The delinquency rate of loans extended to small businesses has tripled in about two years. In particular, the delinquency rate of loans to vulnerable self-employed borrowers who are multiple debtors and have low incomes or poor credit status has risen sharply, exceeding 10 percent.

The quality of real estate project financing (PF) loans has also deteriorated as the real estate market has continued to stagnate amid prolonged high interest rates. The Bank of Korea (BOK) submitted the “June 2024 Financial Stability Report” to the National Assembly on June 26.

The delinquency rate of loans to self-employed people tripled from 0.5 percent at the end of the second quarter of 2022 to 1.52 percent at the end of the first quarter of this year. It is a steeper rise than the delinquency rate for household loans, which has more than doubled over the same period.

In particular, loans extended to the self-employed grew rapidly among vulnerable borrowers with low incomes or poor credit status who borrowed money from multiple lenders. The delinquency rate of loans to vulnerable self-employed borrowers dropped to 3.97 percent in the third quarter of 2021, but rose sharply to 10.2 percent at the end of the first quarter this year. The proportion of vulnerable borrowers was also higher among the self-employed (12.7 percent) than households (6.4 percent).

The BOK also pointed out that it should also be noted that both the number of people who are delinquent and the period of delinquency in loans to small businesses have increased recently. In the case of loans to the self-employed, the number of new delinquent borrowers who paid back on time in the previous quarter and first began to default in the quarter increased significantly to 1.52 percent at the end of the first quarter of this year, compared to just 0.51 percent in the fourth quarter of 2021. The persistent delinquency rate, which refers to borrowers who continue to miss payments, also rose to 74.6 percent at the end of the first quarter, the highest since 2017.

The BOK diagnosed that the rise in the delinquency rate of loans to small businesses during the recent rise in interest rates was steeper than during the rise in interest rates in 2010 and 2017. It attributed the rise to a relatively large increase in lending rates, a contraction in the service industry since the second half of 2022, and a sluggish commercial real estate market, the main source of mortgages for small businesses.

"The most vulnerable segment is the self-employed," said Seo Pyung-seok, head of the BOK's Financial Stability Planning Division. "The risk is that the delinquency rate of loans to the self-employed is rising rapidly in the absence of a clear post-COVID recovery in domestic demand."

The BOK suggested that the government should actively promote debt restructuring through the New Start Fund for the self-employed who are unable to recover.

According to the "Status and Risk Check of Real Estate PF-related Financial Exposers" in the Financial Stability Report, the balance of real estate PF loans by domestic financial companies was 134.2 trillion won at the end of the first quarter of this year. Although the growth rate of real estate PF loans has slowed down, the delinquency rate has continued to rise since 2021. The delinquency rate at the end of the first quarter of this year was 3.55 percent, which was higher than that of securities firms (17.6 percent) and savings banks (11.3 percent).

In particular, bridge loans, which are loans taken out by real estate project developers to finance the balance of land purchases before construction begins, are increasingly being extended instead of being converted into full-fledged PF loans. Extending the maturity increases the loan term and raises the interest rate.

As a result, there is a growing concern that the soundness of small and medium-sized securities companies and real estate trust companies that guarantee PF-backed securities will also deteriorate.

The BOK also pointed to the possibility of contingent liabilities of real estate trust companies through liability-only managed land trusts. As of the end of the first quarter, standardized land trusts held 16.8 trillion won in assets under management, triple the equity capital of real estate trusts (5.6 trillion won).

In the case of standardized land trusts, if the PF project contractor fails to meet the completion deadline, the real estate trust is obligated to complete the project. If the real estate trust fails to complete the project within the deadline, it will be liable for damages to the lenders, and contingent liabilities may materialize.

However, the BOK assessed that it is unlikely to escalate to systemic risk in the event of exceptional circumstances, given the current loss absorption capacity of financial institutions. It said that risks should be managed by means of auctioning and short selling of bad assets.