The degree of collateral-based lending in the Thai banking system has macroeconomic importance and implications, because collateral-based lending is strongly associated with swings in asset prices. During the 1980s and 1990s, a number of countries experienced a real-estate lending boom, going along with rising asset prices - especially of housing and property.

Thailand is a prominent case in question, which ended in the devastating financial crisis of 1997. Collateral-based lending proves to be an easy way to provide financing to a rapidly growing and emerging economy, but it increases the vulnerability of the overall economy.

My research using micro-level bank-lending data reveals that the use and level of collateral are markedly higher than in Thailand. Second, younger and smaller firms have to pledge collateral more often and to a higher degree than older and larger firms. Collateral is used to reduce the observed higher risk of these borrowers. Third, banks that have the status of house bank (main bank) for borrowers capture and secure more collateral, particularly for smaller firms.

The strength of this relation in Thailand is much higher than in developed countries. Instead of reducing this information-deficient problem, house banks seem to exploit the lock-in of their borrowers by demanding higher collateral.

Finally, the existence of market imperfections is also evidenced by the fact that larger banks in Thailand are able to command more collateral.

In a nutshell, the microeconomic aspects of collateral-based lending in Thailand are clearly different from those in mature markets. The finding that small and young firms are likely to pledge collateral values amounting to 100 per cent or more of their credit volumes implies that these firms are particularly prone to the booms and busts of collateral asset prices.

A fall in these prices may thus cause a large reduction of credit availability to these firms, which are usually viewed as the growth engines of an economy, but may not have a financing alternative.

This should have exacerbated the real effects of the financial crisis experienced by Thailand in 1997.

From a macroeconomic point of view, over-reliance on collateral exacerbates business cycles. The value of collateral rises when asset prices rise and falls when asset prices fall; this will heavily affect the amount of credit availability and credit granted to firms, which in turn influences those firms' investment opportunities and levels. This can accelerate the booms and busts of asset prices and the economy.

To illustrate this, during an asset-price bubble, collateral-based lending rises, but what happens when the bubble bursts? There is the real risk of a sudden reversal. This risk has become reality in the wake of Thailand's last financial crisis.

Therefore, collateral-based lending makes firms more prone to swings in asset prices and increases the vulnerability of the overall economy. So, collateral-based lending in Thailand has some important ambiguous implications: it improves availability of credit in the information-lacking environment of emerging markets like Thailand. However, it also seems to cause lock-in situations.

Another negative side is the substantiated and mounting concern that collateral-based lending increases the vulnerability of the economy and exacerbates business cycles.

This is the second part of a series. Chodechai Suwanaporn is director of the Financial Policy Section of the Finance Ministry's Fiscal Policy Office. He can be contacted at chodechai@fpo.go.th.

Chodechai Suwanaporn