The Definition of Bank and the Subprime Mortgage Crisis: Tying Bank Regulation to Banks’ Risk-Return Trade-offs in the 21st Century

Following the onset of the August 2007 subprime mortgage crisis, bank regulators suggest that the old definition of bank may be too narrow – that banking has partially escaped their purview. Perhaps, but this may be partly the regulators’ own doing. We develop this proposition through identification of a measure of differences among global financial institutions that drives a bank-specific risk priced by bank shareholders. We find the most profitable banks are also the least regulated. Yet we find that the least profitable regulated banks in our sample were the most exposed to hazards related to the first subprime mortgage crisis. Thus the risk bared by the subprime mortgage crisis was different from the rent-generating risk associated with profitable banking. Our proposed resolution to this conundrum distinguishes between opaque rent-generating risks taken by profitable private institutions, and transparent taxpayer-subsidized risks taken by large banks that are thinly disguised wards of the state.