Overview of Konomi’s Bad Debt Treatment Procedure from Asset-backed Securitisation’s Perspective — Transaction Risks and Preventive Measures for Asset-backed Securitisation Products

Konomi, as a platform which values and seeks to uphold corporate responsibility, will allow users to be fully informed of the risks before making any transaction, thus enabling them to make a holistic and rational assessment of their risk tolerance level in order to decide whether to trade or not. This article elaborates on the risk amplification mechanism of asset-backed securitisation (ABS) using a mathematical modelling approach.

  1. Risk Amplification Mechanisms of Asset-backed Securitisation Platforms

The main target objects of Konomi’s ABS process are non-performing loans in which arbitrageurs are reluctant to step in and help to resolve. The long repayment cycle and low collateral value of such assets further increased their inherent risk, and ABS may cause its systemic risk to be amplified to an even greater extent. This section will test the impact of ABS on the platform’s systemic risk exposure using a risk model, at the same time quantify the risk amplification effect in the risk transfer mechanism. The model posits the following assumptions:

1. β is the regression coefficient of earning rate on market return rate and is used to measure systemic risk.

2. It is assumed that the platform will only engage in credit activities and therefore the asset in the asset balance sheet refers to the value of the portfolio of assets purchased by the platform.

3. Since the platform will retain securitised products with lower credit ratings, the platform’s risk level will be greater than the average risk level in the pool. Hence the following relationship βsecuritisation>β1asset pool>β1asset

The platform’s assets and interests can therefore be linked using the following equation βasset=βdebt*d+βequity*e

The difference in equity β after ABS can be extrapolated by the following relationship.

∆βequity=β2equity-β1equity=asset2e2-asset1e1-debt2*d2e2+debt1*d1e1

where e1d1 and e2d2 refer to the β ratios of equity and debt before and after ABS, respectively. The asset value β2asset after ABS depends on the asset β for reinvestment of proceeds from securitisation of non-performing loans. Let r be the ratio of ABS proceeds to the original asset portfolio, with the proportion of good loans retained in the platform’s asset balance sheet being 1 — r. Before reinvestment, it is also possible for the platform to use securitisation proceeds to make debt service payments to debtors or to pay dividends to equity holders. Let h denote these two types of expenditure as a proportion of total assets. The proportion of funds that are reinvested then becomes r*=r-h1-h. The proportion of good loans is thus 1-r*=1-r1-h As a result of the dividend payout to the debtor and the obligee, the new asset β changes to

β2asset=(1-r*)*βABS+r**βreinvestment

Substituting this formula into ∆βquity=β2equity-β1equity=asset2e2-asset1e1-debt2*d2e2+debt1*d1e1

Then ∆βequity=(1-r*)*ABS+r**reinvestment2-asset1e1-debt2*d2e2+debt1*d1e1

The resulting formula shows that the change in ∆βequity will be influenced primarily by good loans β, the β of assets undergoing reinvestment and e leverage ratio. As the amount of capital borrowed from Konomi increases, security indicators such as collateral ratios will be lowered, which will lead to a gradual increase in the risk level of non-performing loans. At the same time, the risk level of ABS process based on these assets will also increase, resulting in increase of βABS. The reinvestment made by investors at this point of time will ostensibly be the purchase of more non-performing loan securitised products, which is a repetitive process and the β value should remain constant. However, the reality is that the risk level of the non-performing loans securitised products is continuously increasing andβreinvestment is also increasing. If the market holds a good proportion of realizable assets, both the platform and the investor might both be incentivised to make value e increase, thereby further magnifying existing risk level. All of these factors will contribute to an increased systemic risk level and thus continuously amplifying existing safety concerns.

In response to the above-mentioned problems, the Konomi platform is committed to doing its utmost job to protect all users against systemic risk by taking the following measures.

(1) Konomi guarantees that collateral ratios and other safety indicators will not be adjusted, in order to ensure the elimination of systemic risk before trading.

(2) The platform will maintain its own investments at a reasonable leverage ratio and will not blindly increase leverage ratios. Konomi will concurrently warn investors of the risks of leveraged investments, allowing them to trade within their own risk tolerance capacity.

2. Risk amplification mechanism of Credit Rating Agencies (CRA)

Credit Rating Agency (CRA) is an important part of the ABS process of non-performing assets. The pool of securitised funds consists of assets with differing credit ratings levels, and investors are unable to make a risk-benefit assessment of the underlying assets due to information asymmetry. CRA’s ratings is an important indicator to help investors understand the true value of securitised products. CRAs in traditional financial markets charged fees on issuers of securities as their main source of income. As a result of this mechanism, CRAs seeking to maximise their profits will skew their ratings in favour of the securities issuers’ preferences, thus the rating results might not reflect the true risk level and benefits of the securities.

The emergence of such a credit rating mechanism would lead to a market equilibrium in which all CRAs give up their independence and autonomy in credit rating. In the following section, we will demonstrate the point above by means of a simple payoff matrix. Suppose there are only two CRAs a and b in the market and they are given the choices of colluding or not colluding with the securitisation issuer. Assuming that collusion is S = 1 and non-collusion is S = 0. Different choices will lead to different payoff matrices: when CRA a chooses to collude with the securitisation issuer and CRA b chooses not to collude, the payoff would be (i, 0), with i > 0. When both parties choose not to collude, the payoff would be (0, 0). When both rating agencies a and b choose to collude, the payoff would be (1/2i,1/2i). The matrix is as follows

Revenue Matrix of CRA and Issuers Collusion

According to the Prisoner’s Dilemma Theory, when CRA a makes a decision and assumes that b colludes, if a chooses not to collude, the gain would be 0; if a chooses to collude, the gain would be i, i>0. Therefore, no matter what choice b makes, a will collude, i.e. Sa=1; similarly, it is known that the optimal choice of b is Sb=1, and the only equilibrium solution is {Sa=1, Sb=1}, i.e. the equilibrium gain of both sides at this point of time is 1/2i.

To prevent collusion between CRAs and issuers, Konomi will adopt the following mechanisms to prevent such risks.

(1) The Konomi platform will invite investors with 200,000 KONO or more to participate in a CRA selection exercise together with the platform. Because of the geographical fragmentation of KONO holders, it will be difficult for a certain CRA to reach a collusive agreement with a large number of KONO holders.

(2) The Konomi platform will sign a fixed rating fee contract with all participating CRAs rather than an incentive contract linked to the sale of the product, thus ensuring the independence and objectivity of the CRAs.

(3) One week before the final offering, the Konomi platform will invite a third-party independent auditing firm to conduct a final pre-offering audit of the rated products and issue an independent audit report to ensure that there are no conflicts of interest or any significant design errors in the product review process.

(4) KONO holders will have the right to request a review of the credit rating of any product that they believe to be incorrect or unfair. Konomi will charge the user 100,000 KONO per request for a re-audit and will issue a review result within seven working days. If the product’s rating is changed after the re-audit, Konomi will provide a full refund for the user.

(5) Konomi will form an internal team to re-rate all products every month and publish the results of all products rated for that month on its official website on the first working day of each month.

3. Conclusion

This paper provids an introduction on the risks that ABS may pose to both the users and the platform, allowing users to have a gauge of the different types of risks before making any transaction. It also explains in detail how the Konomi platform can eliminate the existing risks in order to protect the legitimate interests of investors and the platform, preventing the platform from experiencing systemic risk as a result of ABS products.

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