Financial Liberalization

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The Reregulation of Commercial Banking

Commercial banks dominate the financial system in Thailand, with a 73 per cent share of both household savings and credits extended by all financial institutions. Local commercial banks and branches of foreign banks are governed by the Commercial Banking Act of 1962 together with the amendments made in 1979,1985 and 1992. The first two amendments were designed to improve and revise the 1962 Act in order to make it more efficient and suitable to changing circumstances so that public interest could be protected. The main aim of the 1992 amendment was to introduce the capital adequacy standards of the Basle Committee (Laurisden, 1998).

Prior to the 1962 Act, foreign banks were allowed to open sub-branches; however, after 1962, the banks were not allowed to extend sub-branches in the Thai Kingdom. In addition, the BoT became very restrictive in terms of granting licences to new local banks. Hence, domestic banks and branches of foreign banks remained low in number; for example, by the end of December 1993, only 15 local banks and 13 branches of foreign banks were operating in the Kingdom.

The major shareholders of domestic commercial banks mostly belonged to a group of families. For example, Bangkok Bank, the largest bank in the country with a market share of 21 per cent, belonged to the Sophonpanich family. The third largest bank with a market share of 13 per cent, the Thai Farmers Bank, belonged to the Lumsum family. The Bank of Ayuthaya, the fifth largest bank with a market share of 8 per cent, belonged to the Ruthanaruk family. There was only one state-owned bank, the Krung Thai Bank, which was the second largest bank in the Kindgom and held a market share of 15 per cent. The fourth largest bank, the Siam Commercial Bank, had a market share of 9 per cent; it was crown property. Family-owned banks were generally managed by a group of family members and mainly extended loans to the businesses of their executives and related persons. However, by 1979 commercial banks had gradually become public companies, although the family group still remained the major shareholders of banks indirectly. By 1994, the local commercial banks had expanded branches to the whole Kingdom with a network of 1,709 branches in 1983 to 2,838 branches in 1994, operating 2,320 automated teller machines (ATMs) throughout the country (Bank of Thailand, 1999).

It is useful to compare the scenario in 1994 with that in 1998. While at the end of 1994, Thai commercial banks held a market share in deposits of 98 per cent, by 1998 the figure was 96 per cent. The market share for creditors was 88 per cent in 1994 but had fallen to 85 per cent by 1998; the branches of foreign banks, however, increased their market share from 12 per cent by 1994 to 15 per cent by 1998, as the confidence in local banks fell. In general, as shown in Table 17.1, commercial bank lending for personal consumption fell; there was also a decline in lending to real estate business, exports, agriculture, other financial services and wholesale and retail trade. However, the share of total lending to manufacturing, construction, imports, and public utilities increased in 1998 compared to the 1994 base level.2 Moreover, in 1998 commercial banks introduced elec-

Table 17.1 Bills, loans and overdrafts of commercial banks, classified by sector



Share %


Share %



1. Agriculture





2. Mining





3. Manufacturing





4. Construction





5. Real estate business





6. Imports





7. Exports





8. Wholesale and retail trade





9. Public utilities





10. Other financial business





11. Services





12. Personal consumption





13. Others





14. Total





Note: Loan values are in billions of baht; shares are in sectoral percentages of the total.

Source: Bank of Thailand (1999).

Note: Loan values are in billions of baht; shares are in sectoral percentages of the total.

Source: Bank of Thailand (1999).

tronic banking by providing deposit and withdrawal services through an on-line system to branches in almost all provinces, with over 2,320 ATMs in two pools, namely, BANKNET and SIAMNET; these were used to provide out-of-hours deposit and withdrawal nationwide. Swift, used for the transfer of funds among banks throughout the world, was introduced in 1985.

Reforming the Exchange Rate System

The main reform of the Thai exchange rate system can be traced back to immediately after the Second World War when, due to economic difficulties and a serious shortage of foreign exchange, Thailand was forced to adopt a multiple exchange rate system. However, in 1963 the economic situation improved and the exchange rate regime was switched to a par value system such that the value of the baht was fixed in terms of gold. In order to maintain the baht parity, the Exchange Equalization Fund (EEF) was established with the aim of stabilizing exchange rate movements within prescribed margins. The successful operation of the EEF enabled full parity of the baht to be maintained for 15 years or so.

However, in 1978 the volatility of major world currencies forced the BoT to adjust the exchange rate, and the par value system was abolished. A system of pegging the baht to a basket of major currencies (in which the US dollar weight was 0.85) was introduced. The new system allowed greater flexibility in exchange rate adjustments to reflect more accurately economic and monetary conditions. It also facilitated the stability of the baht since the currency was no longer tied to any particular currencies. The system operated smoothly until 1981, when signs of trouble began to emerge due to the strong appreciation of the US dollar relative to other currencies. The baht depreciated rapidly, and although the government devalued the currency twice in mid-1981, public confidence could not be restored. However, in July 1981, a decision on the daily fixing was made, and the EEF fixed the exchange rate of the US dollar at 23 baht. This rate was held fixed until 1984, when the government announced a replacement of the dollar-pegging system by pegging the baht to a basket of currencies.

But it was not until 21 May 1990 that the BoT took the most important step in the process of exchange rate deregulation by accepting the obligations under Article VIII of the Articles of Agreement of the International Monetary Fund (IMF), and implementing the first phase of exchange control relaxation. The aim was to liberalize the foreign exchange system in line with the globalization of the economic and financial systems, and allow freedom of international capital movements. Specifically, exchange rate deregulation was implemented in three main phases. Phase I of the exchange control deregulation began on 21 May 1990 by allowing commercial banks to process customers' applications for the purchase of foreign currency for trade-related transactions, that is, imports and exports without prior approval from the BoT.3 Phase II of the exchange rate deregulation began on 1 April 1991 by allowing greater flexibility to private businesses and the general public in the purchase or sale of foreign exchange. All exchange controls were abolished and new forms were introduced for reporting purposes only. A limit of US$10 million was allowed for an annual investment for one person and for the acquisition of real estate and stocks overseas. Foreign funds, on the other hand, were allowed to move in and out of the country freely. Phase III began on 30 April 1992 to further provide more convenience for the public, and exporters in particular. Exporters were allowed to receive and make payment in baht in addition to foreign currencies, and to transfer foreign currency deposits for overseas debt payment.4

Of all the financial liberalization measures, the development of offshore banking facilities, known as the Bangkok International Banking Facilities (BIBFs), was the most important for developing Bangkok as a regional financial centre. BIBFs were introduced in 1993 when the BoT perceived that the Thai financial system should be developed as a regional financial centre, given its stable economic conditions, liberal exchange rates and interest rates, as well as high international borrowing transactions. The BoT proposed the establishment of BIBFs in order to facilitate and reduce the cost of international borrowing, while encouraging foreign capital inflows to finance domestic investment as well as investment throughout the Indo-Chinese region. Initially, 46 BIBF licences were granted. Licensed banks could use foreign funds raised overseas to lend to their domestic customers (known as 'out-in' operations), or to overseas customers (known as 'out-out' operations). Apart from out-in and out-out operations, which were considered to be the core businesses, BIBFs were also allowed to provide other international banking services, such as cross-currency trading, trade financing on strictly an out-out operational basis, loan syndication arrangements, arranging the issue of debt instruments, and engaging in underwriting in foreign currencies.

Capital flows responded in stylized fashion (Fry and Murinde, 1998). After the floatation of the baht currency in July 1997, net capital outflows peaked in the third quarter of 1997 and the baht currency kept on depreciating against the US dollar until it reached 55 baht per US dollar in January 1998. It then stabilized at around 36-40 baht per US dollar from the fourth quarter of 1998 onward. Although short-term nominal interest rates climbed to more than 20 per cent during the crisis, low confidence and exchange rate uncertainties led to huge capital outflows through non-

Table 17.2 Net private financial flows into Thailand (billions of US$)












Commercial banks




- 4.7

- 4.3












- 2.0

Direct investment






Other loans





- 4.3

Portfolio investment






Non-resident baht A/C





- 2.7

Trade credits












Net private capital inflow






Source: Bank of Thailand (1999).

Source: Bank of Thailand (1999).

renewal and repayment of short-term loans towards the end of 1997 through to 1998. The net outflows of private capital at the end of 1997 accounted for US$8.4 billion and continued to increase to more than US$16.0 billion in 1998. The banking sector, including the BIBFs, shouldered the biggest impact of the financial crisis. The commercial banks recorded a net outflow of US$4.7 billion in 1997, but the net outflow dropped in 1998 to US$4.3 billion. The BIBFs followed with net outflows of US$1.7 billion in 1997, peaking in 1998 at US$9.6 billion. Table 17.2 reports the private financial net flow position in Thailand during 1994-98.

By the end of 1999, the surging volume of foreign exchange activities and derivatives trading made it necessary to strengthen prudential supervision in this area. The BoT imposed net foreign exchange position limits and provided guidelines to reinforce existing internal control procedures and practices widely utilized by commercial banks in monitoring and controlling their foreign exchange activities. In 1999, the required ratio for commercial banks was limited within the range of 15 per cent of the net overbought (asset) position to 15 per cent for the net oversold (liability) position.

Financial liberalization through the BIBF considerably increased short-term debts since most of the credits were on a short-term basis and continually rolled over for long-term use. The deterioration of investor confidence and deceleration of economic growth made foreign creditors unwilling to roll over BIBF credits. The volatile exchange rates motivated borrowers to repay loans, resulting in high net capital outflows throughout the second half of 1997 and 1998.

Interest Rate Liberalization

As Lensink et al. (1998) have shown, interest rate liberalization is the key policy instrument used by many developing countries that wish to embark on financial liberalization. In Thailand, the liberalization of interest rates was conceived and implemented as a three-year plan (1991-93) aimed at enabling the banking system to adjust to changing demand and supply, both domestically and externally. With continuous economic expansion since 1987, there was apparent need to mobilize long-term and stable funds for national development. When it was evident that long-term deposits had not expanded in line with borrowing needs, the BoT deemed it appropriate to lift the ceiling rate on term deposits exceeding one-year maturity from the previous ceiling of 9.5 per cent to 10.5-11.0 per cent per annum in June 1989 in order to accelerate the process of savings mobilization. The gradual process of deregulation was aimed at allowing time for financial institutions and the public to make the necessary adjustments without major disruption.

With regard to the ceilings on other types of deposits, the BoT continued the interest rate liberalization policy. Ceilings on deposits for all maturity periods were abolished on 16 March 1990. On 8 January 1992, the BoT announced the removal of the ceiling on savings deposit rates. In June 1992, the BoT fixed the ceiling rate on promissory notes issued by finance companies and crédits fonciers. Competition for deposit mobilization in the form of attractive offer rates followed as a result of the liberalization process. This factor increased pressure for the ceiling on lending rates to be freely determined according to the prevailing liquidity positions while also minimizing adverse impacts on borrowers. After 1992, interest rates followed a downward trend and the timing was right to remove the lending-rate ceilings for commercial banks, finance companies and crédit foncier companies.

The lifting of the lending-rate ceiling became effective on 1 June 1992, allowing domestic interest rates to fully adjust in accordance with demand and supply conditions. From January 1993, the BoT began to implement measures to encourage commercial banks to reduce their lending rates for general customers in response to changes in the cost of deposits. It managed to do so by requesting cooperation from commercial banks and cutting the bank rate twice, in June and September. As a result, commercial banks responded by reducing both their deposit rates and their lending rates and, thus, narrowing the differential between the lending rate for general customers and the one-year time deposit rate to 6.75 per cent in September 1993. However, the BoT did not wish to lead or intervene in the operation of commercial banks every time, but wanted to establish an adjustment mechanism for the lending rate for retail customers to automatically adjust to the actual cost of funds, as determined by the market mechanism. The BoT and the Thai Bankers' Association set up a working group to study and determine the benchmark for the lending rate for retail customers. Finally, the working group agreed to introduce the minimum retail rate (MRR) as a reference lending rate for retail customers.5

The commercial banks and branches of the foreign banks began to announce the MRR from the end of October, and the MRR was adopted by all banks in mid-November 1993. During the month when the MRR became effective, the interest margin between the lending rate for retail customers and the one-year deposit rate rose to 7.5 per cent, as commercial banks cut the deposit rate by more than the lending rate. Nevertheless, since the profit margin for retail customers was set at not more than 2 per cent, banks were forced to adjust by lowering the rates on both loans and deposits. Moreover, the lending at lower interest rates by the BIBF in the domestic market enhanced the stiff competition among banks and enabled borrowers to acquire cheaper loans.

In May 1997 the minimum loan rate (MLR) and the MRR were allowed to move freely according to the market mechanism in order to help stimulate the economy. The BoT asked the commercial banks to set the MLR limit in line with market conditions and the MRR, as well as the cost of funds, to reflect the risk differentials between the wholesale and retail customers. However, as the competition among financial institutions increased and customers were offered higher rates on both deposits and loans, difficulties arose in liquidity management because of the high cost of funds to the banks. In June-July 1997, the BoT temporarily limited the ceiling on time deposit to 12-14 per cent to reduce the high lending and deposit rates in order to maintain stability in the financial system.

Interest rates started to go up by late 1996, when the weakness in economic indicators, especially in the current account deficit, began to appear (see Table 17.3). The BoT was forced to maintain high interest rates to help support the baht currency, and to raise funds to bail out ailing finance companies through the Financial Institutions Development Fund (FIDF). The policy continued until the floatation of the baht in July 1997. Thailand then sought assistance from the IMF and had to follow the advice that high interest rates were necessary to help reverse the outflow of capital and stabilize the currency. As shown in Table 17.3, the interbank rate peaked in the third quarter of 1997 through the second quarter of 1998 at between 18 and 20 per cent, and began to fall to only 3.8 per cent at the end of the fourth quarter of 1998. The interbank rate bottomed out at around 1-2 per cent at the end of 1999.

Nevertheless, in July 1998, when the economy started to cool down, the

Table 17.3 Movements in interest rates and exchange rates during the reform period


Interbank interest rate (%)

Exchange rate (baht per US$)











































Source: IMF (2000) (Thailand, country pages).

Source: IMF (2000) (Thailand, country pages).

BoT allowed commercial banks to adjust interest rates more freely by using the reference rate.6 Interest payable on savings deposits was made subject to the reference rate plus not more than a 2 per cent mark-up, while time deposits of over three months were made subject to the reference rate plus not more than a 3 per cent mark-up. All the rates had to be disclosed, and the new rules applied to the head office and all branches. In addition, the central bank issued new long-term government bonds to refinance the liabilities of the FIDF. This helped to support the downward trend of short-term money market rates. Market liquidity improved markedly throughout 1999, allowing market interest rates to decline further. Deposit interest rates peaked at 14-15 per cent in 1998, but fell from 6-7 per cent in early 1999 to 3-4 per cent at the end of 1999 (Vatikiotis and Keenan, 1999).

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