By CHANGWOO NAM,  Fellow at KDI

※ This article is part of KDI Journal of Economic Policy, November 2021

We analyze the social welfare effect when a policy-based financial system (PFS) enters a decentralized financial market. Particularly, the PFS in this case supports the interest spread for corporate loans held by firms with heterogeneous bankruptcy decisions under an imperfect information structure. Although support for capital costs through the PFS expands the economy consistently, the optimal level of PFS out of the corporate loan market is estimated to be 8.6% by a simulation model considering social welfare adjusted by the disutility of labor. This result is much lower than the recent level of PFS in the Korean financial sector.

Why does the Korean government want to maintain a very large policy-based finance sector? In the 1960s and 70s, when the market was not well formed, the efficient allocation of limited resources was very important. Accordingly, the government would have a role in directly intervening in the market. The Korean financial industry underwent a major restructuring after the 1997 financial crisis and thus inefficient financial companies had been winnowed out and ousted such that the financial market, mainly composed of large banks, developed more readily, especially under the control of financial holding companies. However, large-scale policy-based institutions such as the Korea Development Bank, the Export-Import Bank of Korea and the Industrial Bank of Korea (hereafter KDB, KEXIM, and IBK) still play a large role in the Korean financial market. In particular, the guarantee insurance market, including the market for credit guarantees, has not yet been opened to third parties. In this situation, KDB and KEXIM have failed to promote the restructuring of insolvent companies properly. Recently, public opinion holds that the policy-based financial system should be greatly improved to achieve financial efficiency and for better financial market development.

However, in order for public opinion to be reflected in the financial policy, it should be verified that the current size of policy-based finance in the Korean financial sector is excessive via rigorous economic logic. From this point of view, the subject of this paper is clear. In other words, this paper analyzes how social welfare arises and what the optimal size of policy-based finance should be in the financial sector when policy-based financial institutions that support firms by supporting loan interest enter the financial sector. In particular, this paper develops a general equilibrium model. First, firms are heterogeneous because they undergo idiosyncratic shocks individually. Second, commercial banks and policy-based banks (government-owned banks) do not fully observe these heterogeneous characteristics of firms. In other words, this paper basically assumes that the financial market operates as an imperfect information system when lending to firms. In this model, firms also decide whether or not to continue operating, that is, whether or not to default, depending on their heterogeneity.1 Finally, the analysis of social welfare does not aim to expand unconditionally the economy because the increase in the labor demand of firms by financial support is reflected in social welfare.

To summarize the results of the analysis, the level of policy-based finance that optimizes social welfare through a simulation is found to be 8.6 percent of the financial sector. This figure is much lower than the 34.4 percent average in the Korean financial market over the past three years. Furthermore, noting not only that policybased finance is more likely to encounter moral hazard than private finance but also that policy-based finance is less efficient, it can be seen that the policy-based finance scheme implemented by the government in the Korean financial market is overabundant.

This paper is organized as follows. Section 2 explains the current state of policybased finance in Korea, and Section 3 explains the theoretical background and how we designed the model in this paper. Section 4 explains the methodology and parameters needed for the simulation based on the theoretical model, and Section 5 explores the results of the social welfare analysis. Finally, Section 6 concludes the paper.

☞ <KDI Journal of Economic Policy, November 2021> (Click)