a new business model to increase its presence in the
secondary loan market in Thailand by opening mortgage companies (MCs), non-deposit
taking mortgage lenders, as a channel to induce mortgage loans in the primary loan market
due to a difficulty in settling loan-purchasing agreements with all commercial banks in
Thailand. MCs would thus originate mortgage loans with long-term fixed rate offers, and
then sell them to the SMC.
This study considers asymmetric information relating to loan quality as an obstacle
preventing the SMC from reaching loan-purchasing agreements with commercial banks.
With permission from the Bank of Thailand(2003), Thai commercial banks could sign credit
default swap (CDS) contracts to guarantee their loan portfolios which could result in more
loan-purchasing agreements betweenthe SMC and commercial banks, and that could lead
to sustainable growth for the secondary loan market. However, a major concern about
credit derivatives is that they are privately-negotiated contracts traded in the over-the-
counter (OTC) market, which has frequently been criticized for its perceived lack of
transparency and unregulated nature. To address these problems, this study proposes an
optimal derivative contract of loan portfolios with credit protection that banks should offer to
signal their types, to convince the SMC to settle loan-purchasing agreements under
different institutional settings. Furthermore, the role of informed regulators who mitigate the
derivatives market opacity and influence the optimal separating contracts, and how this
assists the SMC and banks to reach loan-purchasing agreements is investigated. Findings
can explain why the SMC has struggled to increase credit supply, depict the optimal
contracts that facilitate the loan-purchasing agreements between banks and the SMC, and
the dynamic interactions between banks and the SMC under different institutional settings
are illustrated. This should assist the SMC in making informed decisions on purchasing
housing loans from commercial banks and ultimately enhance the credit supply, leading to
the growth of Thai secondary loan markets.
2. Literature review
Before the 1997 financial crisis, all banks had to retain their loan portfolios for extended
periods of time which required banks to maintain capital reserves resulting in an accrued
opportunity cost of capital and restricted their lending ability since only a primary loan
market existed in Thailand. Thus, portfolio diversification was the only main risk-
management instrument for Thai banks. It was considered a strength of the Thai banking
system because the theory of financial intermediation (Diamond,1984, 1991)
recommended that banks should retain loans and monitor borrowers so that loans should
be illiquid assets. Banks accordingly played a main role in mitigating information asymmetry
problems, and they were induced to strictlymonitor loans and perform the role of delegated

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