In this paper, we examine the existence and the role of the soft budget constraints
(SBC) in the Korean economy. Particular attention is given to the pre-financial crisis
period of 1997 on firm level data when the Korean banking sector generated
inefficient credit allocation. We report that Korean business group (chaebol) firms
have more severe SBC problems, especially in long-term loans, and that there exist
severe adverse effects on the profitability of loans to SBC firms compared to nonchaebol
firms. It appears that the significant negative effects of loans to SBC firms
on profitability before and during the crisis are mainly driven by the inefficient use
of funds by chaebol firms.
Key words: soft budget constraint; Korean financial crisis; bank loans; defaulted firm