Electronic copy available at: http://ssrn.

com/abstract=1711002
A Theory of Asset Pricing and Performance Evaluation
for Minority Banks with Implications for Bank Failure
Prediction, Compensating Risk, and CAMELS Rating
Godfrey Cadogan

Working Paper
First draft: November 18, 2010
This draft: January 27, 2011

Corresponding address: Information Technology in Finance, Institute for Innovation and Technology
Management, Ted Rogers School of Management, Reyerson University, 575 Bay, Toronto, ON M5G 2C5;
e-mail: gocadog@gmail.com. Research support from the Institute for Innovation and Technology Manage-
ment is gratefully acknowledged. This paper builds on Cole (2010b). It beneted from several conversations
with John A. Cole, and I am thankful to him for introducing me to the minority bank topic, for seeking clar-
ication of the relationship between cash ows and CAMELS rating, and for suggesting that this writers
incipient technical appendix be expanded into what is now the instant paper. I thank Samuel Myers, Jr.
for his encouragement, and Walter E. Williams for drawing my attention to early work he did on minority
bank portfolios. The instant revision (1) corrects typographical errors, (2) formalizes heretofore footnoted
heuristic statements, (3) provides details on computing the optimal strike price for the put option on minority
banks assets, (4) added an appendix of proofs, and (5) includes some more references. Any errors which
may remain are my own. Electronic copy available at http://ssrn.com/abstract=1711002
Electronic copy available at: http://ssrn.com/abstract=1711002
Abstract
This paper introduces a comprehensive theory of performance evaluation and asset pricing for
minority (type-m) banks incuding, but not limited to, CAMELS rating, bank failure prediction,
compensating risks, and risk adjusted internal rates of returns in a complete market. Our the-
ory predicts and explains several empirical regularities of minority banks. First, we provide a
novel mechanism for generating a synthetic cash ow stream in Hilbert space, by comparing NPV
projects selected by minority and nonminority (type-n) peer banks. Thus, laying a foundation for
security design for sound type-m banks. Second, even when internal rates of return and managerial
ability are equal for type-m and type-n banks, the expected cash ows for type-n banks uniformly
dominate that for type-m banks by a factor greater than 2. Third, a behavioral mean-variance
analysis of liquidity preference explains type-m banks seeming zero covariance frontier portfolio,
and asset pricing anomalies like concavity of their internal rates of return in project risk. Such
anomalies affect computation of unlevered betas, imply undercapitalization and inefciency that
crowds out positive NPV projects, and suggest that type-m banks overinvest in residual [second
best] projects eschewed by type-n banks. See e.g., Ruback (2002); Jensen and Meckling (1976);
Myers (1977); and Williams-Stanton (1998). Even so, the returns on minority banks portfolios are
viable provided that the risk free rate is less than that for the minimum variance [frontier] portfo-
lio. Fourth, we introduce a compensating risk factor for type-m bankspriced by a two-factor asset
pricing model induced by Vasicek (2002) for loan portfolio value, i.e. return on assets (ROA). Our
theory predicts that that compensating transfer scheme is tantamount to a put option on type-m
bank assets in accord with Merton (1977). And we use Deelstra et al. (2010) model to identify the
optimal strike price for that option. According to Merton (1992) and Glazer and Kondo (2010),
to mitigate moral hazard in such schemes either (1) type-m banks must bear the associated costs,
or (2) the costs must not be bourne by other banks. Arguably, our put option prices type-m banks
under FIRREA 308 (1989). Fifth, on the xed income side, Vasicek (1977) interest rate model
predicts that the term structure of bonds issued by type-m banks is a oor for the term structure of
bonds issued by type-n peer banks. Moreover, if risky cash ows follow a Markov process, then
under Rothschild and Stiglitz (1970) type mean preserving spread analysis, type-m bank bonds are
riskier, provide lower yield, and need to be issued over shorter durationaccording to Barclay and
Smith (1995) empirical ndings on asymmetric information and the contracting-cost hypothesis.
Sixth, we extend Vasicek (2002) to an independently important conditional probit representation
for bank failure predictionmore granular than Cole and Gunther (1998) ad hoc probit model. Sev-
enth, we establish a nexus between random utility analysis, the conditional probit, and a simple
bivariate CAMELS rating function that (1) predict bank examiners attitudes towards type-m banks,
and (2) identies root causes of their bias towards high CAMELS scores for type-m banks. In par-
ticular, we show how bank examiners CAMELS scores for return on assets risk is predicted by
bank specic variables.
Keywords: minority banks, synthetic cash ows, internal rates of return, behavioral asset pric-
ing, CAMELS rating, random utility, options pricing, bank regulation, return on assets
JEL Classication Code: D03, D81, G11, G12, G21, G28, G31, G32, M48
Contents
1 Introduction 2
2 The Model 7
2.1 Diagnosics for IRR from NPV Projects of Minority and Nonmi-
nority Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.1 Fundamental equation of project comparison . . . . . . . 10
2.2 Yield spread for nonminority banks relative to minority peer banks 10
3 Termstructure of bond portfolios for minority and nonminority banks 19
3.1 Minority bank zero covariance frontier portfolios . . . . . . . . . 21
4 Probability of bank failure with Vasicek (2002) Two-factor model 23
5 Minority and Nonminority Banks ROA Factor Mimicking Portfolios 25
5.1 Computing unlevered beta for minority banks . . . . . . . . . . . 26
5.2 On Pricing Risk Factors for Minority and Nonminority Peer Banks 29
5.2.1 Asset pricing models for minority and non-minority banks 29
5.3 A put option strategy for minority bank compensating risk . . . . 37
5.3.1 Optimal strike price for put option on minority banks . . . 38
5.3.2 Regulation costs and moral hazard of assistance to minor-
ity banks . . . . . . . . . . . . . . . . . . . . . . . . . . 39
5.4 Minority banks exposure to systemic risk . . . . . . . . . . . . . 40
6 Minority Banks CAMELS rating 41
6.1 Bank examiners random utility and CAMELS rating . . . . . . . 42
6.2 Bank examiners bivariate CAMELS rating function . . . . . . . 44
7 Conclusion 49
A Appendix of Proofs 50
A.1 PROOFS FOR SUBSECTION 2.1 DIAGNOSICS FOR IRR FROM
NPV PROJECTS OF MINORITY AND NONMINORITY BANKS . . 50
A.2 PROOFS FOR SUBSECTION 3.1 MINORITY BANK ZERO COVARI-
ANCE FRONTIER PORTFOLIOS . . . . . . . . . . . . . . . . . . . 53
A.3 PROOFS FOR SECTION 4 PROBABILITY OF BANK FAILURE WITH
VASICEK (2002) TWO-FACTOR MODEL . . . . . . . . . . . . . 56
1
A.4 PROOFS FOR SECTION 5 MINORITY AND NONMINORITY BANKS
ROA FACTOR MIMICKING PORTFOLIOS . . . . . . . . . . . . . 56
References 59
2
1 Introduction
According to U.S. GAO Report No. 07-06 (2006), as of 2005 there were 195 mi-
nority banks, 37% of themwere Asian, and 24% of themwere African-American
1
.
So the majority (61%) are Asian and African-American owned. Moreover, 44%
of minority banks had asset size less than $100M. Fifty-six (56%) of all minor-
ity banks were regulated by the FDIC, and the average loss reserve for African-
American banks was about 40% of assets, id., at page 11. Starting with Brim-
mer (1971), the literature on minority banks
2
is based mostly on empirical studies
that surmise their viability, and compare their performance to that of nonminority
banks. See e.g., Hasan and Hunter (1996) for an earlier review; and Hays and
De Lurgio (2003) for a more recent review of empirical regularities of minority
banks. Thus, performance evaluation of minority banks is relative to nonminority
peer banks. In fact, bank examination is based on a matched pair process in which
minority banks are compared to nonminority banks with a similar prole
3
. In
the overwhelming number of cases, minority banks do not match up well
4
.
To the extent that minority banks are small banks, they are subject to the
vagaries of the small bank market which includes, but is not limited to, the per-
formance of local economies in their domicile
5
. In fact, the black bank paradox
is described as Black-owned banks face a serious dilemma: founded primarily to
help ll the gap between the demand for and supply of credit to the black commu-
nity, the more they try to respond positively, the greater is the probability that they
will fail
6
. Therefore, comparative analysis of minority banks performance is by
denition comparison of a substratum of small banks.
To close the chasm between minority and nonminority small bank per-
1
For the latest gures see the Federal Reserve Board website http://www.federalreserve.gov/releases/mob/.
2
In this paper minority banks and black banks are used interchangeably. However, there is some variation
within minority banks as Asian banks tend to have a different prole for reasons outside the scope of this paper. See
(U.S. GAO Report No. 07-06, 2006, Appendix II) for heterogeniety in denition of minority bank.
3
For instance, meaningful comparison of return on assets (ROA) require that banks in the same peer group and
have similar asset size. Thus, a minority bank is compared with a nonminority bank in the same class. See e.g.,
memo dated May 27, 2004 on changes made to Uniform Bank Performance Report by Federal Financial Institutions
Examination Counsel available at http://www.fec.gov/ubprmemo200405.htm. See also, (U.S. GAO Report No.
07-06, 2006, pg. 11) for description of peer bank.
4
See e.g., Meinster and Elyasini (1996) (minority banks warrant concern in comparative analysis between foreign,
minority, and holding companies banks); Lawrence (1997) (poor performance of minority banks not due to operat-
ing environment); Iqbal et al. (1999) (with a given set of inputs, minority-owned banks produce less outputs than a
comparable group of nonminority-owned banks).
5
See e.g., Nakamura (1994)
6
See Brimmer (1992). Evidently this paradox is induced by minority banks attempt to alleviate credit rationing
problems in underserved communities. See Stiglitz and Weiss (1981).
3
formance, Cole (2010a) presented qualitative arguments in favor of a designated
regulator of minority banks along the lines of recent Federal Reserve intervention
to correct market failure in credit markets. The thesis of his argument appears to
be that given the peculiarities of minority banks that try to correct for credit market
discrimination in their domicile, use of the Uniform Financial Institutions Rating
System would inevitably produce lower CAMELS
7
ratings which consequently
put these banks on bank watch. Implicit in that argument is that minority banks
are undercapitalized for the seemingly altruistic mission they undertake, and that
perhaps some kind of regulatory subsidization of capital is needed
8
.
To the best of our knowledge, the literature is silent on theory geared
specically towards explaining and or predicting empirical regularities of minority
banks performanceat least in the context of microfoundations of nancial eco-
nomics. To be sure, Henderson (1999) introduced a model of loan loss provision,
based on changes in net interest income (NII), that identied proximate causes
of managerial inefciency by minority banks. There, he found statistically signif-
icant constants for loan loss provisions: (1) positive for African-American owned
banks; and (2) negative for white banks operating in the same market. Among
other things, he also found that black banks had 5 times as much net charge-offs
than white banks during the period sampled. As to managerial inefciency, he
found that managers at black banks appear to place greater weight on other ex-
ogenous factors than on nancial and environmental factors in their decisions to
allocate provisions forn loan loss
9
. By contrast, our theory explains why even if
managerial efciency for minority and nonminority banks is the same, minority
banks do not perform as well as nonminority banks.
(Henderson, 2002, pg. 318) introduced a model that addressed the role of com-
munity banks in combating discrimination. He presented an ad hoc model as a
rst step in better understanding [the Brimmer (1992)] paradox. However, his
7
The acronym stands for: Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market
risk. Details on computation of each component are described in UNIFORM FINANCIAL INSTITUTIONS RATING
SYSTEM (UFIRS) (eff. 1996) available at http://www.fdic.gov/regulations/laws/rules/5000-900.html. Last visited on
11/12/2010.
8
It should be noted in passing that the UFIRS policy statement indicates Evaluations of [a banks CAMELS]
components take into consideration the institutions size and sophistication, the nature and complexity of its activities,
and its risk prole. So arguably, regulatory transfers may fall under the so far nonimplemented Financial Institutions
Reform Recovery and Enforcement Act of 1989 (FIRREA) Section 308. See Cole (2010a) for further details on this
issue. Additionally, it is known that such transfer schemes would induce moral hazard in minority banks. Nonetheless,
that can be mitigated if regulation costs are not bourne by other banks. See e.g., Glazer and Kondo (2010) and (Merton,
1992, Chapter 20).
9
In private communications Prof. Walter Williams pointed out that because of the business climate in black neigh-
borhoods most black banks had most of their asset portfolio outside of the neighborhood. See Williams (1974).
4
model is based on asymmetric response to loan demand and supply shocks in a
quadratic loss function for optimal loan loss provision. His thesis is that greater
loan loss provisions and the inability of community banks and borrowers to accu-
rately predict the impact of shocks on loan performance reduces the protability of
community banks. It is not geared towards minority banks per se; and it does not
explain empirical regularities of minority banks. In our model, we show how com-
pensating shocks to minority banks can alleviate some of the problems described
in Henderson (2002).
On a different note, Cole (2010b) introduced a theory of minority banks
which is focused on capacity building. However, that catch phrase typically im-
plies provision of assistance with a viewtowards eventual self sustenance
10
. While
Cole (2010b) addresses several issues presented in here, this paper is distinguished
by its presentation of inter alia (1) a theoretical estimate of the regulation cost of
providing assistance to minority banks, (2) allocation of the burden of that cost to
preclude moral hazard by minority banks, (3) behavioral framework for CAMELS
rating of minority banks, (4) term structure of bond portfolios held by minority
banks, and (5) the role of minority bank capital structure in determining its price
of debt and equities. In a nutshell, this paper attempts to ll a void in the literature
by providing a comprehensive theory of performance evaluation
11
, asset pricing,
bank failure prediction, and CAMELS rating for minority banks. It also identies
the amount of risk-adjusted capital transfers that may be required to address the
erstwhile minority bank paradox. And it shows how those transfers are priced.
We choose the internal rate of return to motivate our theory because that
variable acts as a risk adjusted discount rate, and it captures the efciency, quality
and earnings rate or yield of the projects undertaken by minority and nonminority
banks
12
. Arguably, it also reects a banks risk based capital (RBC) since capital
10
See e.g., Robinson (2010) who advocates the creation of more minority banks as a vehicle for economic develop-
ment and self sufciency.
11
See e.g., U. S. GAO Report No. 08-233T (2007) recommendations for establishing performance measures for
minority banks.
12
According to capital budgeting theory. See e.g., (Ross et al., 2008, pg. 241).
5
adequacy is a function of RBC
13
. Using a simple project comparison argument in
innite dimensional Hilbert space, we generate a synthetic cash ow stream which
predicts that the cash ows of nonminority banks uniformly dominate that of mi-
nority peer banks in every period almost surely. This implies that minority banks
overinvest in [second best] positive NPV projects that nonminority banks reject
by virtue of their [nonminority banks] underinvestment in the sense of Jensen and
Meckling (1976); Myers (1977). We show how the synthetic cash ow is tanta-
mount to a credit derivative of minority bank assets, and provide some remarks on
its implications for security design for minority banks. Further, if the duration of
projects undertaken is nite, then one can construct a theoretical term structure of
IRR for minority banks
14
. In fact, Lemma 3.2 below plainly shows how Vasicek
(1977) model can be used to explain minority bank asset pricing anomalies like
negative price of risk.
We derive an independently important bank failure prediction model by
slight modication of Vasicek (2002) two factor model. There, we show how the
model is reduced to a conditional probit on granular bank specic variables. We
extend that paradigm to a two factor behavioral asset pricing model for minority
banks, by establishing a nexus between it and factor pricing for minority banks.
Cadogan (2010a) behavioral mean-variance asset pricing model is used to explain
minority banks asset pricing anomalies like ROA being concave in risk. For in-
stance, Cadogan (2010a) embedded loss aversion index acts like a shift parame-
ter in beta pricing for a portfolio of risky assets on Markowitz (1952a) frontier.
Whereupon, minority banks risk seeking behavior over losses causes them to hold
inefcient zero covariance frontier portfolios. Nonetheless, minority banks port-
folios are viable, if the risk free rate is less than that for the minimum variance
13
A banks risk based capital is determined by a formula set by Basel II as follows: The risk weights assigned to
balance sheet assets are summarized as follows:
0% risk weight: cash, gold bullion, loans guaranteed by the U.S. government, balances due from Federal
Reserve Banks.
20% risk weight: demand deposits, checks in the process of collection, risk participations in bankers accep-
tances and letters of credit, and other short-term claims maturing in one year or less.
50% risk weight: 1-4 family residential mortgages, whether owner occupied or rented; privately issued mort-
gage backed securities and municipal revenue bonds.
100% risk weight: cross-border loans to non-U.S. borrowers, commercial loans, consumer loans, derivative
mortgage backed securities, industrial development bonds, stripped mortgage backed securities, joint ventures,
and intangibles such as interest rate contracts, currency swaps, and other derivative nancial instruments
14
See (Vasicek, 1977, pg. 178)
6
portfolio on the portfolio frontier. For there is a window of opportunity in which
the returns on minority banks portfolios is bounded from below by the risk free
rate, and above by the returns from the minimum variance portfolio.
Assuming that risky cash ows follows a Markov process, we use a sim-
ple dynamical system introduced by Cadogan (2009) to show how the embedded
risk in minority bank projects stochastically dominate that for nonminority peer
banks. Accordingly, to correct these asset pricing anomalies, we show how risk
compensating regulatory shocks to minority banks transforms their negative price
of risk to a positive price
15
. And that isomorphic decomposition of such shocks
include a put option on minority bank assets. Further, we show how the amount
of compensating risk is priced in a linear asset pricing framework, and use Merton
(1977) formulation to price the put option in a regulatory setting. The strike price
for such an option is derived from considerations in Deelstra et al. (2010). The
signicance of our asset pricing approach is underscored by a recent GAO report
which states that even though FIRREA Section 308 requires that every effort be
made to preserve the minority character of failed minority banks upon acquisition,
the FDIC is required to accept the bids that pose the lowest accepted cost to the
Deposit Insurance Fund
16
Finally, we provide a microfoundational model of the CAMELS rating
process which identify bank examiners subjective probability distributions, and
sources of bias in their assignment of CAMELS scores. In particular, we establish
a nexus between random utility analysis and a simple bivariate CAMELS rating
function. And use comparative statics from that setup to explain and predict bank
examiner attitudes towards minority banks.
The rest of the paper proceeds as follows. Section 2 introduces project
comparison for minority and nonminority peer banks on the basis of the IRR of
projects they undertake. There, we generate synthetic cash ows, and the main
results are summarized in Lemma 2.11 and Lemma 2.17. Section 3 provides a
deterministic closed form solution for the term structure of bonds issued by mi-
nority banks, which we extend to a bond pricing theory for minority banks. In
15
As a practical matter, regulatory shocks shocks can be implemented by legislation that encourage credit
agreements between minority banks and credit worthy borrowers in the private sector. See Exelon Credit Agree-
ments Expand Relationships with Minority and Community Banks, October 25, 2010. Business Wire
c
. Avail-
able at http://seekingalpha.com/news-article/4181-exelon-credit-agreements-expand-relationships-with-minority-and-
community-banks
16
See (U.S. GAO Report No. 07-06, 2006, pg. 26). It should be noted in passing that empirical research by Dahl
(1996) found that when banks change hands between minority and noonminority ownership, loan growth is slower
when banks are owned by minorities compared to when they are owned by non-minorities.
7
section 4 we introduce our bank failure prediction model. In section 5 we intro-
duce asset pricing models for minority banks. The main results there are in The-
orems 5.10 and 5.13 which explain asset pricing anomalies for minority banks,
and proposal(s) to correct them. In subsection 5.1 we show how standard formu-
lae for weighted average cost of capital (WACC) should be modied to compute
unlevered beta for minority banks. Section 6 provides our CAMELS rating model
which is summarized in Proposition 6.4. Bank regulator CAMELS rating bias is
summarized in Lemma 6.3. Finally, we conclude in section 7 with conjectures for
further research. Select proofs are included in the Appendix.
2 The Model
In the sequel, all variables are assumed to be deterministic unless otherwise stated.
Let C
jt
be the CAMELS rating for bank j at time t, where
C
jt
= f (Capital adequacy jt, Asset quality
jt
, Management
jt
, Earnings
jt
,
Liquidity
jt
, Sensitivity to market risk
jt
)
(2.1)
for some monotone [decreasing] function f .
Let E[K
m
j,t
] and E[K
n
j,t
] be the t-th period expected cash ow for projects
17
under
taken by the j-th matched pair of minority (m) and non-minority (n) peer banks
respectively; and E[C
m
j,t
], E[C
n
j,t
] be their expected CAMELS rating, over a nite
time horizon t = 0, 1, . . . , T 1. Because the internal rate of return (IRR) repre-
sents the risk adjusted discount rate for a project to break even
18
, i.e.,
Net present value (NPV) of the project =Present value of asset Cost =0 (2.2)
, it is perhaps an instructive variable for comparison of minority and non-minority
owned banks for break even projects. We make the following
Assumption 2.1. The conditional distribution of CAMELS rating is known.
17
These include loan and mortgage payments received by the bank(s) every period. Furthermore, in accord with
(Modigliani and Miller, 1958, pg. 265) the expectations of each type of bank is with respect to its subjective probability
distribution. These expectations may not necessarily coincide with the subjective components of bank regulators
CAMELS ratings.
18
See (Damodaran, 2010, Chapter 5) and (Brealey and Myers, 2003, pg. 96-97)
8
Proposition 2.2 (Cash ow CAMELS rating relationship). The conditional distri-
bution of CAMELS rating is inversely proportional to the distribution of a banks
cash ows.
Proof. Let P() be the distribution of CAMELS rating, and c 1, 2, 3, 4, 5 be a
CAMELS rating. So that by denition of conditional probability,
P(C
jt
= c[ K
jt
) = P(C
jt
= c, K
jt
= k)/P(K
jt
= k) (2.3)
Since P is known, for given k the LHS is inversely proportional to P(K
jt
=
k).
Corollary 2.3 (Cash ow sufciency). K
jt
is a sufcient statistic for CAMELS
rating.
Proof. The proof follows from the denition of sufcient statistic in (DeGroot,
1970, pp. 155-156).
Remark 2.1. An empirical study by Lopez (2004) supports an inverse relationship
between average asset correlation with a common risk factor and probability of
default. Thus, if average asset correlation is a proxy for cash ows, and CAMELS
rating is a proxy for probability of default, our proposition is upheld.
Thus, the cash ows for projects under taken by banks are a reasonable proxy
for CAMELS variables. So that
C
j,t
= f (K
j,t
) (K
j,t
)
1
(2.4)
In other words, banks with higher cash ows for NPV projects should have lower
CAMELS rating. In the analysis that follows we drop the j subscript without loss
of generality.
2.1 Diagnosics for IRR from NPV Projects of Minority and Nonminority
Banks
We start with the simple no arbitrage premise that NPV for projects undertaken by
minority and nonminority banks are zero at break even point(s), i.e.
NPV
m
= NPV
n
= 0 (2.5)
For if the NPV of a project is greater that zero, then the project manager could
invest more in that project to generate more cash ow. Once the NPV is zero,
9
further investment in that project should end otherwise NPV would be negative.
In any event, let be the set of states of nature that affect cash ows; F be a
-eld of Borel measureable subsets of ; F
t

t0
be a ltration over F; and P
be a probability measure dened on . So that (, F, F
t

t0
, P) is a ltered
probability space
19
. So that for t xed, we have the cash ow mapping
Denition 2.1.
K
r
t
: R/, , r = m, n and (2.6)
E[K
r
t
()] =
_
E
K
r
t
()dP(), E F
t
(2.7)

Remark 2.2. Implicit in the denition is that future cash ows follow a stochastic
process, see Lemma 5.11 infra, and that for xed t there exists an objective
probability measure P on for the random variable K
r
t
(). In practice, type r
banks may have subjective probabilities P
r
about elementary events which
affect their computation of expected cash ows. Arguably, the objective probabil-
ities P() are from the point of view of an observer of type r banks behavior.

In the sequel we suppress inside the expectation operator E[].

Assumption 2.4. E[K
m
t
] > 0 and E[K
n
t
] > 0 for t ,= 0.
Assumption 2.5. Minority and nonminority banks belong to the same peer group
based on asset size or otherwise.
Assumption 2.6. The success rate for independent projects undertaken by minor-
ity and nonminority banks is the same.
Assumption 2.7. The time value of money is the same for each type of bank so the
extended internal rate of return XIRR is superuous.
Assumption 2.8. The weighted average cost of capital (WACC) for each type of
bank is different.
Assumption 2.9. Markets are complete.
19
See (Karatzas and Shreve, 1991, pg. 3) for details of these concepts.
10
2.1.1 Fundamental equation of project comparison
The no arbitrage condition gives rise to the fundamental equation of project com-
parison
T1

t=0
E[K
m
t
](1+IRR
m
)
t
=
T1

t=0
E[K
n
t
](1+IRR
n
)
t
= 0 (2.8)
Assume that K
m
0
<0 and K
n
0
<0 are the present value of the costs of the respective
projects. So that the index t = 1, 2, . . . corresponds to the benets or expected cash
ows which, under 2.4, guarantees a single IRR
20
.
2.2 Yield spread for nonminority banks relative to minority peer banks
Suppose that minority and nonminority banks in the same class competed for
the same projects, and that nonminority banks are publicly traded while minor-
ity banks are not. The market discipline imposed on nonminority banks implies
that they must compensate shareholders for risk taking. Thus, they would seek
those projects that have the highest internal rate of return
21
. Non publicly traded
minority banks are under no such pressure, and so they are free to choose any
project with positive returns. However, the transparency of nonminority banks
implies that they could issue debt [and securities] to increase their assets in or-
der to be more competitive than minority banks. Consequently, they tend to have
a higher return on equity (ROE)-even if return on assets (ROA) are comparable
for both types of banks-because risk averse shareholders must be compensated for
20
See (Ross et al., 2008, pg. 246).
21
According to Hays and De Lurgio (2003), Competition for the low-to-moderate income markets traditionally
served by minority banks intensied in the 1990s after passage of the FIRREA in 1989, which raised the bar for
compliance with CRA. Suddenly, banks in general had incentives to serve the underserved. This resulted in instances
of skimming the creamtaking away some of the best customers of minority banks, leaving those banks with reduced
asset quality. See also, Benston, George J. Its Time to Repeal the Community Reinvestment Act. September
28, 1999. http://www.cato.org/pubdisplay.php?pubid=4976 (accessed September 24, 2010) (suburban banks often
make subsidized or unprotable loans in central cities or to minorities in order to fulll CRA obligations. This
cream-skimming practice of lending to the most nancially sound customers draws business (and complaints) from
minority-owned local banks that normally specialize in service to that clientele).
11
additional risk
22
. This argument
23
implies that
IRR
n
= IRR
m
+ (2.9)
where is the premium or yield spread on IRR generated by nonminority banks
relative to minority banks in order to compensate their shareholders. So that the
right hand side of Equation 2.8 can be expanded as
T1

t=0
E[K
m
t
](1+IRR
m
)
t
=
T1

t=0
E[K
n
t
](1+IRR
m
+)
t
(2.10)
=
T1

t=0
E[K
n
t
]

q=0
(1)
q
_
t +q1
q
_
(1+IRR
m
)
q

tq
(2.11)
=
T1

t=0
E[K
n
t
]

u=t
(1)
ut
_
u1
ut
_
(1+IRR
m
)
ut

t>0
(2.12)
For the indicator function . Subtraction of the RHS, i.e. Equation 2.12, from the
LHS of Equation 2.10 produces the synthetic NPV project cash ow
T1

t=0
E[K
m
t
] E[K
n
t
]

u=t
(1)
ut
_
u1
ut
_
(
1+IRR
m

)
u
)(1+IRR
m
)
t

t>0
= 0
(2.13)
These results are summarized in the following
Lemma 2.10 (Synthetic discount factor). There exist such that

u=t
(1)
ut
_
u1
ut
_
(
1+IRR
m

)
u
)(1+IRR
m
)
t

t>0
< 1 (2.14)

22
According to (U.S. GAO Report No. 07-06, 2006, pg. 4) Protability is commonly measured by return on assets
(ROA), or the ratio of prots to assets, and ROAs are typically compared across peer groups to assess performance.
Additionally, Barclay and Smith (1995) provide empirical evidence in support of Myers (1977) contracting-cost
hypothesis where they found that rms with higher information asymmetries issue more short term debt. In our case,
this implies that relative asymmetric information about nontraded minority banks cause them to issue more short term
debt (relative to nonminority banks) which is reected in their lower IRR and ROA. It should be noted that Reuben
(1981) unpublished dissertation has the same title as Barclay and Smith (1995) paper. However, this writer was unable
to procure a copy of that dissertation or its abstract. So its not clear whether that research may be brought to bear here
as well.
23
Implicit in the comparison of minority and nonminority peer banks is Modigliani-Millers Proposition I that capital
structure is irrelevant to the average cost of capital.
12
Proof. See Appendix subsection A.1.
Lemma 2.11 (Synthetic cash ows for minority nonminority bank comparison).
Let IRR
n
and IRR
m
be the internal rates of return for projects undertaken by non-
minority and minority banks respectively. Let IRR
n
= IRR
m
+, where is a
project premium, and E[K
m
t
] and E[K
n
t
] be the t-th period expected cash ow for
projects undertaken by minority and nonminority banks, respectively. Then the
synthetic cash ow stream generated by comparing the projects undertaken by
each type of bank is given by
E[K
m
0
] E[K
n
0
],
_
E[K
m
t
] E[K
n
t
]

u=t
(1)
ut
_
u1
ut
_
(
1+IRR
m

)
u

t>0
_

Corollary 2.12 (Synthetic call option on minority bank cash ow). Let be the set
of possible states of nature affecting banks projects; P be a probability measure
dened on ; F be the -eld of Borel measureable subsets of and F
s

F
t
, 0 s t < be a ltration over F. So that all cash ows take place over
the ltered probability space (, F, F
t
, P). For , let K =K
t
, F
t
; t 0
be a cash ow process; E[K
m
t
()] be the expected spot price of the cash ow for
minority bank projects,
K
m be the corresponding constant cash ow volatility, r
be a constant discount rate, and E[K
n
t
()]

u=t
(1)
ut
(
u1
ut
)(
1+IRR
m

)
u
be the
comparable risk-premium adjusted cash ow for nonminority banks. Let K
n
T
be
the strike price for nonminority bank cash ow at expiry date t = T. Then
there exist a synthetic European style call option with premium
C(K
m
t
,
K
m[ K
n
T
, T, IRR
m
, ) =
E
_
max
_
E[K
m
t
()] K
n
T
T

u=t
(1)
ut
_
u1
ut
__
1+IRR
m

_
u
, 0
_

F
t
_
(2.15)
on minority bank cash ows.

Proof. Apply Lemma 2.10, and European style call option pricing formula in
(Varian, 1987, Lemma 1, pg. 63).
13
Remark 2.3. In standard option pricing formulae our present value factor
T

u=t
(1)
ut
_
u1
ut
__
1+IRR
m

_
u
is replaced by e
r(Tt)
where r is a risk free discount rate.
Remark 2.4. Even though the corollary is formulated as a bet on minority bank
cash ows, it provides a basis for construction of an asset securitization and or
collateralized loan obligation (CLO) scheme which could take some loans off of
the books of minority banksprovided that they are packaged in a proper tranche
and rated accordingly. See (Tavakoli, 2003, pg. 28). For example, if investor A
has information about a minority banks cash ow process K
m
, [s]he could pay a
premium C(K
m
t
,
K
m[ K
n
T
, T, IRR
m
, ) to investor B who may want to swap for
nonminority bank cash ow process K
n
with expiry date T-periods ahead. Such
arrangements may fall under rubric of option pricing, credit default swaps, and
security design outside the scope of this paper. See e.g., Wu and Carr (2006),
(Dufe and Rahi, 1995, pp. 8-9), and De Marzo and Dufe (1999). Additionally,
this synthetic cash ow process provides a mechanism for extending our analysis
to real options valuation which is outside the scope of this paper. See e.g., Dixit
and Pindyck (1994) for vagaries of real options alternative to NPV analysis.
Remark 2.5. The assumption of constant cash ow volatility
K
m
is consistent
with option pricing solutions adapted to the ltration F
t

t0
. See e.g., Cadogan
(2010b).
Assumption 2.13. The expected cost of NPV projects undertaken by minority ad
nonminority banks are the same.
Under the assumption that markets are complete, there exists a cash ow stream
for every possible state of the world
24
. This assumption gives rise to the notion
of a complete cash ow stream which we dene as follows.
Denition 2.2. Let (X, ) be a metric space for which cash ows are dened.
A sequence K
t

t=0
of cash ows in (X, ) is said to be a Cauchy sequence if
for each > 0, there exist an index number t
0
such that (x
t
, x
s
) < whenever
s, t >t
0
. The space (X, ) is said to be complete if every Cauchy sequence in that
space converges to a point in X.
24
See Flood (1991) for an excellent review of complete market concepts.
14

Remark 2.6. This denition is adapted from (Hewitt and Stromberg, 1965, pg. 67).

Here, the metric is a measure of cash ows, and X is the space of real
numbers R.
Assumption 2.14. The sequence
E[K
m
0
] E[K
n
0
],
_
E[K
m
t
] E[K
n
t
]

u=t
(1)
ut
_
u1
ut
_
(
1+IRR
m

)
u
_

t=1
(2.16)
is complete in X.
That is, every cash ow can be represented as the sum
25
of a sub-sequence of
cash-ows. In a complete cash-ow sequence, the synthetic NPV of zero implies
that
E[K
m
0
] E[K
n
0
] +E[K
m
t
] E[K
n
t
]

u=t
(1)
(ut)
_
u1
ut
_
(
1+IRR
m

)
u

t>0
= 0
(2.17)
for all t. Because the cash ow stream is complete in the span of the discount fac-
tors (1+IRR
m
)
t
, t = 0, 1, . . ., we can devise the following scheme. In particular,
let
d
t
m
= (1+IRR
m
)
t
(2.18)
be the discount factor for the IRR for minority banks. Then the sequence
d
t
m

t=0
(2.19)
can be treated as coordinates in an innite dimensional Hilbert space L
2
d
m
(X, )
of square integrable functions dened on the metric space (X, ) with respect
to some distribution function F(d
m
). In which case, orthogonalization of the se-
quence by a Gram-Schmidt process produces a sequence of orthogonal polynomi-
als
P
k
(d
m
)

k=0
(2.20)
in d
m
that span the space (X, ) of cash ows.
25
By sum we mean a linear combination of some sort.
15
Lemma 2.15. There exists orthogonal discount factors P
k
(d
m
)

k=0
where P
k
(d
m
)
is a polynomial in d
m
= (1+IRR
m
)
1
.

Proof. See (Akhiezer and Glazman, 1961, pg. 28) for theoretical motivation on
constructing orthogonal sequence of polynomials P
k
(d
m
) in Hilbert space. And
(LeRoy and Werner, 2000, Cor. 17.4.2, pg. 169)] for applications to nance.
Under that setup, we have the following equivalence relationship

t=0
E[K
m
t
] E[K
n
t
]

u=t
(1)
ut
_
u1
ut
_
(
1+IRR
m

)
u
(1+IRR
m
)
t

t>0
=

k=0
E[K
m
k
] E[K
n
k
]

u=k
(1)
uk
_
u1
uk
_
(
1+IRR
m

)
u
P
k
(d
m
) = 0
(2.21)
which gives rise to the following
Lemma 2.16 (Complete cash ow). Let
K
k
=E[K
m
k
] E[K
n
k
]

u=k
(1)
uk
_
u1
uk
_
(
1+IRR
m

)
u
(2.22)
Then

k=0
K
k
P
k
(d
m
) = 0 (2.23)
If and only if
K
k
= 0, k (2.24)
Proof. See Appendix subsection A.1.
Under Assumption 2.13, and by virtue of the complete cash ow Lemma 2.16
this implies that
E[K
m
k
] E[K
n
k
]

u=k
_
(1)
uk
_
u1
uk
_
(
1+IRR
m

)
u
_
= 0 (2.25)
16
However, according to Lemma 2.10 the oscillating series in the summand con-
verges if and only if
1+IRR
m

< 1 (2.26)
Thus
> 1+IRR
m
(2.27)
and substitution of the relation for in Equation 2.9 gives
IRR
n
> 1+2IRR
m
(2.28)
That is, the internal rate of return for nonminority banks is more than twice that for
minority banks in a world of complete cash ow sequences
26
. The convergence
criterion for Equation 2.25 and Lemma 2.10 imply that the summand is a discount
factor
DF
t
=

u=t
(1)
(ut)
_
u1
ut
_
(
1+IRR
m

)
u
) (2.29)
that is less than 1, i.e. DF
t
< 1. This means that under the complete cash ow
hypothesis, for given twe have
E[K
m
t
] E[K
n
t
].DF
t
= 0 (2.30)
Whereupon
E[K
m
t
] E[K
n
t
] (2.31)
So the expected cash ow of minority banks are uniformly dominated by that of
26
Kuehner-Herbert (2007) report that Return on assets at minority institutions averaged 0.09% at June 30, com-
pared with 0.78% at the end of 2005. For all FDIC-insured institutions, the ROA was 1.21%, compared with 1.3% at
the end of 2005. Thus, as of June 30, 2007 the ROA for nonminority banks was approximately 13.45, i.e. (1.21/0.09),
times that for minority banks. So our convergence prerequisite is well denedeven though it underestimates the ROA
multiple. Not to be forgotten is the Alexis (1971) critique of econometric models that fail to account for residual ef-
fects of past discrimination which may also be reected in the negative sign. Compare (Schwenkenberg, 2009, pg. 2)
who provides intergenerational income elasticity estimates which show that black sons have a lower probability of
upward income mobility with respect to parents position in income distribution compared to white sons. Furthermore,
Schwenkenberg (2009) reports that it would take anywhere from 3 to 6 generations for income which starts at half the
national average to catch-up to national average.
17
non-minority banks. One implication of this result is that minority banks invest in
second best projects relative to nonminority banks
27
. Thus, we have proven the
following
Lemma 2.17 (Uniformly Dominated Cash Flows). Assume that all sequences of
cash ows are complete. Let E[K
m
t
] and E[K
n
t
] be the expected cash ow for the
t-th period for minority and non-minority banks respectively. Further, let IRR
m
and IRR
n
be the [risk adjusted] internal rate of return for projects under taken by
the subject banks. Suppose that IRR
n
= IRR
m
+, > 0, where is the project
premium nonminority banks require to compensate their shareholders relative to
minority banks, and that the t-th period discount factor
DF
t
=

u=t
(1)
ut
_
u1
ut
_
(
1+IRR
m

)
u
) 1
Then the expected cash ows of minority banks are uniformly dominated by the
expected cash ows of nonminority banks, i.e.,
E[K
m
t
] E[K
n
t
]

Remark 2.7. This result is derived from the orthogonality of P

k
(d
m
) and telescop-
ing series
E[K
m
t
] E[K
n
t
]

u=t
(1)
ut u1
ut
(
1+IRR
m

)
u
= 0 (2.32)
which according to Lemma 2.10 converges by construction.

Remark 2.8. The assumption of higher internal rates of return for nonminority
banks implies that on average they should have higher cash ows. However, the
lemma produces a stronger uniform dominance result under fairly weak assump-
tions. That is, the lemma says that the expected cash ows of minority banks, i.e.
expected cash ows from loan portfolios, are dominated by that of nonminority
banks in every period.
27
Williams-Stanton (1998) eschewed the NPV approach, and used an information and or contract theory based
model in a multi-period setting to derive underinvestment results.
18
As a practical matter the lemma can be weakened to accommodate instances
when a minority bank cash ow may be greater than that of a nonminority peer
bank. We need the following
Denition 2.3 (Almost sure convergence). (Gikhman and Skorokhod, 1969, pg. 58)
A certain property of a set is said to hold almost surely P, if the P-measure of the
set of points on which the property does not hold has measure zero.

Thus, we have the result

Lemma 2.18 (Weak cash ow dominance). The cash ows of minority banks are
almost surely uniformly dominated by the cash ows of nonminority banks. That
is for some 0 < 1 we have
PrK
m
t
K
n
t
> 1

Proof. See Appendix subsection A.1.

The foregoing lemmas lead to the following
Corollary 2.19 (Minority banks second best projects). Minority banks invest in
second best projects relative to nonminority banks.

Proof. See Appendix subsection A.1.

Corollary 2.20. The expected CAMELS rating for minority banks is weakly dom-
inated by that of nonminority banks for any monotone decreasing function f , i.e.
E[ f (K
m
t
)] E[ f (K
n
t
)]
Proof. By Lemma 2.17 we have E[K
m
t
] E[K
n
t
] and f () is monotone [decreas-
ing]. Thus, f (E[K
m
t
]) f (E[K
n
t
]). So that, for any regular probability distribution
for state contingent cash ows, the expected CAMELS rating preserves the in-
equality.
19
3 Term structure of bond portfolios for minority and nonmi-
nority banks
In (Vasicek, 1977, pg. 178) single factor model of the term structure or yield to
maturity, R(t, T) is the [risk adjusted] internal rate of return (IRR) on a bond at
time time t with maturity date s =t +T. In that case, if T
m
, T
n
are the times to ma-
turity for time t bonds held by minority and nonminority banks, then (t[T
m
, T
n
) =
R(t, T
n
) R(t, T
m
) is the yield spread or underinvestment effect. A minority bank
could monitor its xed income portfolio by tracking that spread relative to the LI-
BOR rate. To obtain a closed form solution, (Vasicek, 1977, pg. 185) modeled
short term interest rates r(t, ) as an Ornstein-Uhlenbeck process
dr(t, ) = ( r r(t, ))dt +dB(t, ) (3.1)
where r is the long term mean interest rate, is the speed of reverting to the mean,
is the volatility (assumed constant here), and B(t, ) is the background driving
Brownian motion over the states of nature . Whereupon for a given state the
term structure has the solution
R(t, T) = R() +(r(t) R())
(T; )

+cT
2
(T; ) (3.2)
where R() is the asymptotic limit of the term structure; (T; ) =
1
T
(1e
T
);
and c =

2
4
3
. By eliminating r(t) (see (Vasicek, 1977, pg. 187) it can be shown
that an admissible representation of the term structure of yield to maturity for a
bond that pays $1 at maturity s = t +T
m
, issued by minority banks, relative to
a bond that pays $1 at maturity s = t +T
n
, issued by their nonminority peers, is
deterministic
R(t, T
m
) = R() +
c
1(T
n
,T
m
)
[T
m

2
(T
m
) (T
n
, T
m
)T
n

2
(T
n
)] (3.3)
where
(T
n
, T
m
) =
(T
m
)
(T
n
)
(3.4)
with the proviso
R(t, T
n
) R(t, T
m
) (3.5)
20
and
lim
T
(T) = 0 (3.6)
We summarize the forgoing as a
Proposition 3.1 (Term structure of minority bank bond portfolio). Assume that
short term interest rates follow an Ornstein-Uhelenbeck process
dr(t, ) = ( r r(t, ))dt +dB(t, )
And that the term structure of yield to maturity, R(t, T), is described by Vasicek
(1977) single factor model
R(t, T) = R() +(r(t) R())
(T;)

+cT
2
(T; )
where R() is the asymptotic limit of the term structure; (T; ) =
1
T
(1 e

);
(T
n
, T
m
) =
(T
m
)
(T
n
)
and c =

2
4
3
. Let s =t +T
m
be the time to maturity for a bond that
pays $1 held by minority banks, and s =t +T
n
, be the time to maturity for a bond
that pays $1 held by nonminority peer bank. Then, an admissible representation
of the term structure of yield to maturity for bonds issued by minority banks is
deterministic
R(t, T
m
) = R() +
c
1(T
n
,T
m
)
[T
m

2
(T
m
; ) (T
n
, T
m
)T
n

2
(T
n
; )]

Sketch of proof. Eliminate r(t) from the term structure equations for minority and
nonminority banks and obtain an expression for R(t, T
m
) in terms of R(t, T
n
). Then
set R(t, T
n
) R(t, T
m
). The inequality induces a oor for R(t, T
n
) which serves as
an admissible term structure for minority banks.
Remark 3.1. In the equation for R(t, T), the quantity cT
r
=

2

3
T
r
, where r = m, n,
implies that the numerator
2
T
r
is consistent with the volatility or risk for a type-r
bank bond. That is, we have
r
=

T
r
. So that cT
r
is a type-r bank risk factor.

21
3.1 Minority bank zero covariance frontier portfolios
In the context of a linear asset pricing equation in risk factor cT
m
, the representa-
tion IRR
m
R(t, T
m
) implies that minority banks risk exposure
m
=

2
(T
m
;)
1(T
n
,T
m
)
.
Let (T
m
) be the risk prole of bonds issued by minority banks. If (T
m
) >(T
n
),
i.e., bonds issued by minority banks are more risky, then 1 (T
n
, T
m
) < 0 and

m
< 0. Under (Rothschild and Stiglitz, 1970, pp. 227-228) and (Diamond and
Stiglitz, 1974, pg. 338) mean preserving spread analysis, this implies that mi-
nority banks bonds are riskier with lower yields. Thus, we have an asset pricing
anomaly for minority banks because their internal rate of return is concave in risk.
This phenomenon is more fully explained in the sequel. However we formalize
this result in
Lemma 3.2 (Risk pricing for minority bank bonds). Assume the existence of a
market with two types of banks: minority banks (m), and nonminority banks (n).
Suppose that the time to maturity T
n
for nonminority banks bonds is given. Assume
that minority bank bonds are priced by Vasicek (1977) single factor model. Let
IRR
m
R(t, T
m
) be the internal rate of return for minority banks. Let () be the
risk prole of bonds issued by minority banks, and
(T
n
, T
m
) =
(T
m
)
(T
n
)
(3.7)
(T
m
) = (T
n
, T
m
[ T
m
) = a
0
(T
m
), where (3.8)
a
0
=
1
(T
n
)
(3.9)
22
is now a relative constant of proportionality, and
(T
m
; ) >
1
a
0
(3.10)

m
=

2
(T
m
; )
1(T
n
, T
m
)
(3.11)
=

2
(T
m
; )
1a
0
(T
m
)
(3.12)

m
= cT
m
(3.13)

n
= cT
n
(3.14)

m
=
(T
m
)
1(T
m
)
1
a
2
0
(3.15)

m
= R() +
m
(3.16)
where
m
is an idiosyncracy of minority banks. Then
E[IRR
m
] =
m

m
+
m

n
(3.17)

Remark 3.2. In our idealized two-bank world

m
is a measure of minority bank
managerial ability,
n
is market wide risk by virtue of the assumption that time
to maturity T
n
is known while T
m
is not,
m
is exposure to the market wide risk
factor
n
, and the condition (T
m
) >
1
a
0
is a minority bank risk prole constraint
for internal consistency (T
n
, T
m
) > 1, and negative beta in Equation 3.12. For
instance, the prole implies that bonds issued by minority banks are riskier than
other bonds in the market
28
. Moreover, in that model IRR
m
is concave in risk
m
.

More on point, let (E[IRR

m
],
m
) be minority bank and (E[IRR
n
],
n
) be non-
minority bank frontier portfolios
29
. Then according to (Huang and Litzenberger,
1988, pp. 70-71) we have the following
Proposition 3.3 (Minority banks zero covariance portfolio). Minority bank fron-
tier portfolio is a zero covariance portfolio.
28
For instance, according to (U. S. GAO Report No. 08-233T, 2007, pg. 11) African-American banks had a loan loss
reserve of almost 40% of assets. See Walter (1991) for overview of loan loss reserve on bank performance evaluation.
29
See (Huang and Litzenberger, 1988, pg. 63)
23
Proof. See Appendix subsection A.2.
In other words, we can construct a an efcient frontier portfolio by short selling
minority bank assets and using the proceeds to buy nonminority bank assets.
4 Probability of bank failure with Vasicek (2002) Two-factor
model
Consistent with Vasicek (2002) and Martinez-Miera and Repullo (2008), assume
that the return on assets (ROA), i.e. loan portfolio value, for a minority bank is
described by the stochastic process
30
dA(t, )
A(t, )
= dt +dW(t, ) (4.1)
where and are constant mean and volatility growth rates. Starting at time t
0
,
the value of the asset at time T is lognormally distributed with
logA(T) = logA(t
0
) +T
1
2

2
T +

TX (4.2)
where X is a normal random variable decomposed as follows
X = Z
S

+Z
_
1 (4.3)
Z
S
and Z are independent and normally distributed; Z
S
is a common factor, Z is
bank specic, and is the pairwise constant correlation for the distribution of Xs.
Vasicek (2002) computed the probability of default, i.e. bank failure in our case,
if assets fall below a threshold liability B as follows
PrA(T) < B = PrX < c =(c) = p (4.4)
30
Implicit in the equation is the existence of a sample space for states of nature, a probability measure P on that
space, a -eld of Borel measureable subsets F, and a ltration F
t

t0
over F where F

=F. The P-negligible

sets are assumed to be in F
0
. So that we have the ltered probability measure space (, F
t

t0
, F, P) over which
solutions to the stochastic differential equation lie. We assume that the solution to such an equation is adapted to the
ltration. See e.g., ksendal (2003); Karatzas and Shreve (1991) for technical details about solution concepts.
24
where (c) is the cumulative normal distribution and
c =
logBlogAT +
1
2

2
T

T
(4.5)
Furthermore, (Vasicek, 2002, pg. Eq(3)) computed the conditional probability of
bank failure given the common factor Z
S
as follows. Let
L =
_
1 if bank fails
0 if bank does not fail
(4.6)
E[L[Z
S
] = p(Z
S
) =
_

1
(p)Z
S

1
_
(4.7)
By slight modication, replace Z
S
with
XZ

) to get the conditional probabil-

ity of bank failure for bank specic factor Z given X. In which case we have
p(Z[X) =
_

1
(p)
XZ

1
_
(4.8)
From which we get the unconditional probability of bank failure for bank specic
variable
p(Z) =
_

p(Z[X)(X)dX (4.9)
where () is the probability density function for the normal random variable X.
Lemma 4.1 (Probit model for bank specic factors). p(Z) is in the class of probit
models.
Proof. See Appendix subsection A.3.
Our theory based result is distinguished from (Cole and Gunther, 1998, pg. 104)
heuristic probit model, i.e., monotone function, with explanatory variables moti-
vated by CAMELS rating, used to predict bank failure. In fact, those authors
opined:
Reecting the scope of on-site exams, CAMEL ratings incorporate a
banks nancial condition, its compliance with laws and regulatory poli-
cies, and the quality of its management and systems of internal control.
25
Regulators do not expect all poorly rated banks to fail but rather fo-
cus attention on early intervention and take action designed to return
troubled banks to nancial health. Given the multiple dimensions of
CAMEL ratings, their primary purpose is not to predict bank failures.
In particular, (Cole and Gunther, 1998, pg. 106) used proxies to CAMELS vari-
ables in their probit model by calculating them as a percentage of gross assets
(net assets plus reserves). Here, we provide theoretical motivation which predict
a probit type model for bank failure probabilities. However, the theory is more
granular in that it permits computation of bank failure for each variable sepa-
rately or in combination as the case may be
31
.
5 Minority and Nonminority Banks ROA Factor Mimicking
Portfolios
In a world of risk-return tradeoffs, one would intuitively expect that nonminority
banks take more risks because their cash ow streams and internal rates of returns
are higher. However, that concordance may not hold for minority banks which
tend to hold lower quality assets and relatively more cash. Consequently, their
capital structure is more biased towards surving the challenges of bank runs
32
. So
the issue of risk management is paramount. We make the following assumptions.
Assumption 5.1. The rate of debt (r
debt
) for each type of bank is the same.
Assumption 5.2. Minority bank are not publicly traded.
Assumption 5.3. Nonminority banks are publicly traded.
31
See Demyanyk and Hasan (2009) for a taxonomy of bank failure prediction models. Rajan et al. (2010) also
provide empirical support for the hypothesis that the inclusion of only hard variables reported to investors in bank
failure prediction models, at the expense of soft but nonetheless informative variables, subject those models to a
Lucas (1983) critique. That is, bank failure prediction models fail to incorporate behavioral changes in lenders over
time, and consequently underestimate bank failure. In fact, Kupiec (2009) rejected Vasicek (2002) model for corporate
bond default in a sample of Moodys data for 1920-2008. However, Lopez (2004) conducted a study of credit portfolios
for U.S., Japanese and European rms for year-end 2000 and reached a different conclusion. Thus, our design matrix
should include at least dummy variables that capture possible regime shifts in bank policy.
32
See e.g., Diamond and Rajan (2000).
26
5.1 Computing unlevered beta for minority banks
Because projects are selected when IRR WACC we assume
33
that
IRR =WACC+ (5.1)
where 0. However,
V = D+E (5.2)
WACC =
D
V
r
debt
+
E
V
r
equity
(5.3)
By assumption, minority banks are not publicly traded. Besides, Bates and Brad-
ford (1980) report that the extreme deposit volatility in Black-owned banks leads
them to hold more liquid assets than nonminority owned banks in order to meet
withdrawal demand. This artifact of Black-owned banks was reafrmed by Hays
and De Lurgio (2003). According to empirical research by (Dewald and Dreese,
1970, pg. 878) extreme deposit variability imposes constraints on a banks portfo-
lio mix by forcing it to borrowmore fromthe Federal Reserve, and hold more short
term duration assets. These structural impediments to minority banks protability
imply that a CAPM type model is inadmissible to price their cost of capital (or
return on equities) (r
p
). To see this, we modify Ruback (2002) as follows. Let
WACC
m
= R
f
+
U,m

R
p
(5.4)

U,m
=
_
D
V

D,m
+
E
V

E,m
_
(5.5)
where R
f
is a risk free rate,
D,m
is the beta computed from debt pricing,
E,m
is
the beta computed fromequity pricing,

R
p
is a risk premium, and
U,m
is unlevered
beta, i.e., beta for ROA with. Instead of the CAPM, our debt beta is computed by
Equation 3.17 in Lemma 3.2; and return on asset beta, i.e. unlevered beta (
U,m
)
is computed by Equation 5.19 in Lemma 5.9. Since minority banks betas tend to
be negative, it means that for IRR
m
> 0 in Equation 5.1 we must have

_
D
V

D,m
+
E
V

E,m
_

R
p
R
f
(5.6)
33
See (Ross et al., 2008, pg. 241).
27
In order for minority bank debt to be properly priced in an equilibrium in which
sgn(
E,m
) < 0 and = 0 (5.7)
we need the constraint
[
E,m
[ >
V
E
R
f

R
p
(5.8)
By the same token, in order for minority bank equity to be properly priced in an
equilibrium in which
sgn(
E,m
) < 0 and = 0 we need (5.9)
[
D,m
[ >
V
D
R
f

R
p
(5.10)
Evidently, for a given capital structure, the inequalities are inversely proportional
to the risk premium on the portfolio of minority bank debt and equities. Roughly
speaking, up to a rst order approximation we get the following
Proposition 5.4 (WACC and minority bank capital structure). For a given debt to
equity ratio
D
E
for minority banks the price of debt to equity is directly proportional
to the debt to equity ratio, i.e.
[
E,m
[
[
D,m
[

D
E
(5.11)
up to a rst order approximation.

Sketch of Proof. For constants b

E
and b
D
, let
[
E,m
[ =
V
E
R
f

R
p
+b
E
(5.12)
[
D,m
[ =
V
D
R
f

R
p
+b
D
(5.13)
Divide [
E,m
[ by [
D,m
[, and use a rst order approximation of the quotient.
Remark 5.1. This result plainly shows that Modigliani and Miller (1958) capital
structure irrelevance hypothesis does not apply to pricing debt and equities of
minority banks.
28

In corporate nance, if is the corporate tax rate, then according to (Brealey

and Myers, 2003, pg. 535) we have

E,m
=
U,m
[1+(1)
D
E
]
D,m
(1)
D
E
(5.14)
From Proposition 5.4 let c
0
be a constant of proportionality so that
[
E,m
[ = c
0
[
D,m
[
D
E
(5.15)
Since classic formulae assumes that betas are positive, upon substitution we get

U,m
=
[
D,m
[[c
0
+(1)]
[1+(1)
D
E
]
D
E
(5.16)
However, once we remove the absolute operation [ [, for minority banks the for-
mula must be modied so that
sgn(
U,m
) = sgn(
D,m
) (5.17)
But
U,m
is the beta for return on assetswhich tends to be negative for minority
banks. This is transmitted to debt beta as indicated. Thus, we have
Proposition 5.5. For minority banks, the sign of beta for return on assets is the
same as that for the beta for debt.

In order to explain the root cause(s) of the characteristics of minority bank be-
tas, we appeal to a behavioral asset pricing model. In particular, let be a loss
aversion index popularized by Khaneman and Tversky (1979), and x be uctua-
tions in income, i.e., liquidity; and
x
be liquidity risk. Then we introduce the
following
Proposition 5.6. Let x be change in income, and v be a value function over gains
and losses with loss aversion index . Furthermore, let
x
and
x
be the average
change in liquidity, i.e. mean, and
2
x
be the corresponding liquidity risk, i.e. vari-
ance. Then the behavioral mean-variance tradeoff between liquidity and liquidity
risk is given by

x
= (x; )
x
(5.18)
29
where (x; ) is the behavioral liquidity risk exposure.

Corollary 5.7. There exists a critical loss aversion value

c
such that (x; ) < 0
whenever >
c
.

Proof. Because the proofs of the proposition and corollary are fairly lengthy, and
outside the scope of this paper, we direct the reader to (Cadogan, 2010a, Sub-
section 2.1 pg. 11) for details of the model and proofs.
Proposition 5.6 and Corollary 5.7 are pertinent to this paper because they use
prospect theory and or behavioral economics to explain why asset pricing models
for minority banks tend to be concave in risk, while standard asset pricing the-
ory holds that they should be convex
34
. Moreover, they imply that on Markowitz
(1952a) type mean-variance efcient frontier, i.e. portfolio comprised of only
risky assets, minority banks tend to be in the lower edge of the frontier (hyper-
bola). This is in accord with Proposition 3.3 which posits that minority banks
hold zero-covariance frontier portfolios. Here, the loss aversion index behaves
like a shift parameter such that beyond the critical value
c
minority banks risk
seeking behavior causes them to hold inefcient zero covariance portfolios.
5.2 On Pricing Risk Factors for Minority and Nonminority Peer Banks
Our focus up to this point has been in relation to projects internal rates of return.
In this section we examine how these rates relate to relative risk for comparable
minority and non-minority banks in the context of an asset pricing model.
5.2.1 Asset pricing models for minority and non-minority banks
Let
m
,
n
be the specic project risks faced by minority and nonminority banks,
and
S
be systemic, i.e. market wide, risks faced by all banks
35
, where as we
34
See Friedman and Savage (1948), Markowitz (1952b), and Tversky and Khaneman (1992) for explanations of
concave and convex portions of utility functions for subjects behavior towards uctuations in wealth.
35
This has been describes thus:
The sensitivity to market risk component reects the degree to which changes in interest rates, foreign
exchange rates, commodity prices, or equity prices can adversely affect a nancial institutions earnings
or economic capital. When evaluating this component, consideration should be given to: managements
ability to identify, measure, monitor, and control market risk; the institutions size; the nature and
30
demonstrate below,
m

n
. Let K
m
t
(
m
[
S
) and K
n
t
(
n
[
S
) be the cash ow
streams as a function of project risk for given systemic risks. By denition, the
NPV relation in the fundamental equation(s) for project comparison Equation 2.8
plainly show that IRR
()
is a function of K
()
. In which case, IRR
()
(
()
[
S
) is
also a function of project risk
()
for given systemic risk. According to Brimmer,
the minority bank paradox arises from the exceptional risks these lenders must
assume when they extend credit to individuals who suffer from above-average
instability of employment and income, or to black-owned businesses, which have
high rates of bankruptcy. This observation is consistent with (Khaneman and
Tversky, 1979, pg. 268) prospect theory where it is shown that subjects are risk
seeking over losses and risk averse over gains
36
. In which case we would expect
returns of minority banks to be negatively correlated with project risk
37
. Despite
their negative betas, minority banks may be viable if we make the following
Assumption 5.8. (Huang and Litzenberger, 1988, pp. 76-77).
The risk free rate is less than that attainable from a minimum variance portfolio.
Thus, even though their portfolios may be inefcient, there is a window of op-
portunity for providing a return greater than the risk free rate. Besides, Lemma
3.2 provides a bond pricing scenario in which that is the case. By contrast, non-
minority banks select projects from a more traditional investment opportunity
complexity of its activities; and the adequacy of its capital and earnings in relation to its level of market
risk exposure.
See e.g., Uniform Financial Institutions Ratings System, page 9, available at
http://www.fdic.gov/regulations/laws/rules/5000-900.html as of 11/12/2010.
36
This type of behavior is not unique to minority banks. Johnson (1994) conducted a study of 142 commercial
banks using Fishburn (1977) mean-risk method, and found that bank managers take more risk when faced with below
target returns. Anecdotal evidence from (U.S. GAO Report No. 07-06, 2006, pg. 20) found that 65% of minority
banks surveyed were optimistic about their future prospects despite higher operating expenses, and lower protability
than their nonminority peer banks. Moreover, despite the availability of technical assistance to correct problems that
limit their nancial and operational performance, id., at 35, most minority banks failed to avail themselves of the
assistance.
37
See also, (Tobin, 1958, pg. 76) who developed a theory of risk-return tradeoff in which a risk lovers indifference
curve is concave downwards in (return,risk) space as opposed to the positive slope which characterizes Black (1972)
zero-beta CAPM. More recently, Kuehner-Herbert (2007) reported negative ROA for African-American banks, and
positive ROA for all others. Also, (Henderson, 1999, pg. 375) articulates how inadequate assessment of risk leads to
loan losses (and hence lower IRR) for African-American owned banks. Additionally, (Hylton, 1999, pg. 2) argues that
bank regulation makes it difcult for inner city banks to compete. For instance, Hylton noted that regulators oftentimes
force banks to diversify their loan portfolios in ways that induce conservative lending and lower returns. According to
empirical research by (Dewald and Dreese, 1970, pg. 878) extreme deposit variability imposes constraints on a banks
portfolio mix by forcing it to borrow more from the Federal Reserve, and hold more short term duration assets. These
structural impediments to minority banks protability imply that a CAPM type model is inadmissible to price their
cost of capital (or return on equities). Intuitively, these negative returns on risk imply that whereas the CAPM may
hold for nonminority banks it does not hold for African-American banks.
31
set in which the return-risk tradeoff is positively correlated. These artifacts of as-
set pricing can be summarized by the following two-factor models of risk-return
tradeoffs
38
:
IRR
m
=
m0

m
+
m

S
+
m
(5.19)
IRR
n
=
n0
+
n

n
+
n

S
+
n
(5.20)
where
m
,
n
> 0, and
()
is an idiosyncratic an error term. The
()
variable
is a measure of bank sensitivity to market risks, i.e., exposure to systemic risks,
and
()
is a proxy for managerial ability. In particular, Equation 5.19 and Equa-
tion 5.20 are examples of Vasicek (2002) two-factor model represented by Equa-
tion 4.2 with the correspondence summarized in
Lemma 5.9 (Factor prices). Let r =m, n,
r
be the price of risk, and
r
be exposure
to systemic risk for minority and nonminority banks is given by
sgn(
r
)
r

r
=
_
T(1
r
)Z
r
(5.21)

S
=
_
T
r
Z
S
(5.22)
where, as before, Z
S
is a common factor, Z
()
is bank specic, is volatility growth
rate for return on bank assets, and
r
is the constant pairwise correlation coef-
cient for the distribution of background driving bank asset factors.

Remark 5.2. sgn represents the sign of

r
.

It should be noted in passing that implicit in Equation 5.21 and Equation 5.22
is that our variables are time subscripted. Thus, our parametrization employs Va-
sicek (2002) factor pricing theory, and incorporates Brimmer (1992) black banks
paradox. Let

m
=
m

S
+
m
(5.23)

n
=
n

S
+
n
(5.24)
38
See (Elton et al., 2009, pg. 629). See also., Barnes and Lopez (2006); King (2009) for use of CAPM in estimating
cost of equity capital (COE) in banking. However, Damodaran (2010) points out that estimates of CAPM betas are
backwards looking while the risk adjusted discount factor is forward looking. To get around that critique, one could
assume that beta follows a Markov process.
32
So the equations are rewritten as
IRR
m
=
m0

m
+

m
(5.25)
IRR
n
=
n0
+
n

n
+

n
(5.26)
Assume arguendo that the IRRand managerial ability for minority and non-minority
banks are equal. So that

m0

m
+

m
=
n0
+
n

n
+

n
(5.27)
where

m0
=
n0
(5.28)
Thus, of necessity

n
variance(

m
) variance(

n
) (5.29)
and consequently

n
(5.30)
We have just proven the following
Theorem 5.10 (Minority Bank Risk Prole). Assuming that Vasicek (2002) two
factor model holds, let
IRR
m
=
m0

m
+

m
IRR
n
=
n0
+
n

n
+

n
be two-factor models used to price internal rates of returns for minority (m) and
nonminority (n) banks, and

m
=
m

S
+
m

n
=
n

S
+
n
be the corresponding market adjusted idiosyncratic risk prole, where
m
is id-
iosyncratic risk for minority banks,
n
idiosyncratic risk for nonminority banks,

S
be a market wide systemic risk factor, and
()
be exposure to systemic risk.
33
If the internal rate of return and managerial ability is the same for each type of
bank, then the market adjusted risk for projects undertaken by minority banks are
a lot higher than that undertaken by minority banks, i.e.

This theorem can also be derived from consideration of the risky cash ow
process K =K
r
(t, ), F
t
; 0 t <, r = m, n. For instance, suppressing the
r superscript, (Cadogan, 2009, pg. 9) introduced a risky cash ow process given
by
dK(t, ) = r(K(t, ))dt +
K
dB(t, ) (5.31)
where the drift term r(K(t, )) is itself a stochastic Arrow-Pratt risk process, and

K
is constant cash ow volatility. He used a simple dynamical system to show
that
r(K(t, )) =

K
cosh(
K
ct)
_
t
0
sinh(
K
cs)e
Rs
K(s, )ds (5.32)
where c is a constant, B(t, ) is Brownian motion, and R is a constant discount
rate. So that the Arrow-Pratt risk process and stochastic cash ows for a project are
controlled by a nonlinear relationship in cash ow volatility and the discount rate
for cash ows. In our case, R is the IRR. So other things equal, since IRR
n
>IRR
m
in Equation 2.9, application of Equation 5.32 plainly shows that
r(K
m
(t, )) > r(K
n
(t, )) (5.33)
This leads to the following
Lemma 5.11 (Arrow-Pratt risk process for minority and nonminority banks cash
ows). Let K =K
r
(t, ), F
t
; 0 t <, r =m, n be a risky cash ow process
for minority (m) and nonminority (n) banks. Then the Arrow-Pratt risk process
r(K
m
) =r(K
m
(t, )), F
t
for minority banks stochastically dominates than that
for nonminority banks r(K
n
) = r(K
n
(t, )), F
t
. That is, for r(K) C[0, 1],
and dyadic partition t
(n)
k
= k2
n
, k = 0, 1, 2, . . . , 2
n
of the unit interval [0, 1],
the joint distribution of r(K
m
(t
(n)
1
, )), . . . , r(K
m
(t
(n)
q
, )) is greater than that for
r(K
n
(t
(n)
1
, )), . . . , K
n
(t
(n)
q
, )) for 0 q 2
n
under Diamond and Stiglitz (1974)
34
mean preserving spread.

Proof. See Appendix subsection A.4.

Thus, Theorem 5.10 and Lemma 5.11 predict Brimmers black banks para-
dox
39
other things equal, the idiosyncratic risks for projects undertaken by minor-
ity banks is a lot greater than that under taken by nonminority banks. To alleviate
this problem
40
, quantied in Theorem 5.10, induced by structural negative price
of risk (presumably brought on by minority banks altruistic projects), we introduce
a compensating risk factor
41
> 0 (5.34)
Let the risk relationship be dened by

m
=
2

n
(5.35)
Since each type of bank face the same systemic risk
S
, we need another factor,
call it

such that

m
=

=
m

S
+
m

n
(5.36)
where

m
is compensating risk adjusted shock to minority banks that makes their
idiosyncratic risks functionally equivalent to that for nonminority banks after con-
trolling for market wide systemic risk , i.e.,

m
=
2

n
(5.37)
39
Compare, (Henderson, 2002, pg. 318) introduced what he described as an ad hoc model that provides a rst
step in better understanding [Brimmers] economic paradox.
40
According to (U. S. GAO Report No. 08-233T, 2007, pg. 8) many minority banks are located in urban areas
and seek to serve distressed communities and populations that nancial institutions have traditionally underserved.
Arguably, minority banks should be compensated for their altruistic mission. Cf. Lawrence (1997).
41
Arguably, an example of such a compensating risk factor may be government purchase of preferred stock issued
by minority banks. Kwan (2009) outlined how the federal reserve banks instituted a Capital Purchase Program (CPP)
which used a preferred stock approach to capitalizing banks in the Great Recession. This type of hybrid subordinated
debt instrument falls between common stock and bonds. It falls under rubric of so called Pecking Order Theory in
Corporate Finance. It is a non-voting share which has priority over common stock in the payment of dividends and
the event of bankruptcy. (Kwan, 2009, pg. 3) explained that a convertible preferred stock is akin to a call option the
bankss common stock. Furthermore, many small banks that did not have access to capital markets chose this route.
35
In that case,

m
=
2

m
+
2

2cov(

m
,

) (5.38)
This quantity on the right hand side is less than
2

m
if and only if the following
compensating risk factor relationship holds

2cov(

m
,

) 0 (5.39)
That is,
= 2cov(

m
,

)
2

> 0 (5.40)
This compensating equation has several implications. First, it provides a measure
of the amount of compensated risk required to put minority banks on par with
nonminority banks. Second, it shows that the compensating shock

to minority
banks must be positively correlated with the market adjusted idiosyncratic risks

m
of minority banks. That is, the more idiosyncratic the risk, the more the compen-
sation. Third, the amount of compensating shocks given to minority banks must
be modulated by
2

before it gets too large. We summarize this result with the

following
Theorem 5.12 (Minority bank risk compensation evaluation). Suppose that the
internal rates of return (IRR) of minority (m) and nonminority (n) banks are priced
by the following two factor models:
IRR
m
=
m0

m
+
m
IRR
n
=
n0
+
n

n
+
n
Let
()
be the factor for managerial ability at each type of bank. Further, let the
market adjusted idiosyncratic risk for each type of bank be

m
=
m

S
+
m

n
=
n

S
+
n
36
Assume that managerial ability
()
and IRR are the same for each type of bank.
Let > 0 be a compensating risk factor such that

m
=
2

n
Let

be a risk compensating shock to minority banks. Then the size of the com-
pensating risk factor is given by
= 2cov(

m
,

)
2

> 0
where
2

is the variance or risk of compensating shock.

The covariance relation in Equation 5.40 suggests the existence of a linear pric-
ing relationship in which

is a dependent variable and

m
and
2

are explanatory
variables. In fact, such a pricing relationship subsumes a mean-variance analysis
for the pair (

,
2

) augmented by the factor

m
. Formally, this gives rise to the
following
Theorem 5.13 (Minority bank risk compensation shock). Minority bank compen-
sating shock is determined by the linear asset pricing relationship

=
m,

(5.41)
where is exposure to compensating shock risk, and

is an idiosyncratic error
term.

Remark 5.3. This pricing relationship resembles Treynor and Mazuy (1966) oft
cited market timing modelexcept that here the timing factor is convex down-
wards, i.e. concave, in minority bank compensation risk.

Corollary 5.14 (Ex ante compensation price of risk). The ex-ante compensation
price of risk for minority banks is positive, i.e. sgn(
m,
) > 0

37
Remark 5.4. This corollary implies that the compensating shock

caused the
price of risk for minority banks to go from
m
to +
m,
. That is, the price of
risk is transformed from negative to positive. From an econometric perspective,
OLS estimation of
m,
in Equation 5.41 suffers from classic errors-in-variables
problem which can be corrected by standard procedures. See (Kmenta, 1986,
pp. 348-349) and (Greene, 2003, pp. 84-86).

5.3 A put option strategy for minority bank compensating risk

The asset pricing relationship in Equation 5.41 implies that the compensating
shock to minority banks can be priced as a put option on the idiosyncratic adjusted-
risk in minority banks projects. To wit, the asset pricing relation is concave in
compensating shock risk. So isomorphically, a put strategy can be employed to
hedge against such risks. See e.g., Merton (1981); Henriksson and Merton (1981).
In fact, we propose the following pricing strategy motivated by Merton (1977).
Lemma 5.15 (Value of regulatory guarantee for compensating risk for minority
bank). Let B

be the value of the bonds held by loan guarantors or regulators

of minority banks, and V

m
be the value of the assets or equity in minority banks.
Let () be the cumulative normal distribution, and
V

m
be the variance rate per
unit time for log changes in value of assets. Suppose that bank assets follow the
dynamics
dV

m
(t, )
V

m
=

m
dt +
V

m
dW(t, )
where

m
and
V

m
are constants, andW(t, ) is Brownian motion in the state
. Let G

(T) be the value of a European style put option written on minority bank
compensating risk with exercise date T. The Black and Scholes (1973) formula for
the put option is given by
G

(T) = B

e
rT
(x
1
) V

m
(x
2
) (5.42)
38
where
x
1
=
log
B

m
(r +

2
V

m
2
)T

T
(5.43)
x
2
= x
1
+
V

T (5.44)

Remark 5.5. It should be noted in passing that the put option dynamics are func-
tionally equivalent to Vasicek (2002) loan portfolio model for return on assets
(ROA). Except that (Vasicek, 2002, pg. 2) decomposed the loan portfolio value
into 2-factors: (1) a common factor, and (2) company specic factor. Thus, we es-
tablish a nexus between a put option on the assets of minority banks, and concavity
in the asset pricing model for compensating shock in Equation 5.41.

5.3.1 Optimal strike price for put option on minority banks

Recently, (Deelstra et al., 2010, Thm. 4.2) introduced a simple pricing model for
the optimal strike price for put options of the kind discussed here. Among other
things, they considered a portfolio comprised of exposure to a risky asset X and a
put option P. They let P(0, T, K) be the time 0 price of a put option with strike price
K exercised at time T for exposure to risky asset X(T). Additionally, h, 0 h <1
is the allocation to the put option; (X(T)) is a coherent measure of risk
42
;
and C is the budget allocated for hedging expenditure for the portfolio H =
X, h, P. They assumed that the impact of short term interest rate was negligible
and formulated an approximate solution to the optimal strike price problem
min
h,K
[X(0) +C((1h)X(T) +hK)] (5.45)
s.t C = hP(0, T, K), h (0, 1) (5.46)
42
Given a probability space (, F, P) and a set of random variables dened on , the mapping : R is a
risk measure. The coherent measure of risk concept, which must satisfy certain axioms, was popularized by Artzner
et al. (1999).
39
Whereupon the optimal strike price K

is determined by solving the put option

relation
P(0, T, K) (K+(X(T)))
P(0, T, K)
K
= 0 (5.47)
Their put option P(0, T, K) is our G

(T); their asset X(T) is our V

m
(T); and their
strike price K is our B

. Thus, a bank regulator can estimate B

accordingly in
order to determine the put option premium on minority banks assets for insurance
purposes.
5.3.2 Regulation costs and moral hazard of assistance to minority banks
Using a mechanism design paradigm, Cadogan (1994) introduced a theory
of public-private sector partnerships with altruistic motive to provide nancial as-
sistance to rms that face negative externalities. There, he found that the scheme
encouraged moral hazard and that the amount of loans provided was negatively
correlated with the risk associated with high risk rms
43
. In a two period model,
Glazer and Kondo (2010) use contract theory to show that moral hazard will be
abated if a governments altruistic transfer scheme is such that it does not reallo-
cate money from savers to comparative dissavers. They predict a Pareto-superior
outcome over a Nash equilibrium with no taxes or transfers.
More on point, (Merton, 1992, Chapter 20) extended Merton (1977) put option
model to show[] that the auditing cost component of the deposit insurance pre-
mium is, in effect, paid for by the depositors, and the put option component is paid
for by the equity holders of the bank. In order not to overload this paper we did
not include that model here. Sufce to say, that by virtue of the put option charac-
teristic of the model used to price transfers, i.e. compensating shocks, to minority
banks, in order to mitigate moral hazard, theory predicts that minority banks will
bear costs for any regulation scheme ostensibly designed to compensate them for
the peculiarities of the risk structure of altruistic projects they undertake. This
gives rise to another minority bank paradoxminority banks must bear the cost of
transfer schemes intended to help them in order to mitigate moral hazard. The
literature on minority banks is silent on mitigating moral hazard in any transfer
scheme designed to assist themor for that matter distribution of the burden and
regulation costs of such schemes.
43
See e.g., (Laffont and Matrimint, 2002, Chapters 4, 5)
40
5.4 Minority banks exposure to systemic risk
An independently important consequence of the foregoing compensating relation-
ships is that when
S
is a random variable we have the following decomposition
of compensating risk factor
cov(

m
,

) =
m
cov(
S
,

) +cov(
m
,

) > 0 (5.48)
Assuming that cov(
S
,

) ,= 0, and
m
,= 0, we have the following scenarios for
cov(

m
,

) > 0:
Scenario 1. Negative exposure to systemic risk (
m
< 0). Either cov(
S
,

) < 0 and
cov(
m
,

) > 0 or cov(
S
,

) > 0 and cov(

m
,

) >
m
cov(
S
,

)
Scenario 2. Positive exposure to systemic risk (
m
> 0). Either cov(
S
,

) > 0 and
cov(
m
,

) >0 or (a) if cov(

S
,

) <0 and cov(

m
,

) >0, then cov(

m
,

) >

m
cov(
S
,

), and (b) if cov(

S
,

) >0 and cov(

m
,

) <0, then cov(

m
,

) <

m
cov(
S
,

)
As a practical matter the foregoing analysis is driven by exposure to systemic
risk (
m
). From an econometric perspective, since

n
we would expect that
on average the residuals from our factor pricing model are such that e

m
e

n
.
From which we get the two stage least squares (2SLS) estimators for systemic
risk exposure

m
=
cov(e

m
,
S
)

2
S
(5.49)

n
=
cov(e

n
,
S
)

2
S
(5.50)

n
(5.51)
This is an empirically testable hypothesis.
More on point, Scenario 1 plainly shows that when minority banks are
subject to negative exposure to systemic risks, they need a good, i.e. positive,
compensating shock

to idiosyncratic risks. That is tantamount to an infusion

of cash or assets that a regulator or otherwise could provide. The situations in
Scenario 2 are comparatively more complex. In that case minority banks have
positive exposure to systemic risks, i.e. there may be a bull market, low unem-
ployment, and other positive factors affecting bank clientele. We would have to
41
rule out sub-scenario (a) as being incongruent because a good shock to idiosyn-
cratic risk would be undermined by its negative correlation with systemic risk to
which the bank has positive exposure. So that any sized good shock to idiosyn-
cratic risk is an improvement. A similar argument holds for sub-scenario (b) be-
cause any sized negative correlation between good shocks and idiosyncratic risks
is dominated by the positive exposure to systemic risks and positive correlation
between good shocks and systemic risks. Thus, Scenario 2 is ruled out by virtue
of its incoherence with compensatory transfers. In other words, Scenario 2 is the
rising-tide-lifts-all-boats phenomenon in which either sufciently large good id-
iosyncratic or systemic shocks mitigate against the need for compensatory shocks.
The foregoing analysis gives rise to the following
Theorem 5.16 (Compensating minority banks negative exposure to systemic risk).
Let

m
=
m

S
+
m
, and
= 2cov(

m
,

)
2

be a compensating risk factor for minority banks relative to nonminority banks.

Then a coherent response to compensating minority banks for negative exposure
to systemic risk is infusion of a good shock

to idiosyncratic risks
m
.
That is, to generate similar IRR payoffs, given similar managerial skill at mi-
nority and nonminority banks, minority banks need an infusion of good shocks to
idiosyncratic risks in projects they undertake. That is, under Brimmers surmise a
regulator could compensate minority banks with good

shocks for trying to ll a

void in credit markets. By contrast, non-minority banks do not need such shocks
because they enjoy a more balanced payoff from both systematic and idiosyncratic
risks in the projects they undertake.
6 Minority Banks CAMELS rating
In this section we provide a brief review of how a regulators CAMELS rat-
ing/score may be derived. In particular, the choice set for CAMELS rating are
determined by regulation:
Under the UFIRS, each nancial institution is assigned a composite rat-
ing based on an evaluation and rating of six essential components of an
42
institutions nancial condition and operations. These component fac-
tors address the adequacy of capital, the quality of assets, the capability
of management, the quality and level of earnings, the adequacy of liq-
uidity, and the sensitivity to market risk. Evaluations of the components
take into consideration the institutions size and sophistication, the na-
ture and complexity of its activities, and its risk prole.
Source: UFIRS Policy Statement (eff. Dec. 20, 1996). Composite ratings re-
ect component ratings but they are not based on a mechanical formula. That
is, [t]he composite rating generally bears a close relationship to the component
ratings assigned. However, the composite rating is not derived by computing an
arithmetic average of the component ratings, op. cit. Moreover, CAMELS scores
are assigned on a scale between 1 (highest) to 5 (lowest). Given the seemingly sub-
jective nature of score determination, analysis of CAMELS rating is of necessity
one that falls under rubric of discrete choice models.
6.1 Bank examiners random utility and CAMELS rating
The analysis that follow is an adaptation of (Train, 2002, pp. 18-19) and relies on
the random utility concept introduced by Marschak (1959). Let
C 1, 2, 3, 4, 5 the choice set, i.e., possible scores, for CAMELS rating
U
nj
utility regulator/examiner n obtains fromchoice of alternative j, i.e., CAMELS
score, from choice set C
x
nj
attributes of alternatives, i.e., CAMELS components, faced by regulator
s
n
be attributes of the regulator/examiner
V
nj
= V
nj
(x
n j
, s
n
) representative utility of regulator specied by researcher

nj
unobservable factors that affect regulator utility

n
= (
n1
, . . . ,
n5
)
/
is a row vector of unobserved factors
U
nj
= V
nj
+
n j
random utility of regulator
43
The researcher does not know
nj
but species a joint distribution f (
n
). So that
the probability that she chooses to assign a CAMELS score i instead of an alter-
native CAMELS score j is given by
P
ni
= Pr(U
ni
>U
nj
) (6.1)
= Pr(V
ni
+
ni
>V
nj
+
nj
, j ,= i) (6.2)
= Pr(
n j

ni
<V
ni
V
nj
, j ,= i) (6.3)
This probability is known since V
ni
V
nj
is observable, and the distribution of

n
was specied. In particular, if I is an indicator function, then
P
ni
=
_

n
I(
n j

ni
<V
ni
V
nj
, j ,= i) f (
n
)d
n
(6.4)
In Lemma 4.1 we derived a probit model for bank specic factors. Thus, we
implicitly assumed that
n
has a mean zero multivariate normal distribution

n
N (0,) (6.5)
with covariance matrix . Suppose that for some unknown parameter vector
V
nj
=
/
x
n j
, so that (6.6)
U
nj
=
/
x
n j
+
n j
(6.7)
The bank regulators CAMELS rating is given by
Pr(CAMELSrating 1 ~2 ~3 ~4 ~5)
= Pr(U
n1
>U
n2
>U
n3
>U
n4
>U
n5
)
(6.8)
Let

U
njk
=U
n j
U
nk
(6.9)
x
njk
= x
n j
x
nk
(6.10)

njk
=
n j

nk
(6.11)
44
So that by subtracting adjacent utilities in reverse order, i.e. low-high, we trans-
form
Pr(U
n1
>U
n2
>U
n3
>U
n4
>U
n5
) = Pr(

U
n21
<

U
n32
<

U
n43
<

U
n54
) (6.12)
The random utility transformation is based on a design matrix
MMM =
_
_
_
_
1 1 0 0 0
0 1 1 0 0
0 0 1 1 0
0 0 0 1 1
_
_
_
_
(6.13)
In which case, for the vector representation of random utility
U
n
=V
n
+
n
(6.14)
we can rewrite Equation 6.12 to get the probit generated probability for the regu-
lator
Pr(CAMELSrating 1 ~2 ~3 ~4 ~5)
= Pr(

U
n21
<

U
n32
<

U
n43
<

U
n54
)
(6.15)
= Pr(MMMU
n
< 0) (6.16)
= Pr(MMM
n
<MMMV
n
) (6.17)
Whereupon we get the transformed multivariate normal
MMM
n
N (000, MMMMMM
/
) (6.18)
6.2 Bank examiners bivariate CAMELS rating function
The analysis in Section section 4, based on Vasicek (2002) model, suggests the
existence of a hitherto unobservable bivariate CAMELS rating function U(), i.e.,
random utility function, for a bank examiner/regulator, which is monotonic de-
creasing in cash ows K, and monotonic increasing in exposure to systemic risk
. In other words, we have an unobserved function U(K, ) where
Assumption 6.1.
U
K
=
U
K
< 0 (6.19)
45
Assumption 6.2.
U

=
U

> 0 (6.20)
However, under Vasicek (2002) formulation, K is a proxy for bank specic fac-
tor Z, and is a proxy for systemic factor Z
S
. In the context of our factor pricing
Lemma 5.9 the bivariate CAMELS function reveals the following regulatory be-
havior. For r = m, n substitute
K
r
Z
r
=
sgn(
r
)
r

_
T(1
r
)
(6.21)

T
r
Z
S

S
(6.22)
Since dZ
r
d
r
we have
U

r
=
U

sgn(
r
)
r

_
T(1
r
)
U
K
r
(6.23)
According to Equation 6.19 this implies that for minority banks
U

m
=

m

_
T(1
m
)
U
K
m
> 0 (6.24)
That is, the regulators CAMELS rating is increasing in the risk
m
for minority
bank projects
44
. Thus, behaviorally, regulators are biased in favor of giving mi-
nority banks a high CAMELS score by virtue of the negative risk factor price for
NPV projects undertaken by minority banks. By contrast, under Assumption 6.1
U

n
=

n

_
T(1
n
)
U
K
n
< 0 (6.25)
44
According to (U.S. GAO Report No. 07-06, 2006, pg. 37) bank examiners frown on cash transaction by virtue
of the Bank Secrecy Act which is designed to address money laundering. However, traditionally, in many immigrant
communities there are large volumes of cash transaction. A scenario which could cause an examiner to give a lower
CAMELS score.
46
which implies that regulators are biased in favor of giving a low CAMELS score
for nonminority peer banks by virtue of the positive risk factor price for their NPV
projects. Continuing with the behavioral analysis, we have
U

S
=

T
r
Z
S

2
S
U

(6.26)
According to the UFIRS policy statement on sensitivity to market risk, small
minority and nonminority peer banks are primarily exposed to interest rate risk.
Heuristically, other things equal, a decrease in interest rates could increase small
bank capital because they could issue more loans against relatively stable deposits.
In which case, the Z
S
market wide variable, and hence is positive. Behaviorally,
under Assumption 6.2, this implies that
U

S
=

T
r
Z
S

2
S
U

< 0 (6.27)
That is, regulators would tend to decrease CAMELS scores for minority and non-
minority peer banks alike when interest rates are declininng, ceteris paribus. The
reverse is true when interest rates are rising. In this case, the extent to which the
CAMELS score would vary depends on the pairwise correlation
r
for the distri-
bution of risk factors driving the banks ROA.
Another independently important sensitivity analysis stems fromthe reg-
ulators behavior towards unconditional volatility of loan portfolio value , in
Equation 4.2, based on bank specic factors. There we need to compute
U

=
U

=
U
K
r
K
r

(6.28)
=U
K
r
sgn(
r
)
r

2
_
T(1
r
)
(6.29)
Once again, bank regulator attitude towards is affected by their attitudes towards
K
r
and sgn(
r
). In particular, type m banks tend to get higher CAMELS scores
for their loan portfolios because of their asset pricing anomaly sgn(
m
) < 0.
The foregoing results give rise to the following
Lemma 6.3 (Behavioral CAMELS scores). Let r = m, n be an index for minority
and nonminority banks, and U(K
r
,
r
) be a bivariate random utility function for
bank regulators. Let be the unconditional volatility of loan portfolio value,
r
be
47
the risk in NPV projects undertaken by type r banks,
r
be the corresponding risk
factor price, and
r
be exposure to systemic risk. Then bank regulators CAMELS
scores are biased according to
U

r
=
U

sgn(
r
)
r

_
T(1
r
)
U
K
< 0 (6.30)
U

=
U

=U
K
r
sgn(
r
)
r

2
_
T(1
r
)
(6.31)
U

S
==
U

S
=

T
r
Z
S

2
S
U

> 0 (6.32)
In particular, bank regulators are biased in favor of giving type m banks high
CAMELS scores by virtue of the negative risk factor price for their NPV projects;
and biased in favor of giving type n banks low CAMELS scores by virtue of their
positive factor price of risk. Bank regulators CAMELS scores are unbiased for
type m and type n banks exposure to systemic risk.

Remark 6.1. The random utility formulation implies that there is an idiosyncratic
component to CAMELS scores. That is, bank regulators commit Type I [or Type
II] errors, accordingly.

As a practical matter we have

V
n
j =
/
x
nj
, where (6.33)
x
n j
= (K, )
/
,
/
= (
0
,
1
) (6.34)
U
n j
=
/
x
nj
+
nj
(6.35)
where j corresponds to the CAMELS score assigned to bank specic factors, as
indicated. It should be noted that the management component of CAMELS con-
templates risk management in the face of systemic risks. Ignoring the nj subscript
we write U instead of U
n j
to formulate the following
Proposition 6.4 (Component CAMELS rating of minority banks). Let the sub-
scripts m, n pertain to minority and nonminority banks. Let
S
be a measure of
market wide or systemic risks; K
m
t
(
m
[
S
) and K
n
t
(
n
[
S
) be the cash ows;
48
and
n
,
m
be the risks associated with projects undertaken by nonminority and
minority banks, respectively. Let
m
,
n
be the exposure of minority and nonmi-
nority banks to systemic risk. Let U(K, ) be a bivariate CAMELS rating function.
Assume that
U
K
< 0, and
U

> 0
so the marginal densities U
[K
(K)
1
and U
[
. Assume that the IRR and
managerial ability for minority and nonminority banks are equivalent. Let be
the space of market exposures, X be the space of cash ows; () is the probability
density function for state contingent cash ows; and () is the probability density
for state contingent market exposure. Then we have the following relations:
1. The probability limit for minority bank exposure to systemic risk is greater
than that for nonminority banks:
Plim


m
Plim


n
(6.36)
2. As a function of cash ow generated by NPV projects, the expected compo-
nent CAMELS rating for minority banks, is much higher than the expected
CAMELS rating for nonminority banks
E[U
[K
(K
m
)] = E[
_

U(K
m
,
m
)(
m
)d
m
] (6.37)
E[U
[K
(K
n
)] = E[
_

U(K
n
,
n
)(
n
)d
n
] (6.38)
3. As a function of exposure to systemic risk, the expected component CAMELS
rating for minority banks is much higher than that for nonminority banks
E[U
[
(
m
)] = E[
_
X
U(K
m
,
m
)(K
m
)dK
m
] (6.39)
E[U
[
(
n
)] = E[
_
X
U(K
n
,
n
)(K
n
)dK
n
] (6.40)

49
7 Conclusion
Using microfoundations, this paper provides a menu of criteria which could be
used for performance evaluation, regulation, and pricing of minority banks. We
provide formulae for project comparison of minority and nonminority peer banks,
ceteris paribus. And show how synthetic options on those cash ows are derived.
Additionally, starting with dynamics for a banks return on assets, we introduce a
simple bank failure prediction model and show how it relates to the probit class.
That dynamic model also laid the foundation of a two factor asset pricing model.
Furthermore, we introduced an augmented behavioral mean-variance type asset
pricing model in which a measure for compensating risks for minority banks is
presented. Whereupon we nd that isomorphy in that asset pricing model is func-
tionally equivalent to a regulators put option on minority bank assets. And we
showhowto determine an optimal strike price for that option. In particular, despite
the negative beta phenomenon minority banks portfolios are viable, if not inef-
cient, provided that the risk free rate is less than that for the minimum variance
portfolio of the portfolio frontier. Finally, we provide a brief review of how a reg-
ulators seemingly subjective CAMELS score can be predicted by a polytomous
probit model induced by random utility analysis. And we use that to show how
bank examiner/regulator behavior can be described by a bivariate CAMELS rating
function. The spectrum of topics covered by our theory suggests several avenues
of further research on minority banks. In particular, security design motivated by
synthetic cash ow relationship between minority and nonminority banks; optimal
bidding in the pricing of failing minority banks; real options pricing in lieu of NPV
analysis of projects undertaken by minority and nonminority peer banks; econo-
metric estimation and testing of seemingly anomalous asset pricing relationships;
behavioral analytics of bank examiner CAMELS rating; and regulation costs asso-
ciated with providing assistance to minority banks all appear to be independently
important grounds for further research outside the scope of this paper.
50
A Appendix of Proofs
A.1 PROOFS FOR SUBSECTION 2.1 DIAGNOSICS FOR IRR FROM NPV PROJECTS
OF MINORITY AND NONMINORITY BANKS
Proof of Lemma 2.10
Proof. Since the summand comprises elements of a telescoping series, the inequal-
ity holds if >1+IRR
m
. See (Apostol, 1967, pg. 386) for details on convergence
of oscillating and or telescoping series.
Proof of Lemma 2.16
Proof. Let F(d
m
) be the [continuous] distribution function for the discount rate
d
m
. For a present value PV(d
m
) on the Hilbert space L
2
d
m
dene the k-th period
cash ow by the inner product
K
k
=< PV(d
m
), P
k
(d
m
) > =
_
d
m
X
PV(d
m
)dF(d
m
) (A.1)
Orthogonality of P
k
implies
< P
i
(d
m
), P
j
(d
m
) > =
_
1 if i = j
0 otherwise
(A.2)
Moreover
PV(d
m
) =

k=0
K
k
P
k
(d
m
) (A.3)
So that
< PV(d
m
), P
k
(d
m
) > = 0 (A.4)
<

k=0
PV(d
m
), P
k
(d
m
) >= 0 (A.5)
K
k
= 0 (A.6)
51
Prooof of Lemma 2.18
Proof. Consider the ltered probability space (, F, F
t

t0
, P) in Corollary
2.12. By an abuse of notation, for some small, and k discrete, let F
k
be a
-eld set such that the set
A
k
=[ K
m
t
() K
n
t
() F
k
(A.7)
P(A
k
) < 2
k
(A.8)
So that
lim
k
P(A
k
) = 0 (A.9)
Let
M
q
=/

_
k=q
A
k
(A.10)
be the set of -convergence. In which case, we have the set of convergence

q=1
M
q
, and the corresponding set of divergence given by
A =/

_
q=1
M
q
=

p=1

_
k=p
A
k
(A.11)
So that
P(A) = lim
k
P(A
k
) = 0 (A.12)
Since the set has probability measure 0 only when k , it implies that for k <,
there exist n
0
such that
P(A) = P(

p=n
0

_
k=p
A
k
) (A.13)
52
So that
P(A
k
) P(A) P(

_
k=n
0
A
k
) <

k=n
0
2
k
= 2
n
0
+1
(A.14)
Whereupon
P(A
c
k
) P(A
c
) 12
n
0
+1
(A.15)
P([ K
m
t
() K
n
t
() < ) 12
n
0
+1
= 1 (A.16)
which has the desired form for our proof when = 2
n
0
+1
. That is, in the context
of our theory, there are nitely many times when the cash ow of a minority bank
exceeds that of a nonminority bank. But countably many times when the con-
verse is true. That is. the number of times when nonminority banks cash ows are
greater than that for minority banks is much greater than when it is not.
Proof of Corollary 2.19
Proof. Since E[K
m
t
] E[K
n
t
], it follows from (Myers, 1977, pg. 149) that nonmi-
nority banks pass up positive cash ow projects with low return in favor of those
with higher returns in order to maximize shareholder wealth. To see this, assume
that the random variables
K
m
t
= K
n
t
+
t
(A.17)
where
t
has a truncated normal probability density. That is
(
t
) =
_
_
_
2

2
t
2

t
0
0
t
> 0
(A.18)
Furthermore,

2
K
m
t
=
2
K
n
t
+
2

t
+2

t
,K
n
t
(A.19)
53
where
2
()
is variance and

t
,K
n
t
the covariance term is negative for any positive
cash ow stream K
n
t
. We have two scenarios for

t
,K
n
t
< 0 (A.20)
i. If

t
,K
n
t
is sufciently large, i.e. 2[

t
,K
n
t
[
2

t
then
2
K
m
t
<
2
K
n
t
. That is,
the risk in the cash ows for minority banks is lower than that for nonminor-
ity banks. In that case nonminority banks have a higher expected cash ow
stream for more risky projects. So that, [risk averse] nonminority banks are
compensated for the additional risk by virtue of higher cash ows. For exam-
ple, under Basel II they may be hold more mortgage backed securities (MBS)
or other exotic options in their portfolios. In which case, minority banks
are more heavily invested in comparatively safer short term projects. The
higher expected cash ows for nonminority banks implies that their invest-
ment projects [rst order] stochastically dominates that of minority banks. In
either case, minority bank projects are second best.
ii. If
2
K
m
t
>
2
K
n
t
, then the risk in minority bank projects is greater than that for
nonminority banks. In this case, the risk-return tradeoff implies that minority
banks are not being compensated for the more risky projects they undertake.
In other words, they invest in risky projects that nonminority banks eschew.
Thus, they invest in second best projects.
Thus, by virtue of the uniform dominance result in Lemma 2.17, it follows that
the expected cash ows for minority banks, E[K
m
t
], must at least be in the class
of second best projects identied by nonminority banks-otherwise the inequality
fails.
A.2 PROOFS FOR SUBSECTION 3.1 MINORITY BANK ZERO COVARIANCE FRON-
TIER PORTFOLIOS
Proof of Proposition 3.3
Proof. Following (Huang and Litzenberger, 1988, Chapter 3), let www
r
, r = m, n be
the vector of portfolio weights for minority (m) and nonminority (n) banks frontier
54
portfolios. So that for some vectors ggg and hhh we have
www
m
=ggg+hhhE[IRR
m
] (A.21)
www
n
=ggg+hhhE[IRR
n
] (A.22)
According to the two fund separation theorem, there exist and a portfolio (E[IRR
q
],
q
]
such that upon substitution for E[IRR
m
] and E[IRR
n
] we get
E[IRR
q
] =E[IRR
m
] +(1+)E[IRR
n
] (A.23)
=ggg+hhh[(1+)E[IRR
n
] E[IRR
m
]]
(A.24)
From Lemma 3.2 write
IRR
r
=
r0
+
r

r
+
r

S
+
r
, r = m, n
(A.25)
And let

m
=
m

S
+
m
(A.26)

n
=
n

S
+
n
(A.27)
Without loss of generality assume that
cov(
m
,
n
) = 0 (A.28)
To get the zero covariance portfolio relationship between minority and nonminor-
ity banks, we must have
cov(IRR
m
, IRR
n
) = E[(IRR
m
E[IRR
m
])(IRR
n
E[IRR
n
])]
(A.29)
= E[

n
] (A.30)
=
m

2
S
+
m
cov(
S
,
n
) +
n
cov(
S
,
m
) +cov(
m
,
n
)
(A.31)
= 0 (A.32)
55
Divide both sides of the equation by
m

2
S
to get
1

m
cov(
S
,
m
)

2
S
+
1

n
cov(
S
,
n
)

2
S
+1 = 0, so that (A.33)

Sm

m
+

Sn

n
+1 = 0 (A.34)
Since each of
m
and
n
prices the banks exposure to economy wide systemic risk,
we can assume concordance in this regard. So that

n
> 0, and
m
> 0 (A.35)
For Equation A.34 to hold we must have
either
Sm
< 0 or
Sn
< 0 or both (A.36)
But by hypothesis in Lemma 3.2,
m
< 0. Therefore, it follows that for internal
consistency we must have

Sm
< 0 (A.37)

Sn
> 0 (A.38)
That is

Sn

n
+1 =

Sm

m
(A.39)
In Equation A.23 let

Sm

m
= (A.40)
to complete the proof.
Remark A.1. Each of the 4-parameters
Sm
,
Sn
,
m

n
can have +ve or -ve signs.
So we have a total of 2
4
= 16 possibilities. The zero-covariance relation in Equa-
tion A.34 rules out the case when the signs of all the parameters are -ve or +ve.
Thus, we are left with 14-possible scenarios that satisfy Equation A.34. In fact,
Meinster and Elyasini (1996) found that minority and nonminority banks hold in-
56
efcient portfolios. In which case, its possible that
Sm
and
Sn
each have negative
signs. If so, then either
m
< 0 or
n
< 0. Thus, our assumption in Equation A.35
can be weakened accordingly without changing the result.
A.3 PROOFS FOR SECTION 4 PROBABILITY OF BANK FAILURE WITH VA-
SICEK (2002) TWO-FACTOR MODEL
Proof of Lemma 4.1
Proof. Rewrite

1
(p)(XZ

1)

1
, as (A.41)

0
+X
1
+Z
2
, where (A.42)

0
=

1
(p)
(1p)
;
1
=
1
(1p)
, and
2
= 1 (A.43)
In matrix form this is written as XXX
/
where 1, X, Z are the column vectors in the
matrix, and the prime
/
signies matrix transposition, so
XXX = [1 X Z] (A.44)
And
= (
0

1

2
)
/
(A.45)
is a column vector. In which case
p(Z[ X) =(XXX
/
) (A.46)
which is a conditional probit specication.
A.4 PROOFS FOR SECTION 5 MINORITY AND NONMINORITY BANKS ROA
FACTOR MIMICKING PORTFOLIOS
PROOFS OF LEMMA 5.11
57
Proof. Assuming that
K
=, (Cadogan, 2009, Prop. II.B.1) showed how Arrow-
Pratt risk measure r(x) can be embedded in a Markov process X =X(t, ), F
t
; 0
t < by virtue of the innitesimal generator
L =

2
2

2
x
2
+r(x)

x
(A.47)
which, for Brownian motion B(t, ) dened on F
t
produces
dX(t, ) = r(X(t, ))dt +dB(t, ) (A.48)
In our case, we assume that risky cash ow K = X follows a Markov process
K =K(t, ), F
t
; 0 t <. Cadogan considered a simple dynamical system
K(t, ) =
_
t
0
e
Rs
H(s, )ds (A.49)
dK(t, ) =C(t)dU(t, ) (A.50)
dK(t, ) = r(K)dt +(K)dB(t, ) (A.51)
(A.52)
where K(t, ) is the discounted cash ow H(t, ), F
t
; 0 t <, and U(t, )
and B(t, ) are Brownian motions. After some simplifying assumptions motivated
by Kalman-Bucy lter theory, and (ksendal, 2003, pp. 99-100), he derived the
solution
r(K(t, )) =

cosh(ct)
_
t
0
sinh(cs)dK(s, ) (A.53)
=

cosh(ct)
_
t
0
sinh(cs)e
Rs
H(s, )ds (A.54)
Assuming that minority and nonminority banks risky cash ows follows a Markov
process described by the simple dynamical system, then under the proviso that
R = IRR, other things equal, i.e.
K
= and H(s, ) is the same for each type
of bank, substitution of IRR
n
= IRR
m
+ in the solutions for r(K
m
(t, ) and
comparison with the solution for r(K
n
(t, )), leads to the result r(K
m
(t, )) >
r(K
n
(t, )). The proof follows by application of (Gikhman and Skorokhod, 1969,
Thm. 2, pg. 467) for dyadic partition t
(n)
k
, k = 0, 1, . . . , 2
n
in C([0, 1]), and Roth-
schild and Stiglitz (1970) deformation of nite dimensional distribution functions
58
for r(K
r
(t
(n)
n
1
, )), . . . , r(K
r
(t
(n)
n
k
, )), n
k
0, . . . , 2
n
to shift probability weight
to the tails.
59
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