can be use ful sme

8/3/2019 can be use ful sme

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Asia-Pacific Journal of Financial Studies (2007) v36 n6 pp897-926

897

The New BASEL Accord and

Bank Capital Requirements for SMEs in Korea

Joon-Ho Hahm**

Yonsei University, Seoul, Korea

Dongsoo Kang

Korea Development Institute, Seoul, Korea

Received 29 December 2006; Accepted 29 October 2007

Abstract

This paper evaluates the impact of Basel II on bank capital requirements for SME lend-

ing in Korea. We explicitly account for the risk mitigation effect of collateral and credit

guarantee provisions in SME lending. We find that, with the current credit guarantee

scheme, banks will have benefits from lower capital requirements under the standardized

and advanced-IRB approaches. We also conduct sensitivity analyses with respect to the

guarantee coverage ratio. Our findings suggest that Basel II and downward adjustmentsin the guarantee coverage ratio may not produce significantly discouraging effects on

SME lending in Korea.

Keywords:Basel II; Bank Capital Requirement; Credit Guarantee; SME Finance;Credit Risk

* This is a substantially revised version of the manuscript presented at the KDI conference,Adopting the NewBasel Accord, July 2006, Seoul, Korea. This work was supported in part

by Yonsei University Global 5-5-10. We would like to thank two anonymous referees for

their valuable comments and suggestions. We would also like to thank Sohyoung Park for

her excellent research assistance. All remaining errors are our own.

**Corresponding Author. Address: Graduate School of International Studies, Yonsei University,134 Shinchon-dong, Seodaemoon-ku, Seoul, Korea, 120-749; E-mail: [email protected];

Tel: +82-2-2123-4210; Fax: +82-2-392-3321.


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The New BASEL Accord and Bank Capital Requirements for SMEs in Korea

898

1. Introduction

Small- and medium-sized enterprises (SMEs) are an important part of economic

growth. They are main drivers of economic activities contributing to job creation and

sustainable growth of an economy. An important factor conducive to the development

of a thriving SME sector is to improve access to external finance. Since bank lending

is the primary source of external finance for SMEs, credit allocation and risk man-

agement practices of banking institutions deeply affect overall performance of the

SME sector.

As in many countries, the new Basel capital accord (Basel II) has brought about se-

rious concerns in Korea in that it may structurally change the way banks behave in

allocating credits to SMEs. Note that a key feature of Basel II is its emphasis on the

better alignment of economic risk and bank capital requirements. It is argued that,

given the relatively high risks of SMEs, the new capital requirements would be too

costly for banks, which might discourage SME lending. Faced with this criticism, a

series of concessions (Basel Committee on Banking Supervision 2002, 2003b, 2005)

has been made in order to contain potentially negative consequences on SME lending.

This paper evaluates the impact of Basel II on bank capital requirements for SME

lending in Korea. In exploring the potential consequence of Basel II, our approach is

differentiated from the existing research in that we explicitly account for a unique

feature of SME financing in Korea, namely, the wide provision of public credit guar-

antee on SME lending. Korea is one of the few countries that have operated an exten-

sive public credit guarantee program especially after the 1997 financial crisis.1) Note

that Basel II allows banks to take account of a wider set of credit risk mitigation

schemes including credit guarantees. Since a relatively large portion of bank SME

lending is supported by the public credit guarantee program, it is necessary to con-

sider this feature in attempting to assess the quantitative impact of the new Basel

accord in Korea.

Note that, while the credit guarantee is intended to expand banks risk-return fron-1)Faced with worsening information asymmetry and imperfections in SME loan markets in the aftermath of

the 1997 crisis, the Korean government provided a relatively generous public credit guarantee to encour-age SME lending of banks by sharing the risk of loan default. At the end of 2004, the outstanding balance

of public credit guarantees reached 47.1 trillion Korean won or 6% of nominal GDP in Korea, and pub-licly guaranteed loans accounted for 24% of total bank SME loans. Koreas credit guarantee volume in

terms of GDP is one of the highest levels in the world.


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Asia-Pacific Journal of Financial Studies (2007) v36 n6

899

tier in favor of SMEs, it also carries a risk of moral hazard on the part of banks and

borrowing firms. Recognizing these problems, the Korean government has recently

proposed a plan to gradually retire existing credit guarantee provision and make the

scheme more market oriented. Consequently, the SME sector in Korea is faced with

two regulatory shocks the new bank capital requirement under Basel II and the

gradual reduction of public credit guarantees. While the new Basel accord may lower

capital requirements for SME loans especially under the special treatment permitted

for SMEs, a reduction in the credit guarantee supply may raise risk capital charges

for banks. However, there seems to be little systematic research evaluating the im-pact of the new Basel accord under the shifting credit guarantee scheme in Korea.

Utilizing a unique dataset on bank loan exposures as well as credit guarantees ex-

tended to 5,631 externally audited SMEs, we make quantitative impact analyses on

bank capital requirements under Basel II. We also conduct sensitivity analyses of

capital requirements with respect to the SME credit guarantee coverage ratio. Our

findings suggest that, under the current credit guarantee scheme, the new Basel ac-

cord does not necessarily lead to an increase in bank capital requirements. While

capital requirements may increase under the foundation-IRB approach, banks will

have benefits from lower capital requirements under the standardized and advanced-IRB approaches. We also find that the adverse impact of the reduced guarantee cov-

erage ratio can be alleviated under Basel II. In sum, Basel II and reduced credit

guarantees would not produce significantly discouraging effects on SME lending in

Korea.

The present paper is organized as follows: Section 2 overviews the existing litera-

ture. Section 3 discusses the treatment of the credit guarantee under the new Basel

capital accord. In Section 4, we present data, methodology and major empirical re-

sults. Finally, Section 5 will summarize and conclude this paper.

2. Literature Review

This section provides a review of the relevant research on the effects of the Basel II

implementation on bank SME lending. As mentioned above, the potentially negative

impact of the new Basel accord on SME lending has been a common concern for many

developing and developed countries alike. Some commentators criticized the uniform


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treatment of loan exposures across firms with different sizes arguing that the risks of

SME loans would be more idiosyncratic, and the idiosyncratic risks could be diversi-

fied away in bank loan portfolios requiring less risk capital.2)

Accordingly, a series of concessions (Basel Committee on Banking Supervision 2002,

2003b, 2005) have been made to respond to this criticism. First, the Basel Committee

proposed that different risk weight functions would be applied for SMEs. According to

the proposal, a special discount in the asset correlation calculation would be applied

to SMEs with annual turnover less than 50 million. Furthermore, if the banks total

exposure is less than 1 million for a relatively small SME, the SME loan could beclassified as retail exposure, and a separate, more favorable risk weight curve could

be applied. Second, the asset correlation coefficient would be determined by the prob-

ability of default so that firms with higher default probabilities such as SMEs could

benefit more.

While the special treatment of SMEs has softened criticisms on the new Basel ac-

cord, it is still a matter of debate as to what degree the Basel II capital regulation

would affect bank SME lending. There has been a volume of research on this front in

European countries, which generally reports a favorable effect of the revised Basel II.

For instance, Dietsch and Petey (2002) investigated 224,000 French SMEs and foundthat the bank capital requirement would fall from 27.5 billion French franc under

Basel I to 21.7 billion French franc under Basel II. The quantitative impact study

(QIS3) of Basel Committee (2003a) also demonstrated that the bank capital require-

ments for European SMEs would be reduced by 2 to 5% under Basel II compared to

the current 8% in Basel I.

Saurina and Trucharte (2004) investigated the potential impact of Basel II on

Spanish SME lending. They found that, once they took into account of the special

treatment of SMEs, the new capital accord would not lead to a significant change in

the existing pattern of SME lending in Spain. According to their computations, thebank capital requirement for SMEs considered as corporate was 8.94% under the in-

ternal ratings-based (IRB) approach. However, it dropped to 6.26% when SMEs were

2)For instance, Lopez (2004) investigated the relationship between average asset correlation, firm probabil-ity of default, and firm asset size using data for US, Japanese, and European firms. He finds that the aver-age asset correlation is a decreasing function of probability of default and an increasing function of firm

asset size. Dietsch and Petey (2004) also obtained results that the asset correlations in SMEs were muchweaker relative to large businesses using the French and German firm data. However, they found that the

relationship between the probability of default and asset correlation was not negative.


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considered as retail, which was considerably less than 8% under Basel I. They also

found that the smaller a borrowing firm, the bigger its probability of default.

In a similar context, Altman and Sabato (2005) investigated the effects of the new

Basel accord on bank capital requirements for SMEs using data from the U.S., Italy

and Australia. They found that banks would have significant benefits in terms of

lower capital requirements when considering SME loans as retail exposures. How-

ever, when SME loans were classified as corporate, the capital requirements were

larger than the requirements under the current Basel I. Based upon a breakeven

analysis, Altman and Sabato argued that at least 20% of SMEs must be classified asretail for banks to be able to maintain the current 8% capital requirement of Basel I.

In the U.S., according to the QIS3 of Basel committee (2003a) which surveyed 17

large U.S. banking organizations, the average reduction in required capital of the 17

banks was 33% for their SME portfolios. In the U.S. the bifurcated implementation of

the Basel II capital requirements has raised another concern that community and

smaller banks that cannot adopt the advanced approach may be put at competitive

disadvantages as the large banking organizations that are likely to adopt the ad-

vanced approach may want to exploit the benefit of lower capital requirements for

SME lending under Basel II. However, Berger (2004) argued that this substitutioneffect on the part of large banks would be relatively limited as community banks

would continue to have comparative advantages in relationship lending to smaller

SMEs.3)

On the other hand, there seems to be relatively little research on the impact of

Basel II on SME lending in Korea. According to the quantitative impact study con-

ducted by the financial supervisory authority in 2004, commercial banks in Korea

would not suffer a lot from the adoption of Basel II especially when the special treat-

ment of SME loans are allowed. However, using SME lending data of a large bank in

3)The literature on relationship banking suggests that large and small banks may have comparative advan-tages in distinct types of SME lending. For instance, large banks may have comparative advantages intransactions lending but not in relationship lending, as they do not have adequate managerial structure or

communication channels to handle the soft relationship information on which loans for relativelyopaque SMEs are based. (Berger and Udell 2002, Stein 2002) Indeed, Haynes, Ou and Berney (1999)

found that large banking organizations tend to lend to relatively larger, older, and more financially secureSMEs. In a similar context, Acharya et al. (2006) provided a rationale why banks would not extend scopeand fully diversify across different sectors. Using Italian bank portfolio data, they found that there existed

diseconomies of scope, possibly from weakened monitoring incentives and a poorer quality loan portfoliowhen a risky bank expanded into additional industries or sectors. Berger and Udell (1998) also showed

how sources of SME financing and their capital structure could vary with firm size and age.


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Korea, Chung and Cho (2005a) found that the risk weighted asset would increase by

44% under the foundation IRB approach of Basel II. They also found that the main factor

behind this substantial increase in risk weighted asset was due to the relatively large

amount of unused loan commitment which must be added to the exposure at default

(EAD) under the new Basel accord. They argued that as a result of the increased bur-

den in capital requirements, banks would become more prudent in SME lending.

Kim and Park (2004) conducted related research investigating the relationship be-

tween capital requirements as prescribed by Basel II and the magnitude of economic

risks of SME lending in Korea. They computed economic capital using firm-level dataand found that economic capital required to cover true credit risks would be 6 to 8%

point higher than the capital requirements computed under Basel II. Based upon the

results, they argued that the Basel II treatment of SME loans might significantly un-

derestimate the true correlation of SME exposures. However, Chung and Cho (2005b)

examined empirical asset correlations obtained from the Korean SME data during

1999 ~ 2004 and found that the asset correlation was positively related to firm turn-

over volume and negatively to credit ratings as postulated by Basel II. Based on this

result, they argued that the asset correlation of Basel II would be suitable to Korean

SMEs and might actually cause a significant upward bias in regulatory capital re-quired under Basel II.

Suh (2006) theoretically investigated potential effects of Basel II on the optimal

lending behavior of banks. He found that there would be no unambiguous negative

relationship between the degree of capital requirements and the resulting quantity of

SME lending if obligor substitution effects were large enough. Doh (2005) examined

the possibility that the introduction of Basel II could worsen the pro-cyclicality of

SME lending and suggested macro-prudential policies aiming at mitigating the de-

stabilizing cyclical effects. Yet, despite the progress in the related research, there

seems to be little empirical work which studies the quantitative impact of Basel IIunder explicit consideration of the credit guarantee provision in SME lending, which

is the focus of our paper.

3. Treatment of Credit Guarantee under the New Basel Accord

Banks adopt various measures to mitigate the credit risk of loans. For instance,


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loan exposures could be collateralized or guaranteed by a third party, in whole or in

part. The new Basel accord allows banks to take account of such credit risk mitiga-

tion in calculating capital requirement on the condition that guarantees are direct,

explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfill

certain minimum operational conditions relating to risk management processes.4)

Under the new accord, the substitution approach is applied to the guaranteed loans

as in the current 1988 Basel I accord. According to this approach, the risk weight of

the guarantor is assigned to the guaranteed portion of the underlying exposure,

whereas the unprotected portion retains the risk weight of the original borrower. Forpartial guarantees, where the amount guaranteed is less than the amount of the ex-

posure and the bank and the guarantor share losses on a pro-rata basis, capital relief

is afforded on a proportional basis. Namely, the protected portion receives the treat-

ment applicable to eligible guarantees whereas the remainder is treated as unpro-

tected.

Currently in Korea, under Basel I, the protected portion of the exposure guaran-

teed by the Korea Credit Guarantee Fund (KODIT) and Korea Technology Credit

Guarantee Fund (KOTEC) is risk weighted at 10% in computing banks risk weighted

assets. The remaining unprotected portion is treated as unsecured corporate claimswith risk weight of 100%.

3.1 The Standardized Approach

The new Basel accord allows banks to choose from two broad methods in computing

their capital requirement for credit risk. One is the standardized approach and the

other is the internal ratings-based (IRB) approach. In the standardized approach, the

risk weight is determined by the credit rating of the obligor firm. As noted above,

banks adopting the standardized approach are allowed to use the risk weight of the

guarantor for the protected portion, and the risk weight of the underlying borrower

for the unprotected portion of the exposure.

Note that, under Basel II, the protected portion of the exposure by public sector en-

tities (PSEs) may be risk weighted according to the credit assessment on the sover-

4)This section is based upon the revised Basel II framework of Basel Committee on Bank Supervision

(2005).


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904

eign in whose jurisdictions the PSEs are established. As such, the protected portion

by the KODIT and KOTEC whose losses are ultimately covered by the Korean gov-

ernment may be risk weighted at zero percent as the sovereign credit rating of Korea

is currently A(S&P) and the risk weight for Korean won denominated sovereign

debt is zero percent. The unprotected portion is risk weighted according to the credit

assessment of the respective borrowing firm. For unprotected corporate claims, the

risk weight varies from 20% to 150% depending upon the credit rating of obligors.

The risk weight is 100% for unrated corporate claims.

Under the new Basel accord, banks continue to comply with the 8% minimum capi-tal requirement rule as under the current Basel I. The rate of regulatory capital

charge is computed as follows:

0.08K = (1)

where Kis the minimum capital requirement rate per unit exposure and is the risk

weight of the corporate claim. Under the standardized approach, risk-weights for cor-

porate exposures are also applied to SME exposures. However, for smaller exposures

of less than 1 million (one billion Korean won in the case of Korea), banks would be

able to apply a fixed retail credit risk weight of 75% as they are qualified as retail

exposures.

3.2 The Internal Ratings-based (IRB) Approach

The internal ratings-based approach is to link regulatory capital with a more accu-

rate measure of economic capital defined within a value-at-risk (VaR) framework.

According to the VaR framework, banks need to accumulate equity capital sufficient

to cover the unexpected loss up to a certain probability of survival. The IRB approach

is based on the asymptotic single risk factor model of Gordy (2003), which yields a

convenient property that the capital charge on a given instrument depends only on

its own characteristic, and not the characteristics of the portfolio in which it is held.

This property of portfolio invariance makes it easier for banks to compute capital re-

quirements for loan portfolios as a sum of capital charges of individual exposures.5)

5)According to Gordy (2003), two conditions are necessary to obtain the property of portfolio invarianceunder VaR risk factor models. First, the portfolio must be asymptotically fine-grained, and second, there


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905

As an alternative to the standardized approach, subject to certain minimum condi-

tions and disclosure requirements, banks that receive supervisory approval may use

the IRB approach in which banks rely on their own internal estimates of risk compo-

nents in determining the economic capital requirement for a given exposure. The risk

components include measures of the probability of default (PD), loss given default

(LGD), exposure at default (EAD) and effective maturity (M). In some cases, banks

may be required to use values assigned by the supervisory authority rather than in-

ternal estimates for one or more of the risk components.

With these risk components for corporate exposures, the capital requirement rate(K) is calculated as follows:

( ) ( )1 1 1 ( 2.5) ( )1 1.5 ( )1

[ ] PD r C M b PD

K LGD PDb PDr

+ + =

(2)

2( ) (0.11852 0.05478 ln( ))b PD PD= (3)

where, ( ) is the cumulative distribution function for a standard normal random

variable, C is the confidence level, and r is the asset return correlation. Note that the

maturity adjustment term is a function ofPD.

The new Basel accord suggests a formula to compute the asset correlation for cor-

porate exposures and proposes an adjustment for exposures to SMEs whose reported

sales turnover on a consolidated group basis is less than 50 million (60 billion Ko-

rean won in the case of Korea). The formula for SME exposures to be used by Korean

banks when the sales volume is S (in 10 billion Korean won) is the following:

50 50

50 50

1 10.12 0.24 1

1 1

PD PDe e

r

e e

= +

( )60.04 1

54

S

(4)

For retail exposures, effective maturity (M) is fixed at 2.5 and a lower range in

credit correlation is allowed relative to corporate exposures as follows:

must be at most a single systematic risk factor. These assumptions were criticized by many commentators.

For instance, Jarrow (2006) finds that the revised Basel II framework is not a good approximation of theideal capital rule, and argues that the new capital rule should not replace the existing approaches but must

be used only complementarily in determining minimum regulatory capital.


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906

35 35

35 35

1 10.03 0.16 1

1 1

PD PDe e

re e

= +

(5)

Then, the minimum capital requirements against SME loans are obtained using

the same formula used for corporate exposures in (2).

3.2.1 The Foundation IRB Approach (F-IRB)

Under the foundation IRB approach, banks provide their own estimates ofPD as-

sociated with each of their borrower grades, but they must use supervisory estimatesfor the other relevant risk components (LGD, EAD and M). ThePD is the greater of

the one-yearPD associated with the internal borrower grade to which that exposure

is assigned, or 0.03%. ThePD of borrowers assigned to a default grade is 100%. As for

the LGD, a 45% LGD is assigned for senior claims on corporate not protected by rec-

ognized collateral, and a 75% LGD is assigned for unprotected subordinated claims

on corporate. LGD mitigation may be allowed for claims protected with collateral. For

banks using the foundation IRB approach, effective maturity (M) is 2.5 years except

for repurchase agreement transactions where the effective maturity is 6 months.

For banks adopting the foundation IRB approach, the treatment of credit guaran-tees closely follows the substitution principle of the standardized approach. The

range of eligible guarantor is the same as the range under the standardized approach

except that companies that are internally rated and associated with aPD equivalent

to A- or better may also be recognized under the foundation approach. For the pro-

tected portion of exposures, the capital requirement rate is computed by replacingPD

with that of the guarantors. Hence, for the protected portion of the guaranteed expo-

sures by the KODIT or KOTEC, the minimumPD value of 0.03% is used. For the un-

protected portion of the guaranteed exposures,PD of the underlying obligor is used.

3.2.2 The Advanced IRB Approach (A-IRB)

Under the advanced IRB approach, banks provide their own estimates ofPD, LGD,

EAD, and Msubject to satisfying a minimum standard set by the supervisory author-

ity. Based upon the internal estimates, above described formula are used to compute

the capital requirements. As for the guaranteed exposures, banks using the A-IRB

approach may reflect the risk mitigating effect through eitherPD or LGD. Hence, for


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907

banks that choosePD, 0.03% is used for the protected portion by the public guarantor.

Banks may instead choose to make an adjustment to their LGD estimates for the pro-

tected portion of guaranteed exposures. Under this option, there are no limits to the

range of eligible guarantors although certain qualifications must be satisfied concern-

ing the type of guarantee. For instance, in Korea, LGD of 5% would be used for the

protected portion of the guaranteed loans in the case of public guarantors. The treat-

ments of the guarantees under the Basel I and Basel II in Korea are summarized in

Table 1.

Table 1. Summary Framework of Capital Requirements for Credit Risks

This table summarizes and compares risk weights and other key elements in computing Basel

I and Basel II bank capital requirements for corporate loans with different types of credit risk

mitigation.

Unprotected Loans Collateralized LoansGuaranteed Loans

(Protected Portion)

[Basel I] - risk weight 100%

- residential real es-

tate: 50%

- commercial real es-

tate: 100%

- KODIT and KOTEC

guarantees: risk

weight 10%

[Basel II]

Standardized

Approach

- risk weight of rated

loans: 20~150%

- unrated: 100%

- retail exposure(1 bil-lion KRW)1): 75%

- eligible financial: 0%

- residential real es-

tate: 35%

- commercial real es-

tate: 100%

- KODIT and KOTEC

guarantees: 0%

Foundation

IRB

Approach

- PD: estimated

- LGD: senior: 45%

subordinate: 75%

- M: 2.5

- SME exposure(sales 60billion KRW)2) and retail

exposure: correlation ad-

justment

- PD: estimated

- LGD: up to 70% of

collateral value: 35%

remaining 30%: 45%

- PD: 0.03%

LGD: senior: 45%

subordinate: 75%

Advanced

IRB

Approach

- PD: estimated

- LGD: estimated

- M: estimated

- SME exposure (sales 60 billion KRW) and re-

tail exposure: correla-

tion adjustment

- PD: estimated

- LGD: up to 70% of

collateral value: 35%

remaining 30%: 45%

- PD: 0.03%

LGD: senior: 45%

subordinate: 75%

or

- PD: estimated

- LGD: 5%

Notes) 1) The hurdle amount for retail exposure is 1 million in the case of European countries.

2) The criteria for SME adjustment is 50 million in annual turnover in the case of European countries.


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908

4. Empirical Analysis

4.1 Data and Basic Profile of SMEs

This study has mainly relied upon the dataset provided by the Korea Federation of

Banks, which reports the aggregate amount of credits extended by its member banks

for respective SMEs as of the end of 2004. After deleting outliers and missing values,

the total number of SMEs that we use for analysis is 5,631, which includes almost allexternally audited SMEs that have a non-zero outstanding loan balance from com-

mercial banks in Korea.6) Note that firms whose total asset size is 7 billion Korean

won (approximately 7.6 million U.S. dollars) or more are subject to the external audit

requirement in Korea. Hence, our dataset excludes relatively small and young SMEs

whose asset size is less than 7 billion Korean won.

Decompositions of the total bank credit outstanding for a given SME are also avail-

able in the dataset, which reports purely unprotected loans without risk mitigation,

effective value of collateral for collateralized loans, and credit guaranteed loans.

Other balance sheet, and profit and loss information for respective firms were ob-tained from the Korea Information Service (KIS). The KIS dataset also reports its

own credit score evaluation for respective borrowing firms, which we utilize to assign

internal credit risk grade for our sample SMEs.

There are a number of caveats that should be noted regarding our dataset. First, as

mentioned above, our dataset does not include relatively small and young SMEs for

which external audits are not required. The use of this restricted sample is inevitable

due to lack of data availability. Note, however, that our dataset would not yield any

systematic bias a priori as our results may underestimate or overestimate the true

impact. Since credit guarantee supply is relatively more concentrated on thosesmaller SMEs excluded from the sample, our results may underestimate the negative

impact of the reduction in credit guarantee supply. However, it may overestimate the

increase in capital charge since most of loan exposures to the smaller SMEs excluded

would qualify for retail exposures and thus treated favorably under the new Basel

accord.

6)In our dataset the total number of firms that have a non-zero bank loan balance was 6,551. Out of the6,551 firms we eliminated observations with missing or abnormal values for variables used in the analysis.


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909

Second, while our bank loan data reports the effective value of collateral for respec-

tive borrowing firms, it does not report the exact loan amount backed by the collat-

eral. Hence, we assume that the face value of the collateralized loan is the same as

the effective value of the collateral. Although this is a simplifying assumption which

was inevitable due to data availability, it should not affect the outcome of our sensi-

tivity analysis in any significant way, especially given that the focus is on the impact

of the change in the credit guarantee scheme. Moreover, our dataset does not provide

detailed information on the type of collateral and we assume that the collateral is

commercial real estate or such, and not residential real estates.

Table 2. Basic Profile of Credit Guaranteed Firms

This table compares key financial ratios of the credit guaranteed SMEs and SMEs without

credit guarantees in our sample.

Firms with Credit

Guarantee

Firms without

Credit Guaranteet-value1), 2)

Growth Rate in Total Assets

(average)9.32% 6.09% 5.21

***

Growth Rate in Net Sales

(average)15.23% 12.10% 2.89

***

Debt Equity Ratio3)

(average)355.15% 357.75% -0.17

Total Borrowings to Total Assets

Ratio (average)40.62% 34.47% 9.95

***

Interest Coverage Ratio (average) 3.58 6.64 -8.01***

Operating Income to Net Sales

Ratio (average)4.02% 5.42% -5.60

***

Return on Assets (average) 3.49% 3.89% -2.13**

Number of Years since Establish-

ment (average)15.7 years 15.4 years 1.05

KIS Credit Score (average) 56.86 56.85 0.02

Shares of Top 3 Industries

Manufacturing 70.4%

Wholesale & Retail

trade 13.1%

Construction 11.1%

Manufacturing 56.5%

Wholesale & Retail

trade 10.2%

Construction 9.3%

Number of Firms 1,316 4,315

Notes) 1) In the last column, t-values are for the hypothesis that the means of two groups are equal under the

assumption of equal variance.

2) ***, **, * denote that the t-value is statistically significant at the 1%, 5%, and 10% level respectively.


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910

According to our dataset, 1,316 firms out of a total of 5,631 externally audited

SMEs (approximately 23%) received credit guarantees as of the end of 2004.7) The

basic profile of the credit guaranteed firms and firms without credit guarantees are

summarized in Table 2. The credit guaranteed firms on average show a higher

growth rate (both in asset and net sales growth rates) relative to non-credit guaran-

teed firms. However, the credit guaranteed firms in general show a lower profitability

(both in terms of operating income to net sales ratio and return on assets) and a

lower debt service capacity (interest coverage ratio). Hence, the public guarantees are

relatively more concentrated on the SMEs with a lower profitability but with a highergrowth rate.

Table 3. Distribution of Credit Guaranteed Loans by Annual Sales Turnover

This table shows the distribution of credit guaranteed SMEs across different annual sales

turnover. The second column shows the number of firms and percentage shares in total credit

guaranteed firms. The third column reports the average balance of credit guaranteed bank

loan for respective sales turnover group. The forth column shows the distribution of credit

guaranteed loans across groups, and the fifth column reports the group average of the share of

credit guaranteed loan out of a firms total bank borrowing.

Annual Sales

Turnover(billion KRW) 1)

Number of Firms(%)

Average Balance

of Credit Guaran-teed Loan (billion

KRW)

Share in Total

Credit GuaranteedLoans

Ratio of Credit

Guaranteed Loanto Total Bank Bor-

rowing (average)

Over 60 177 (14.46%) 2.47 23.53% 18.00%

50~60 57 (4.66%) 2.18 6.68% 24.26%

40~50 71 (5.80%) 2.32 8.87% 21.51%

30~40 142 (11.60%) 1.53 11.67% 18.25%

20~30 253 (20.67%) 1.47 19.97% 20.76%

10~20 380 (31.05%) 1.12 22.93% 19.48%

Below 10 144 (11.76%) 0.82 6.35% 19.69%

Totals / Average 1,224 (100%) 1.52 100% 19.75%

Note) 1) One billion Korean won is approximately 1.08 million U.S. dollars as of July 2007.

7)According to the annual report of KODIT, as of December 2004, the total number of firms that receivedcredit guarantee was 252,544, among which, 235,095 firms received guarantees less than 300 million Ko-rean won. Most of these firms are very small and individually owned firms. Note that only externally au-

dited SMEs are included in our dataset.


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911

Next, we proceed to the profile of credit guaranteed SMEs. Table 3 shows the dis-

tribution of credit guaranteed loans across firms with different annual sales turn-

overs. For instance, among the credit guaranteed SMEs, nearly 50% of firms had

their sales turnover between 10 and 30 billion Korean won. The overall average bal-

ance of credit guaranteed loan was 1.52 billion Korean won, and the average ratio of

Table 4. Distribution of Credit Guaranteed Loans by Industry

This table shows the distribution of credit guaranteed SMEs across different industries. The

second column shows the number of firms and percentage shares in total credit guaranteed

firms. The third column reports the average balance of credit guaranteed bank loan for respec-tive industry groups. The fourth column shows the distribution of credit guaranteed loans

across different groups, and the fifth column reports the group average of the share of credit

guaranteed loan out of a firms total bank loan. The industry classification is based on the Ko-

rea Standard Industry Code of the National Statistical Office.

IndustryNumber of

Firms (%)

Average Balance

of Credit Guar-

anteed Loan

(billion KRW)1)

Share in

Total Credit

Guaranteed

Loans

Ratio of Credit

Guaranteed Loan

to Total Bank

Borrowing

(average)

Agriculture & Forestry 2 (0.16%) 1.38 0.15% 34.35%

Fishing 1 (0.08%) 0.28 0.02% 5.46%

Mining & Quarrying 3 (0.25%) 0.51 0.08% 17.47%

Manufacturing 899 (73.45%) 1.41 68.09% 16.81%

Electricity, Gas & Water

Supply1 (0.08%) 0.50 0.03% 15.53%

Construction 105 (8.58%) 1.94 10.93% 32.18%

Wholesale & Retail Trade 156 (12.75%) 1.92 16.11% 24.96%

Hotels & Restaurants 2 (0.16%) 0.36 0.04% 4.68%

Transport 25 (2.04%) 1.36 1.82% 25.35%

Real estate and Renting &

Leasing

9 (0.74%) 1.45 0.70% 21.53%

Business Activities 11 (0.90%) 1.66 0.98% 40.65%

Recreational, Cultural and

Sporting Activities6 (0.49%) 0.96 0.31% 42.01%

Other Community, Repair &

Personal Service Activities4 (0.33%) 3.43 0.74% 29.52%

Totals / Average 1,224 (100%) 1.52 100% 19.75%

Note) 1) One billion Korean won is approximately 1.08 million U.S. dollars as of July 2007.


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912

credit guaranteed loan to total bank borrowing was 19.75% implying that approxi-

mately one fifth of total bank loan was a guaranteed loan for a typical credit guaran-

teed firm in our sample. Note that approximately 43% of the credit guaranteed loans

were allocated to the firms with sales between 10 and 30 billion Korean won. It is

also notable that the firms with very large turnover (more than 60 billion Korean

won) received a relatively large share (23.53%) in total credit guaranteed loans.

Hence, the present results seem to support the criticism that the public credit guar-

antees for relatively large firms with high sales turnover need to be curtailed and

shifted towards smaller and younger SMEs.Table 4 shows the distribution of the credit guaranteed loans across different in-

dustrial sectors. Note that 68% of the total guaranteed loans outstanding were con-

centrated on the manufacturing industry. The wholesale and retail trade and the con-

struction industry received relatively large shares of more than 10%. In terms of the

Table 5. Distribution of Credit Guaranteed Loans by KIS Credit Score

This table shows the distribution of credit guaranteed SMEs across different credit risk grades.

The second column shows the number of firms and percentage shares in total credit guaran-

teed firms. The third column reports the average balance of credit guaranteed bank loan for

respective groups. The fourth column shows the distribution of credit guaranteed loans across

different groups, and the fifth column reports the group average of the share of credit guaran-

teed loan out of a firms total bank loan. The credit score data was obtained from the Korea

Information Service (KIS).

KIS

Credit Risk

Grade1)

(Credit Score)

Number of Firms

(%)

Average Balance

of Credit Guaran-

teed Loan

(billion won)2)

Share in Total

Credit Guar-

anteed Loans

Ratio of Credit

Guaranteed Loan to

Total Bank

Borrowing (average)

Grade 2 (80~90) 20 (1.77%) 2.84 3.3 23.96

Grade 3 (70~80) 115 (10.20%) 2.27 15.0 28.16

Grade 4 (60~70) 312 (27.66%) 1.63 29.3 21.33

Grade 5 (50~60) 382 (33.87%) 1.48 32.5 18.39

Grade 6 (40~50) 210 (18.62%) 1.22 14.7 16.15

Grade 7 (30~40) 69 (96.12%) 0.96 3.8 14.76

Grade 8 (20~30) 20 (1.77%) 1.23 1.4 15.96

Totals / Average 1,1283) (100%) 1.54 100% 19.62%

Notes) 1) No firms belong to grade 1 (over 90 in credit score) and grade 9 (10~20 in credit score) in our data.

2) 1 billion Korean won is approximately 1.08 million U.S. dollars as of July 2007.

3) Additional 96 firms with no credit score were deleted from the sample.


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913

credit guaranteed loan to total bank borrowing ratio, the recreational, cultural and

sporting activity industry, and business activities received a relatively large amount

of credit guarantees. Finally, Table 5 shows the distribution of the credit guaranteed

loans in terms of credit risk score of borrowing firms. According to the KIS credit

score evaluation, 33.87% of credit guaranteed firms belong to grade 5 with credit

scores between 50 and 60. This group also received the largest share of credit guaran-

teed loans (32.5%). In terms of the ratio of the guaranteed loan out of total bank bor-

rowing, firms in grade 3 with credit scores between 70 and 80 received the highest

share (28.16%).

4.2 Assumptions

Our quantitative impact analysis needs to rely upon several assumptions because

we have no access to detailed loan information such as loan maturities and the na-

ture of collaterals. Moreover, banks internal credit rating evaluations as well as PD

and LGD estimates for respective SMEs are also unknown. Major assumptions em-

ployed in the empirical analysis are summarized as follows.

First, following the guideline of the financial supervisory service in Korea (FSS

2004) we apply the SME adjustment to corporate exposures for SMEs whose annual

sales turnover is 60 billion Korean won or less. We also classify exposures as a retail

exposure if the unprotected pure exposure without risk mitigation is less than 1 bil-

lion Korean won. Second, we assume that all uncollateralized claims are senior, and

for collateralized loans, all collaterals are commercial real estates rather than resi-

dential real estates. This seniority assumption may lead to an underestimation of

Basel II capital requirements if some SME loans belong to subordinate class. How-

ever, the collateral assumption may overestimate true capital requirements if some

SME loans are collateralized by residential real estates. Third, in the standardized

approach, we use external credit ratings of commercial paper or corporate bond for

those firms that have issued such corporate securities. In assigning the risk weight,

we choose the lower rating in case both ratings are available as suggested by the

Basel guideline. Those firms that have not issued rated securities are classified as

unrated.

Fourth, note that we need internal credit risk grade of respective borrowing firms


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914

in the IRB approaches. In order to determine the credit risk grade of respective SMEs,

we utilize the credit scores assigned by the KIS. We obtained PD and LGD estimates

as well as the proportions of SMEs across different credit risk grades from a large

representative commercial bank in Korea, which is summarized in Table 6.8) After

ordering the 5,479 SMEs according to the KIS credit score, we applied the propor-

tions of firms in Table 6 to determine the credit risk grade of respective firms. Accord-

ing to this credit risk grade, we assignPD and LGD estimates to respective borrow-

ing firms. Fifth, under the advanced IRB, we may choose to substitute either PD or

LGD for guaranteed loans. We substitutePD for guaranteed loans by assigning 0.03%as suggested by Basel II guidelines. We choose the approach ofPD substitution

rather than LGD substitution for A-IRB for a more consistent comparison with F-IRB.

Table 6. PD and LGDby Credit Risk Grade

This table shows PDs, LGDs, and the numbers and percentage shares of firms for different

credit risk grade groups of sample externally audited SMEs. We obtained PDs, LGDs and the

percentage distribution of externally audited SMEs from a large representative commercial

bank in Korea. Credit risk grades 8, 9, 10 are default grades.

Credit Risk

Grade PD LGDNumber of Firms

Percentage in Total

Firms

1 0.03% 45.0% 4 0.08%

2 0.03% 50.3% 20 0.36%

3 0.71% 34.2% 226 4.13%

4 0.91% 31.1% 997 18.19%

5 2.73% 29.2% 2,278 41.58%

6 5.93% 23.7% 1,723 31.45%

7 7.14% 30.4% 142 2.59%

8 100% 44.0% 22 0.41%

9 100% 29.1% 16 0.28%

10 100% 28.3% 51 0.94%

Total 5,479 100%

8)While unavoidable due to data availability, two potential problems may arise with this approach. First, theloan portfolio of the representative bank may be significantly different from our portfolio. However, the potential bias due to this representativeness problem may not be significant as the representative bank

portfolio includes 3,634 externally audited SMEs, which accounts for 66% of externally audited SMEs inour sample. Another problem may arise from the potential heterogeneity between the KIS credit rating

and commercial bank credit rating methods.


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915

However, thePD substitution method may lead to an underestimation of capital re-

quirements under A-IRB as the capital requirement reduction effect ofPD substitu-

tion seems to be larger than that ofLGD substitution. Finally, in the advanced IRB

approach, the effective maturity (M) is assumed to be 2.5 years as a base case as in

the foundation IRB. However, to reflect that the average maturity of SME loans is 1.5

years in Korea (Kim and Park 2004) we also assume Mas 1.5 years in conducting

sensitivity analysis for A-IRB.

4.3 The Impact of Basel II Under Current Credit Guarantee Scheme

In this section we apply the Basel I and Basel II methodologies described in section

3 to obtain bank capital requirements for our SME portfolio under the current credit

guarantee scheme. For a consistent comparison of the impact on capital requirements

under alternative Basel approaches, we choose a common measure - the weighted

average capital requirement rate. To obtain the weighted average capital require-

ment rate, we first computed the capital requirement rate (K) for respective expo-

sures, and then, the weighted average was obtained using the total bank loan expo-

sure of respective firms as weights.

The results of the quantitative impact analysis for the whole sample as well as

three sub-samples with different firm sizes are summarized in Table 7. For each

sample, we compute the weighted average capital requirement rate according to al-

ternative methods of SME treatment under Basel II. We also compute the Basel I

capital requirement rate as a benchmark. Note that, in the case of pure credit-based

loans without credit risk mitigation, the capital requirement rate is 8% under Basel I.

However, actual capital requirement rates obtained under Basel I can be less than

8% because our analysis explicitly accounts for the credit risk mitigation effect of col-

lateral and public credit guarantee provisions.

For the whole sample including all SMEs, the weighted average capital require-

ment rate under Basel I is 7.75%. Note that the first line shows the capital require-

ment rates obtained under different Basel II methods by treating all exposures as

corporate without applying the SME and retail adjustments. The second line shows

the Basel II capital requirement rates when we apply only SME adjustment in com-

puting correlations for the exposures to SMEs with sales turnover less than 60 billion


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916

Korean won. The third line shows capital requirement rates when we apply the retail

adjustment for qualified exposures of less than one billion Korean won in addition to

the SME adjustment for qualified SMEs. Finally, the fourth line shows hypothetical

capital requirement rates obtained by assuming that all sample SME exposures are

qualified as retail exposure.

Note that, compared to Basel I, the standardized approach invariably leads to

lower capital requirement rates, which reflects two factors. First, while 10% risk

weight is applied to the protected portion of the publicly guaranteed loans under the

Table 7. Comparison of Capital Requirement Rates

(Under the Current Credit Guarantee Scheme)

This table reports the results of the quantitative impact analysis for the whole sample as well

as three sub-samples with different firm sizes in terms of annual sales turnover. For each

sample, weighted average capital requirement rates are reported according to different meth-

ods of SME exposure treatment. All corporate exposure indicates that capital requirement

rates are obtained by treating all exposures as corporate. SME adjustment indicates that we

apply the SME adjustment in computing correlations for qualified exposures to SMEs with

sales turnover less than 60 billion Korean won. SME & retail adjustments indicates that we

apply the retail adjustment for qualified exposures of less than one billion Korean won in addi-

tion to the SME adjustment for qualified firms. Finally, all retail shows hypothetical capital

requirement rates obtained by assuming that all sample SME exposures are qualified as retail

exposure.

Basel II

SampleTreatment of

ExposuresBasel I

Standardized F-IRBA-IRB

(M = 2.5)

A-IRB

(M = 1.5)

All Corporate

Exposure7.75 7.67 10.72 8.62 7.83

SME Adjustment 7.75 7.67 9.69 7.78 7.06

SME & Retail

Adjustments7.75 7.65 9.67 7.76 7.04

All SMEs

All Retail 7.75 6.78 8.07 6.78 6.16

Sales > 60 bil.KRW

(Large SMEs)

All Corporate

Exposure7.80 7.67 9.13 7.09 6.31

SME Adjustment 7.70 7.63 9.45 7.56 6.8660 bil. > Sales

> 10 bil. SME & Retail

Adjustments7.70 7.61 9.42 7.54 6.84

SME Adjustment 7.87 7.86 12.38 10.74 10.0810 bil. > Sales

(Small SMEs) SME & Retail

Adjustments7.87 7.82 12.33 10.71 10.05


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917

current Basel I, zero risk weight can be applied under Basel II. Second, most of SMEs

are unrated firms and thus 100% risk weights continue to be applied for those un-

rated SMEs under Basel II. Contrary to the standardized approach, the F-IRB ap-

proach invariably leads to higher capital requirement rates. The capital requirement

rate increases up to 10.72% when all SMEs are treated as corporate. While the capi-

tal requirement falls to 9.67% when we apply both SME and retail adjustments for

qualified exposures, the capital requirement rate is still far higher than that of Basel

I. Note also that the capital requirement rate is greater than 7.75% even under the

all retail assumption.For the A-IRB approach, the impacts differ depending upon the assumption of ef-

fective maturity. With a more conservative assumption of the average maturity of 2.5

years, the capital requirement rate is 7.76% when we apply both SME and retail ad-

justments for qualified exposures, which is approximately on par with 7.75% under

Basel I. Under the A-IRB approach with a more realistic assumption of effective ma-

turity of 1.5 years, the capital requirement rate falls below Basel I when we apply

SME adjustment alone, or both SME and retail adjustments. In sum, our analyses for

the whole sample indicate that the new Basel accord does not necessarily lead to an

increase in bank capital requirements. While banks suffer most under the F-IRB ap-proach, the regulatory capital requirement may actually fall under the standardized

and A-IRB approaches.

As for the sub-sample of large SMEs with sales turnover more than 60 billion Ko-

rean won, all exposures are treated as corporate since these firms cannot be qualified

for the SME adjustment. Note that, except for the case of the F-IRB, the Basel II

capital requirement rates fall below the Basel I requirement for this group of rela-

tively large SMEs. This result reflects that large SMEs tend to have a lower credit

risk. However, in the case of the F-IRB, banks cannot benefit from the lower LGDs of

firms as a uniform LGD of 45% is applied. This result is also found for the sub-sample of SMEs with sales between 10 and 60 billion Korean won. Note, however,

that, for the sub-sample of relatively small SMEs with sales less than 10 billion Ko-

rean won, not only the F-IRB but also the A-IRB approaches lead to the increase in

capital requirements compared to Basel I. In the case of the standardized approach,

the capital requirement for this small firm portfolio is approximately the same as it is

in Basel I.

As noted above, Altman and Sabato (2005) conducted a breakeven analysis in order


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918

to identify the percentage of SMEs that need to be classified as retail for Basel II

capital requirements not to rise above the current 8%. Indeed, as an endogenous re-

sponse to the new Basel capital accord, commercial banks may want and will be able

to classify SMEs as retail by adjusting their exposures to respective obligors. We con-

ducted a similar breakeven analysis for the whole sample portfolio using the capital

requirement rates computed under the all corporate and all retail assumptions in

Table 7. Specifically, we computed the capital requirement rate assuming a certain

percentage of the SME portfolio as retail and the remaining percentage as corporate.

Since the range of Basel II capital requirements does not include the Basel I capitalrequirement in the case of the standardized and F-IRB approaches, we conduct the

breakeven analysis focusing on the A-IRB approach. Table 8 compares capital re-

quirement rates for the two A-IRB approaches obtained for differing percentage of

SMEs classified as retail. Note that in the case of the A-IRB with 2.5 year maturity,

at least 50% of SMEs need to be classified as retail for the capital requirement rate

not to rise above the current 7.75% under Basel I. In the case of the A-IRB with 1.5

year maturity, the breakeven percentage is 10%, which indicates that, as long as 10%

Table 8. Breakeven Analysis of Capital Requirement RatesThis table compares capital requirement rates of the A-IRB approaches for the whole sample

portfolio across the cases in which a certain fraction of the SME portfolio is treated as retail

exposure and the remainder as corporate exposure. Under Basel I, the capital requirement rate

is invariant regardless of the treatment of SME exposures.

Basel II

Basel I A-IRB

(M = 2.5)

A-IRB

(M = 1.5)

0% retail 100% Corporate 7.75 8.62 7.83












23/30


919

of SMEs are classified as retail, banks will benefit from the A-IRB approaches in

terms of capital requirements.

4.4 Sensitivity of Capital Requirement Rates to Guarantee Coverage

Ratio

As discussed in the introduction, another key objective of the present paper is to

explore the impact of the reduction in public credit guarantee provision. According to

the Korean government, a key reform measure is the gradual reduction of the guar-

antee coverage ratio. As of 2004, the guarantee coverage ratio was uniform at 85%,

which implies that the guarantor covers up to 85% of the guaranteed loan exposure in

cases of obligor default. A lower partial coverage ratio would make the guarantee

scheme more incentive compatible by strengthening the screening and monitoring

incentives of lending banks.9)

Table 9 summarizes the impact of the reduced guarantee coverage ratio on bank

capital requirement rates under Basel I and Basel II. We applied the SME and retail

adjustments for qualified exposures and conducted sensitivity analyses by applying

different levels of guarantee coverage ratio in order to identify the coverage ratio

which yields a Basel II capital requirement rate similar to the current rate under

Basel I. Table 9.a reports the sensitivity analysis result for the whole sample portfolio.

Note that, under the current Basel I, downward adjustments of the coverage ratio

raise the capital requirement rate ultimately to 8% when the coverage ratio becomes

zero (no credit guarantee).

Under Basel II, banks suffer most under the F-IRB approach and benefit most from

lower capital requirements under the A-IRB with maturity of 1.5 years as above. If

we compare Basel II capital requirement rates with the current rate of 7.75% in the

case of 85% coverage ratio under Basel I, the guarantee coverage ratio can be reduced

to 55% without causing additional capital burdens under the standardized approach.

As for the F-IRB and A-IRB with maturity of 2.5 years, the capital requirement rates

are invariably higher than the current 7.75%. In contrast, under the A-IRB with ma-

turity of 1.5 years, the capital requirement rate is always lower than the current

9) For more detailed discussions of the credit guarantee reform measures and the impact analyses under alter-

native reform scenarios, see Hahm, Kim, and Kang (2006).


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920

7.75% regardless of the partial coverage ratio. The capital requirement rate is 7.2%

even in the case of no credit guarantee at all.

Table 9. Sensitivity of Capital Requirement Rates to Guarantee Coverage Ratio

This table compares capital requirement rates for different levels of partial guarantee coverage

ratio. Note that under the current partial credit guarantee scheme in Korea, up to 85% of the

face value of a credit guaranteed loan is covered in the case of the loan default.

a. All sample SMEs

Basel II

Credit Guarantee Par-tial Coverage Ratio Basel IStandardized F-IRB

A-IRB

(M = 2.5)

A-IRB

(M = 1.5)

95% 7.73 7.62 9.67 7.75 7.03

85% (Current) 7.75 7.65 9.67 7.76 7.04

75% 7.78 7.68 9.70 7.78 7.06

65% 7.81 7.71 9.73 7.80 7.08

55% 7.84 7.74 9.76 7.82 7.10

45% 7.87 7.77 9.80 7.84 7.12

35% 7.90 7.80 9.83 7.86 7.13

25% 7.93 7.83 9.86 7.87 7.15

15% 7.96 7.86 9.89 7.89 7.175% 7.99 7.89 9.93 7.91 7.19

0% 8.00 7.90 9.94 7.92 7.20

b. Sub-sample of credit guaranteed SMEs

Basel IICredit Guarantee Par-

tial Coverage RatioBasel I

Standardized F-IRBA-IRB

(M = 2.5)

A-IRB

(M = 1.5)

95% 6.99 6.82 8.49 6.87 6.19

85% (Current) 7.10 6.93 8.61 6.94 6.25

75% 7.21 7.04 8.73 7.01 6.32

65% 7.31 7.15 8.85 7.08 6.38

55% 7.42 7.25 8.97 7.14 6.45

45% 7.52 7.36 9.09 7.21 6.51

35% 7.63 7.47 9.21 7.28 6.58

25% 7.74 7.58 9.32 7.35 6.64

15% 7.84 7.69 9.44 7.42 6.71

5% 7.95 7.79 9.56 7.48 6.77

0% 8.00 7.85 9.62 7.52 6.80


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921

It is interesting to note that the net adverse impact of the reduced guarantee cov-

erage ratio is alleviated under the A-IRB approaches compared with Basel I. For in-

stance, the capital requirement rate increases from 7.75% to 8%, a 25 basis point in-

crease under Basel I. However, the net increases in the capital requirement rates un-

der the A-IRB approaches are only 16 basis points. Two factors underlie the relatively

alleviated negative impact under the A-IRB approaches. First, while the protected

portion decreases as the coverage ratio falls, a lower risk weight is applied for the

protected portion (0% under Basel II compared with 10% under Basel I). Second, for

unprotected portion of the guaranteed loans, the SME and retail adjustments are al-lowed under Basel II, which provide cushions to guard against the adverse impact of

the reduced coverage ratio.

Table 9.b conducts the same sensitivity analysis for the sub-sample of credit guar-

anteed SMEs. Note that, when evaluated in terms of the magnitude of the incremental

capital requirement, the adverse impact of the reduced coverage ratio is bigger than

the whole sample results above. In the case of credit guaranteed sub-sample, all three

Basel II approaches except for the F-IRB approach now lead to lower capital re-

quirement rates relative to Basel I, which implies that Basel II allows a broader scope

Figure 1. Sensitivity Analysis of Capital Requirement Rates (All sample SMEs)

6.5

7

7.5

8

8.5

9

9.5

10

10.5

95% Current

85%

75% 65% 55% 45% 35% 25% 15% 5% 0%

Standardized F-IRB A-IRB (M =2.5) A-RIB (M =1.5)

7.75


26/30


922

Figure 2. Sensitivity Analysis of Capital Requirement Rates

(Sub-sample of Credit Guaranteed SMEs)

5.5

6

6.5

7

7.5

8

8.5

9

9.5

10

95% Current

85%

75% 65% 55% 45% 35% 25% 15% 5% 0%

Standardized F-IRB A-IRB (M =2.5) A-RIB (M =1.5)

7.10

to reduce the guarantee coverage ratio without imposing additional regulatory capital

charges for banks. Namely, the coverage ratio could be reduced to 75% and 65% un-

der the standardized approach and the A-IRB with maturity of 2.5 years, respectively,

and to zero percent in the case of the A-IRB with maturity of 1.5 years without caus-

ing additional capital requirements above the current 7.1% under Basel I. These find-

ings are visually summarized in Figures 1 and 2, which show the capital requirement

rates for Basel II as the guarantee coverage ratio falls. The solid horizontal line in

each figure indicates the capital requirement rate for the case of the current 85% cov-

erage ratio under Basel I.

5. Summary and Concluding Remarks

In this paper we evaluated the impact of the new Basel accord on bank capital re-

quirements for SME lending in Korea. Our approach is differentiated from the exist-

ing research in that we explicitly account for the credit risk mitigation effect of collat-


27/30


923

eral and public credit guarantee provisions in SME financing. Utilizing a unique

dataset of bank loan exposures to 5,631 externally audited SMEs, we conducted

quantitative impact analyses for alternative approaches specified by Basel II under

the current credit guarantee scheme. We also conducted sensitivity analyses of Basel

II capital requirements with respect to the variation in the credit guarantee coverage

ratio. Our major findings can be summarized as follows.

First, under the current credit guarantee scheme, the new Basel accord does not

necessarily lead to an increase in bank capital requirements. While banks suffer most

under the foundation-IRB approach as they cannot benefit from applying lower LGDs,regulatory capital requirements may actually decrease under the standardized and

advanced-IRB approaches with a realistic assumption on the effective maturity of

SME loans.

Second, we conducted a breakeven analysis in order to identify the percentage of

SMEs that need to be classified as retail for capital requirements not to rise above

the current requirement under Basel I. We found that at least 50% of SMEs in the

case of the A-IRB with maturity of 2.5 years, and at least 10% of SMEs in the case of

the A-IRB with maturity of 1.5 years need to be classified as retail for banks to be

able to benefit from the A-IRB approaches.Third, we also investigated the impacts of the reduced guarantee coverage ratio on

bank capital requirement rates under Basel I and alternative approaches of Basel II.

While the reduction of the guarantee coverage ratio invariably increases bank capital

requirements, its adverse impact is alleviated under the A-IRB approaches due to the

lower risk weight applied to the guaranteed portion of SME exposures, and the SME

and retail adjustments allowed for unprotected exposures. We found that, when com-

pared with the benchmark case of the current 85% coverage ratio under Basel I, the

guarantee coverage ratio can be reduced to 55% under the standardized approach

and zero percent under the A-IRB with effective maturity of 1.5 years without impos-ing additional capital charges for banks. However, for the F-IRB and A-IRB with ma-

turity of 2.5 years, the capital requirement rates would be invariably higher than the

current requirement.

In sum, our findings suggest that, despite widespread and increasing concerns,

Basel II and downward adjustments of the credit guarantee coverage ratio may not

produce significantly discouraging effects on SME lending in Korea.


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924

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