Banking

Loss Aversion and The Risk Premium for Minority Banks Seemingly Altruistic Portfolios in Underserved Communities

Several countries have policies geared towards providing access to credit and other banking services to undeserved ethnic or religious minorities, e.g., India, China, Malaysia, South Africa, United States. In this paper, we characterize the compensating risk premium for minority banks (MBs) that participate in such social preference programs. Our theory apparatus synthesizes KMV Moody loan portfolio model with statistical risk accounting. We find that differences in internal rate of return (IRR) and interest rate elasticity of bond prices, for MBs and (nonminority) peer banks (PBs), induce an anomalous concave risk return pricing structure for MBs. We show how the concave payoff structure is convexified with compensating risk factors. We apply the theory to US MBs seemingly altruistic motives to provide banking services and access to credit in underserved communities. Using Federal Reserve Statistical Release on select FFIEC Form 031 (``Call Report") data for a sample of US banks, we fit a risk-return function for MBs and estimate the compensating risk premium for return on assets. We use a novel application of security market line analysis to construct a robust estimator of loss aversion indexes for the following MBs: Low Income Credit Union (3.56), Native American (3.17), Caucasian-Women (3.05), Black (2.93), Asian (2.78), and Hispanic (2.42). With the exception of Asian-American and Hispanic banks, other MBs are clustered near the minimum return-risk range. Thus, they hold inefficient frontier portfolios. In fact, without brokered deposits only Caucasian Women and Hispanic Banks remain profitable. We estimate the compensating return required to convexify payoffs. We extended the analysis to a pseudo panel of minority banks and estimate a range of relationships including but not limited to: the extent of loan provision constraints for minority banks, heterogeneity in MBs Tier 1 (risk based) capital, loan dependence on brokered deposits, bank profitability, etc.

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