Ireland is setting up a new state bank to pump hundreds of millions of euro into struggling small businesses.

The Strategic Banking Corporation of Ireland (SBCI) will be funded by Germany and the EU as well as Irish pensions after a deal was struck with German chancellor Angela Merkel.

The Government has vowed that SBCI will lend more than half a billion euro to small and medium-sized firms which are being frozen out by the banks.

Taoiseach Enda Kenny said the new state-owned lender would help reinforce Ireland's economic recovery.

"Using funds from the German promotional bank KfW, the European Investment Bank and the Irish Strategic Investment Fund, the first phase will make over 500 million euro available for small Irish business," he said.

The new state bank is expected to be lending to businesses before the end of the year.

The plan promises "innovative loans" which will be channelled from the SBCI through so-called on-lenders, which are usually existing high street lenders who will assess loan applications and administer the funding.

The loans will be low-interest and targeted at firms who cannot get credit through the normal channels.

These include established small businesses looking to buy new machinery or start-ups looking for longer term loan repayment plans, for example over six years rather than a typical three-year plan.

Mr Kenny said the plan was hatched after a meeting last year with Ms Merkel, during which she agreed to pursue the German investment bank KfW to help fund the new Irish lender.

"It will focus on financing SMEs in first instance but can grow to finance other key sectors of the economy," he added.

Business groups have broadly welcomed the new bank but voiced concerns about the involvement of retail banks.

Mark Fielding, of the Irish Small and Medium Enterprises Association, said there is a fear that bailed out banks will "revert to form" and divert the low-cost loans to "safer" large businesses.

"Our banks have form in this area and previous European low-interest loans found their way to less risky larger businesses, making a killing for the banks, while starving SMEs of much-needed finance," he said.

Ian Talbot of Chambers Ireland, an umbrella group of Ireland's chambers of commerce, attacked what he branded a vague timeline for the set up of the bank.

"There is an urgent need for this to be put in place and we are calling for a deadline of September 2014 to be set," he said.

PA Media