The Optimal Leverage Ratio of Credit Guarantee Institution: Case of Local Credit Guarantee Foundation in South Korea*

Abstract

This study aims to estimate the optimal leverage ratio of the Local Credit Guarantee Foundation (hereafter LCGF), which plays an important role in financing small and micro businesses in South Korea. The optimal leverage ratio refers to the rate of credit guarantee balance to capital at which the guarantee system can be soundly and stably operated while meeting the credit guarantee demand. The optimal leverage ratio of LCGF is derived using three methods: a sustainable budget constraint-based leverage ratio, an institutional objective maximizing leverage ratio, and a BIS ratio-based leverage ratio.

Assuming that the average trend of the past ten years is maintained, the sustainable leverage ratio is evaluated to be 7.55. In addition, the institutional objective maximizing leverage ratio is estimated to be 7.24. When the optimal BIS ratio increases from 11.5% to 14%, the BIS ratio-based leverage ratio is evaluated to be between 8.39 and 10.21. The leverage ratio at the end of 2020, which was 9.16, is appropriate when using the BIS ratio, considering the COVID-19 crisis. However, it is judged to be slightly higher than the sustainable leverage ratio or the institutional objective maximizing leverage ratio.

KEYWORDS:

• Leverage ratio
• BIS ratio
• sustainability
• credit guarantee
• small and micro business

Subject classifications codes:

• G23
• G32
• L32

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 There are three guarantee institutions in South Korea: (1) Korea Credit Guarantee Fund, which provides credit guarantees to SMEs, (2) Korea Technology Credit Guarantee Fund, which provides credit guarantees to innovative companies such as venture companies, and (3) Local Credit Guarantee Foundation, which provides credit guarantees to small and micro businesses.

2 Overall, it can be viewed as a policy variable determined through consultation with local governments and financial institutions. However, to find the optimal contribution through this study, it is necessary to include the budget constraints of the entire country in the model and consider the government's total revenue and expenditure. The purpose of this study is to suggest an optimal leverage ratio from the point of view of the LCGF; therefore, finding the optimal contribution amount is far beyond the scope of this study.

3 The relationship between the subrogation rate and leverage ratio may not be perfectly linear. However, considering that the purpose of this study is to examine the factors that are important in determining the optimal leverage ratio rather than to find the exact optimal leverage ratio, to reduce the complexity of the model, a linear relationship is assumed. In future studies, the relationship between subrogation rate and leverage ratio can be reflected more realistically.

4 There are two solutions to (Eq. 13), but one always produces a negative (-) value and the other always produces a positive (+) value. Since the leverage ratio has a non-negative value, negative (-) solutions are excluded. Also, the value in the square root of (Eq. 15) always produces a non-negative (-) value, so there is a solution. Therefore, there is a unique solution that satisfies the condition at the steady state in this model.

5 Similar to Section 2.1 or Section 2.2, it is also a good way to present an economic model that considers the business cycle. We are conducting further research to present the model. In this study, it was judged that it is also meaningful to suggest a method to utilize the BIS ratio, which is generally used in the real financial market.

6 In 2020, due to COVID-19, the guarantee balance increased rapidly while the subrogation rate decreased significantly. The reason for the decrease in the subrogation rate is that subrogation occurs following a one-year grace period after receiving a credit guaranteed loan. In addition, as interest subsidy was implemented to support small and micro businesses who are experiencing difficulties due to the pandemic, the subrogation rate drastically decreased. Considering this, the subrogation rate in 2020 was judged to be difficult to be regarded as a general case, so it was excluded and the average value of the subrogation rate for the previous three years was used.

7 In this model, the time discount rate () is different from the time discount rate of individual consumers. This is because the decision maker in this model considers the institutional objective of the guarantee institution. As stated by Pierson (2011), policy makers generally have a higher time discount rate than individual consumers. Considering this, it is assumed that the time discount rate is relatively low.

8 As a result of an empirical analysis, in the long run, when the leverage ratio increased by 1, the subrogation rate increased by 0.27%. This was a statistically significant result at the 10% level. Here we set the baseline value of to 0.003 which is close to 0.0027.

Additional information

Notes on contributors

Hongkee Kim

Hong Kee Kim is a professor of economics department at Hannam University in Republic of Korea. He received his Bachelor of Economics in 1983 and completed his master and Ph.D. in Economics at Seoul National University, Republic of Korea in 1992.

Eui-hwan Park

Euihwan Park is an assistant professor of economics at Hannam University in Republic of Korea. He received his B.A. in economics from the Korea University in 2008 and completed his Ph.D. in Economics at Korea University, Republic of Korea in 2019.

Gyeahyung Jeon

Gyeahyung Jeon is a assistant professor of economics department at Hannam University in Republic of Korea. He received his Bachelor of Science in 2009 and completed his Ph.D. in Economics at Seoul National University, Republic of Korea in 2015.