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SME Policy Financing in Korea According to the Korea Federation of Small and Medium Business (Kbiz), bank loans accounted for 98% of SME financing in Korea in 2009 at 443.5 trillion won, while direct financing like stocks, corporate debentures, etc. accounted for 2% at just 9 trillion won. Since the 1998 foreign exchange crisis, bank lending to SMEs has increased steadily, affected by shrunken lending to major conglomerates and stiffer regulations on household loans. As of May 2010, outstanding bank loans to SMEs totaled 448.2 trillion won, accounting for 46.6% of aggregate won-currency lending. Bank lending to SMEs is characterized by “blue-chip” loan practices and loans backed by mortgages and certificates of credit guarantee. This environment presents financing bottlenecks that stifle micro-enterprises as well as promising SMEs with competitive technology and growth potential but weak financial structure. Meanwhile, SMEs also face hurdles in the direct financing market due to low credit ratings. In fact, SME capital formation from the direct financing market in the first six months of 2010 was just 1.7 trillion won, about 8% of that of large corporations. Signs point to a recovery in angel investment this year, but it is projected to remain significantly lower than in 2006 and 2007. While SMEs continue to be the backbone of the national economy, accounting for the vast majority of number of companies and employment as well as 46.3% of manufacturing production and 32.4% of exports, mortgage-based lending practices and private financing institutes’ avoidance of assistance are a recipe for market failure. This is the reason why policy financing is so critical. To compensate for the shrunken lending environment stemming from business fluctuation as well as the global financial crisis, policy financing supports business start-ups and areas where market failure have cropped up. It also is fostering excellent new and green technologies in next-generation growth sectors that are facing bottlenecks in access to mainstream financial markets. The main forms of policy financing consist of policy capital loans, credit guarantees, on-lending, and aggregate ceiling lending, the scale of which has increased significantly in the wake of the global economic crisis that began in late 2008. SME policy financing began to take shape in the 1960s and 70s when Korea turned to large enterprises and the heavy and chemical industries to lead the national economy with export-oriented policies. During this period, the government also realized that it would be necessary to protect SMEs. Therefore, it established financing and support organizations to carry out SME policy financing, among which were. the Industrial Bank of Korea, Korea Credit Guarantee Fund and the Small and medium Business Corporation. In 1965, a mandatory minimum lending ratio system for SMEs was introduced, which led to an increase in SME loans at provincial banks from 30% to 40% in 1972. The 1980s through 1997 was a high-growth period for Korea, but it led to structural imbalances in the economy between heavy and light industries and between large and small-medium enterprises. Despite this fact, awareness of the critical role and functions of SMEs increased, leading to incorporation of a provision in the national constitution regarding protection and cultivation of SMEs. As a result, bank lending to SMEs expanded, with the SME loan ratio at commercial banks rising from 30% to 35%, at provincial banks growing from 40% to 55% and at domestic branches of foreign banks starting at 25%. Centering on provincial and special banks, SME access to household loans began to increase. In the wake of the 1997-98 foreign exchange crisis, banks began to reinforce loan marketing for households and blue-chip SMEs as large enterprises shied away from loans in order to reinforce their financial positions. Into the early 2000s, the risk-avoidance trend prevailed and the household loan ratio began to outpace the corporate loan ratio. Then, in 2005, the government, concerned about a real estate bubble, started to implement restrictions on household lending, which subsequently boosted the SME loan ratio sharply from 258 trillion won in 2005 to 444 trillion won in 2009. Today, the key players in the SME financing support system are the Small and medium Business Corporation (SBC), which primarily facilitates investment and loans from start-up and promotion funds as well as credit guarantees, the Bank of Korea, which implements the aggregate credit ceiling system, and the Korea Policy Banking Corporation, which oversees the on-lending program. The support for policy loan funds from SBC consists of the supply of long-term-low-interest funds to SMEs, which are avoided by private banks due to weak credit and collateral despite their technological and business viability. SBC has revamped its corporate evaluation system to focus on technological and business viability, including future marketability and growth potential, rather than on financial status, while strengthening complementary functions related to market-failure areas. The corporation supplies long-term (3-8 years) funds at low interest rates compared with banking institutions. The policy fund interest rate in the second quarter of 2010 was 4.03-4.40%. The areas supported by the fund include initial period of start-up, long-term facility investment, and micro-businesses, among others. SBC offers access to two types of loan, direct loan and proxy loan. Under its direct loan program, the corporation performs all of the related procedures, receipt of loan applications, loan examination and post-loan management. Under the proxy loan system, it conducts the preliminary loan examination while banks carry out the final loan examination, loan, and post-loan management functions. In 2009, 46.3% of SBC’s loan activities were of the direct loan type involving 2.2 trillion won, while 53.6% were of the proxy type involving 2.6 trillion won. This year, SBC has a total loan support budget of 3.14 trillion won and as of the end of June had 16.5 trillion won in outstanding loans. SBC’s role is to contribute to SMEs’ stable capital management and reduction of capital expenses as well as to supply funding for SMEs in a timely manner and minimize damage to SMEs when shocks occur due to non-economic factors such as natural disasters or sharp international raw material price hikes. In terms of job-creation effect, a secondary benefit of the SBC loan program, more than 39,000 new jobs were created in 2009, an average employment growth per enterprise of 3.21 and representing a 0.77 job creation effect per 100 million won. The targets for 2010 are 44,500 new jobs created for an average of 3.64 per enterprise and a 0.88 job creation effect per 100 million won. A second program in place to facilitate SMEs’ access to financing is the credit guarantee support system, which provides guarantees for SMEs that are experiencing difficulties in obtaining loans from private banks due to a lack of collateral. The implementing agencies for this program are the Korea Credit Guarantee Fund (KODIT), Korea Technology Finance Corporation (KOTEC) and the Korea Federation of Regional Credit Guarantee Funds (KFRCGF). The three implementing agencies respectively serve SMEs operating in different categories: KODIT supports non-technology-oriented SMEs – start-up firms, exporting firms and green-growth firms; KOTEC serves technology-oriented SMEs – venture firms, INNO-BIZ firms and greengrowth firms; and KFRCGF supports regional micro businesses – small firms, self-managed micro firms and unregistered micro businesses. The basic procedure for obtaining credit guarantee support starts with the enterprise that requires funds submitting an application to one of the guarantee agencies for consultation on guarantee. The agency will then contact the enterprise to collect data, conduct a credit inquiry and examine the guarantee request. After satisfying the agency’s requirements, the agency will issue a guarantee certificate to a banking or other supporting financial institution, which will in turn provide the loan to the applying enterprise. In the first six months of this year, the credit guarantee support scale reached 71.1 trillion won (compared to 67.6 trillion won for all of 2009). By guarantee agency, the first-half figures were 41.0 trillion won (39.2 trillion won for all of 2009) for KODIT, 17.5 trillion won (17.1 trillion won) for KOTEC and 12.6 trillion won (11.2 trillion won) for KFRCGF. With expanded policy financing through the credit guarantee program, as well as other sources, SMEs were able to overcome the recent financial crisis at an early date, as the guarantees facilitated loans to reduce SME market failure, while contributing to the reinforcement of the national economy. The credit guarantee system is seen as having positive effects on government, bank and SME activities. In the case of the government, the system strengthens the public benefits of financing functions by supporting viable technologically innovative enterprises with growth potential despite relatively weak collateral and low credit ratings. With respect to banks, the credit guarantee program reinforces financial health while supporting SMEs smoothly in accordance with a downward adjustment of risk weight (10%-0%) in Basel II. The system benefits SMEs by increasing accessibility to bank financing and facilitating the smooth supply of business capital in a timely manner, compensating for weak collateral and credit ratings through the guarantees. The third program designed to increase SME access to financing is support through on-lending, or re-lending, which refers to funds that are recorded as a deposit to a supporting financial institution but the original lending bank and the contractual borrower (the supporting financial institution) agree that the loan proceeds will be made available to thirdparty SMEs. Under this program, the Korea Policy Banking Corporation (KPBC) suggests guidelines regarding SMEs targeted for support and supplies on-lending funds to financing institutions. The financing institutions then examine applicant SMEs and decide whether to provide loans or not, as well as the loan interest rate. KPBC provides credit and liquidation underwriting to ease the risk to the financing institutions. In 2009, the on-lending program provided 230 billion won to applying SMEs. This year, the budget for the program was increased sharply to 2.1 trillion won. In a fourth pillar of support, the Bank of Korea (BOK) ensures systematic support for SMEs under two key programs – the aggregate credit ceiling system and the mandatory minimum SME loan ratio system. In the aggregate credit ceiling system, the BOK allocates funds to 17 banks after determining aggregate credit ceilings quarterly based on the results of loans provided to SMEs by the banking institutions. In July 2007, the aggregate credit ceiling support provided by the BOK was 6.5 trillion won, but in response to the economic crisis, the central bank increased the ceiling sharply to 10 trillion won by March 2009. The BOK applies lower than prevailing market interest rates to its aggregate credit ceiling loans to achieve policy goals, including expansion of SME lending and balanced regional development; for example, the rate was lowered from 3.5% per annum in August 2008 to 1.75% in December 2008 and further to 1.25% in February 2009. The positive effects of the aggregate credit ceiling system have been to accelerate banking institutions’ selective financial support for SMEs, reduce SME loan-related expenses with the application of preferential interest rates and increase banking institutions’ issuance of loan products. However, while still positive, the system offers lower economic benefit to SMEs during times of low market interest rates like at present. The second BOK program that assists SMEs is the mandatory minimum SME loan ratio system. The central bank encourages lending banks to provide more than an established ratio of loans from the won-currency finance fund to SMEs: for commercial banks the ratio is more than 45%, provincial banks over 60%, and domestic branches of foreign banks over 35%. Those banks that do not achieve these ratios are disadvantaged when the BOK allocates aggregate credit ceilings by having 50% of the amount not achieved cut from their respective aggregate credit ceilings. The Small & Medium Business Administration (SMBA) augments and supplements the foregoing programs by providing additional support to facilitate SMEs access to financing. Two of these programs are related to bond issuance by SMEs. First, SMBA supervises a system that insures SME sales bonds. SMEs may purchase insurance from the Credit Guarantee Fund for the supply of goods or services with sales bond to purchasing enterprises, thus protecting the rights of the purchasing enterprise and instilling confidence in the SME. Second, as SMEs face difficulties in issuing non-guaranteed corporate bonds in the financial market based on their own credit rating as 99.3% of the issuing enterprises have a credit rating lower than BB (speculative rating), SMBA assists by issuing asset backed securities (ABS). Between 2000 and 2009, SMBA provided about 2.75 trillion won in funds for 1,053 SMEs, including 152 billion won for 64 SMEs in 2009. Going forward, SMBA intends to continue to develop SME financing support programs. It will work to maintain an optimum level of liquidity supply, in connection with expanded policy financing, to support the growth and development of promising enterprises. In the meantime, SMBA also will strengthen its technological viability appraisal system to provide access to financing for those enterprises that possess excellent technology and business success potential but which lack sufficient financial and collateral capacity. In addition, SMBA will sustain its efforts in smoothing the way for SMEs to raise capital in the direct finance market and in helping microenterprises stand on their own feet by developing an appropriate financing support system.