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Management & Engineering 08 (2012) 1838-5745
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Management & Engineering
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Study on the Construction of SME Folk Capital Financing
Channel
Ping LUO, Ling JIN
School of Economics and Management, Shenyang Ligong University, 110159, P.R.China
KEYWORDS
ABSTRACT
Small and medium-sized enterprise,
Folk capital,
Financing channel
Financing difficulty is the main factor that restricts the development of small and
medium-sized enterprises for a long time. However, there are many idle funds lack of
effective investment channels in folk capital market meanwhile. SMEs demand a large
amount of capital while folk capital needs effective investment channels. Capital
suppliers and demanders have the common development goals and the function of capital
they supply and demand has the strong complementary to each other. Actually, the
success rate of capital supply and demand is very low. This paper expounds the necessity
and feasibility of folk financing for SMEs; analyzes the factors which restrict SMEs from
folk financing; and put forwards measures to perfect SMEs folk financing. Measures
include completing related laws, perfecting market interest rates system of private
financing, completing information disclosure system, strengthening financial regulation,
and constructing risk prevention system.
© ST. PLUM-BLOSSOM PRESS PTY LTD
1 Introduction
SMEs have become a big part in China's national economic development. Financing difficulty is a major factor that restricts the
development of SMEs in a long term. Reasons for financing difficulty include both internal and external factors. Internal ones
include information asymmetry, the imperfection of enterprise governance and management system etc. External factors are such as
macro policies application injustice, the restriction of external financing environment and formal financial credit terms, and so on.
When the SMEs can not break through the limits of formal financial institutional factors, they will rely on folk capital much more.
However, folk financing is still in a state of underground in reality. As it is spontaneous and lack of standardization and the financial
regulation, many problems emerge such as the instability of funds supply, the small size of financing amounts, the obstructed channel
of capital supply and demand, and especially the financial risk. In order to solve those problems and improve the SMEs development,
it is necessary and effective to strengthen the study on folk financing and establishing its legal status.

Corresponding author.
E-mail address: [email protected]
English edition copyright © ST. PLUM-BLOSSOM PRESS PTY LTD
DOI:10.5503/J.ME.2012.08.010
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2 The Necessity and Feasibility of SMEs Folk Financing
2.1 The main financing obstacles SMEs facing to
2.1.1 SMEs mainly rely on indirect financing
Because of the strict requirements of financing in securities market, it is difficult for most SMEs to finance through capital market.
SMEs rely on their own internal accumulations which couldn’t demand the needs of development as they expand the scale of
production and improve the technology. Investigation shows that 65.7% enterprises financing depend on various types of financial
institutions loans, 33.3% belong to equity financing, 16.4% finance from other channels. Bonds financing rate is the least and is only
1.8%. The proportion of external financing of SMEs is relatively low because that direct external financing channels are few. Many
SMEs financing rely on indirect external way-financial institutional loans.
2.1.2 Financing channels are few and narrow for SMEs
Although there are many financing ways for SMEs to choose such as equity financing, bank credit financing, commercial credit
financing, international trade financing and policy financing, SMEs qualified with the financing terms are few in reality. Common
financing measures employed by SMEs are internal funds financing, financial institutions credit, private loans and lease loans.
Effective financing channels are not only few but also narrow.
2.1.3 It is difficult for SMEs to meet the requirements of the commercial bank credit
Commercial bank credit is the most important source that SMEs could finance from. However, the proportion of bank credit funds is
relatively low in SMEs capital structure. Banks seldom provide long term funds to SMEs because they are restricted by the size of
assets, competition strength and their own quality. Large enterprises and big projects are main objectives supported by bank credits.
The proportion of financial institution credits for SMEs is very low, which could not satisfy the needs of SMEs for funds. Funds
shortage of SMEs is serious.
2.2 Folk capital has become an important source for SMEs
Although financial institutions savings deposit is growling in 2008, the increased amount and increasing speed is dropping obviously.
The reason is that folk capital is profit oriented. SMEs’ great demand for funds stimulates the development of folk financing market;
and adequate folk capital meet the SMEs’ requirements for funds. Since there are few investment channels for folk idle funds, great
amounts of folk funds flow into SMEs in order to maintain and increase their value. In Jiangsu province, folk capital participated in
the establishment of town bank, Microfinance Company and the medical institution. It also participated in the construction of
transportation infrastructure and coastal shelter forest under the government guide.
2.3 Folk capital investment subject and SMEs have complementary functions
Comparing with other financial ways, folk capital financing naturally has the characteristic suitable for SMEs. Folk financing has
advantages compared with formal finance. Firstly, the operating cost is low and there are no requirements for fixed costs of fixed
assets and operation sites. Secondly, the guarantee term is easy that most financing is guaranteed by family property. Thirdly,
information symmetry is good because both the creditors and the borrowers live in the same area and they have adequate information
about each other’s credit status and investment prospects. Fourthly, pricing form is flexible. Creditors and borrowers set the price
according to the capital supply and the interest rate formation mechanism is flexible. Formal financial institution can not meet the
SMEs’ requirements for funds. As a transition form in an incomplete financial system, folk capital makes up the deficiency of the
formal finance and becomes an indispensable financing channel for SMEs.
3 Restricting Factors of SMEs Folk Financing
Folk finance can overcome the shortcomings of formal financial inadequate capital supply and solve the problem of market failure to
a certain extent. It is a natual choice made by market economy and an autonomy choice made by SMEs. But actually there is a
contradiction between SMEs’ capital shortage and the private funds plenty supply. The deep reason is that folk finance is in a
marginalization in a long term.
3.1 The lack of legal protection of folk finance
Although some laws involved in folk finance have been published, they are not systematic and particular. On one hand, the
construction of folk finance legal system lags behind. The management subject of folk finance is indefinite and no specific
examination and approval departments are set up. There is no definition between folk finance and illegal fund raising credit. The
legal nature and status of folk finance is not clear. Since most folk finance is not approved by authority, it is often recognized as
illegal fund raising and is likely to be punished by law. On the other hand, there is no specific folk financing law to guide and direct
the private financing activities. Existing laws related with folk finance haven’t been revised while the situation of folk finance
changed to more open. They become more unreasonable, inharmonious and contradict. There are no harmonious laws for folk
finance. Policies to guide the folk finance activities are not carried out effectively. Defects exist in current financial protection laws
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which could not fit the high speed development of economy.
3.2 High rates and unsuitable contract of folk finance
Folk financing rate is limited by laws that it could not be more than four times the same type of bank interest rates. But in reality,
high rates of folk finance are quite common and that results in contradiction between main bodies of financing. Major reasons are as
follows. Firstly, the highest folk loan interest rate is limited in judicial interpretation, but there are no specific words in contract law.
Secondly, no punish measures are stated in laws for the usury in folk finance. Thirdly, folk capital is not in government statistics and
regulation. In the situation that the interest rate of folk finance keeps increasing stably, the probability of debt repayment failure is
high, which hinders private funds sustainable circulation.
3.3 The lack of information disclosure in folk finance market
Information asymmetry is the main factor result in SMEs capital supply restriction. Meanwhile, the incomplete information
disclosure system is one of the most important factors that restrict the folk capital flowing into SMEs. Firstly, no information
platform exists to provide the information of folk capital supply and demand. Although several information platforms are set up by
the support of government in some area, they mainly aim to help the communication between SMEs and formal financial institutions.
Secondly, since folk finance is based on the relationship of person, district and relatives, the production and communication of
information is in private manner and restricted by the limitation of area.
3.4 The invalid regulation for folk finance
Under current regulation mode, the ineffectiveness of regulation for folk finance is reflected in such area as follows. (1) The main
body of regulation is indefinite and the responsibility is not performed. There is no effective communication among the central bank,
the banking regulatory commission and the court. (2) Regulatory object focuses on the examination of the main body of application
and neglects the analysis of folk capital’s flow and developing tendency in folk finance market. (3) Regulatory content is incomplete
that it focuses on the normalization and neglects the regulation of risk. (4) No adequate information is provided to help and guide the
SMEs folk finance in regulatory service. (5) There are no connections between regulatory laws and some of them conflict to each
other. As an informal financial institutional credit activity, folk finance is lack of management and regulation by government.
3.5 The lack of operation security of folk finance
The real reason caused difficulty in SMEs financing is systematic rather than technical. Folk finance is based on such a cultural
concept which relies on private relationships. There is no credit security system which formal finance has and enormous risk of
morality, economy and society is concealed. Folk finance is in a state of disorder. No specific credit evaluation institution is set up to
provide service for folk finance. No standard assessment procedure and method exists and measures to cope with risks and losses are
absent. Folk finance operation is not standard. There is no guideline system of capital flow, strict regulation and suitable guarantee
system.
4 Constructions of SMEs Folk Capital Financing Channel
In order to solve the problems in SMEs folk finance, we must perfect the system and improve the mechanism. Financing mechanism
serves for both suppler and demander of folk funds; promotes to the match of SMEs capital supply and demand.
4.1 Perfecting SMEs financing laws
4.1.1 Confirm the legal status of folk financing and define the boundary of illegal finance and folk finance
Finance under the background of real productive or consummative payment and maintain its interest rate in a reasonable level should
be regarded as proper financing. Finance aiming on financial fraud, usury and money laundering should be regarded as illegal
financing. Clear definition should be made in such aspects as rights and responsibilities of suppliers and demanders, trade method,
contract requirements, interest rate, tax collection, the responsibility of breach and the rights and interests protection. Make folk
finance become more contractual and standardized by using legal means.
4.1.2 Revising laws about SMEs folk financing
On one hand, adjust unsuitable laws and policies; coordinate existing laws involved in folk finance like contract law and general rule
of the civil law. On the other hand, specific law suitable for SMEs folk finance development should be legislated. Confirm the legal
status and subject qualification of SMEs folk financing activity. Uniform credit procedure and operation rules should be clear.
Detailed rules are needed to guide the folk capital flows and investment direction. Standard contract items should be made in order to
ensure the standardization of contract and the effectiveness of laws. Rights and obligations of both sides of financing should be clear.
4.2 Perfecting the marketable rate mechanism of folk capital
Firstly, government rate control could be canceled as long as folk finance market is effective and the supplers and demanders of
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capital both obey the marketing rules. Secondly, adequate space for folk finance development should be saved when designing the
rate policy. Using rate lever to guide the capital flow back into folk capital market. Distrubute SMEs available folk funds to formal
and informal financial institutions reasonbaly. Enhance the benefit of folk finance. Thirdly, the rate level should be dicided by folk
finance subjects in the controllable scope of bank benchmark interest rate. Expand the region of folk finance loan interest rate chages.
Optimize the using efficiency and benefit of folk capital through both sides gaming and competition.
4.3 Perfecting the information disclosure of SMEs folk finance
On one hand, information management agency should be set up to provide information service to folk capital suppler and demander.
The agency should public and update information about the situation of folk capital supply and demand, both sides’ credit conditions,
interest rates and enterprise default. On the other hand, website should be set up to public information of SMEs financing and the folk
capital supply. Any suppler or demander of capital can find the suitable communication object immediately through the website.
SMEs can choose better folk capital organization by comparing the line of credit, interest rate, speed and conditions. The suppliers of
folk capital can inquire about the information of SMEs default record, guarantee situation, credit rating and acceptable interest rate so
that they can find the target customer quickly; expand business and control risk efficiently. The construction of network platform can
realize folk finance information circulation mechanism at the lowest cost so that solve the problems of SMEs financing difficulty.
4.4 Strengthening and completing SMEs folk finance supervision
Appropriate government intervention is needed. Establish and perfect the external supervision system which focuses on the SMEs
folk finance prudent supervision and bring folk finance into China Banking Regulatory Commission supervision network. Firstly,
strengthen the monitoring to SMEs folk finance development state and give warning when necessary. The regulatory department
should investigate SMEs folk finance situation regularly and take measures to prevent credit risk. Secondly, Research on supervision
mechanism suitable for folk finance development. SMEs folk financing interest rate should be monitored, analyzed and reported
regularly. Thirdly, spread related knowledge of laws and financial policies in order to improve the legal consciousness of the whole
society. Fourthly, establish and perfect long term management mechanism. Government and financial institutions should
communicate efficiently. Malicious debt evasion should be punished seriously.
4.5 Establish risk prevention system of SMEs folk finance
The fund provided by folk finance is limited in both size and term, which could result in great relevance risk. It is very important to
establish risk prevention system and ensure the security of SMEs folk finance. On one hand, request for financing objects prudently,
which includes supporting repetitive credit deals between the same supplier and demander rather than choosing worse debtor just for
profits; limit funds using scope and control financing scale; Determine the main body of responsibility clearly, emphasize the first
reimbursement source and request for mortgage. On the other hand, strengthen the risk prevention for folk capital supply. Measures
include establish risk rating assessment system; execute different guaranty money system according to folk finance total risk;
emphasize on supervision and maintenance of huge amount of folk capital and ensure the order of folk finance safe and effective.
5 Conclusion
According to the analysis, this paper draws conclusions as follows. It is necessary and practicable for SMEs to finance from folk
capital. Because of the lack of laws, incomplete of information disclosure system, ineffectiveness of supervision and imperfection of
guaranty system, folk finance does not help to dissolve the SMEs financing difficulty. Under the premise that folk finance risk is
controlled effectively, take measures to realize the efficient matching of SMEs funds demand and folk capital supply. Establish
capital market and information market for both the capital suppler and demander; adjust the contradiction between folk capital supply
and demand.
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