As financial institutions evolve, the definition of capital needs to evolve as well. To have a meaningful discussion of capital requirements for today’s forward looking financial firms, we need to clarify and develop the meaning of capital in financial firms.

Historically, the primary purpose of financial firms – be they commercial banks, investment banks, insurers or others – was to use their balance sheets to intermediate in relatively illiquid assets. Illiquid assets are informationally intensive. They may be subject to potentially important informational asymmetries in their trading, or they may lack standardization, and therefore require a high degree of individual inspection. Classic examples of such illiquid assets include small and mid-size company loans, all forms of insurance contracts, young-company equity and debt claims, real estate loans, etc.

Traditionally, it is through the intermediation process that illiquid assets have become more liquid. Banks and other financial institutions aggregate exposures, each of which is extremely illiquid, and finance the exposure pool through the issuance of their own liabilities and equity. The liquidity of these pooled claims against banks is far greater than the liquidity of the average exposure that the bank takes on. In this way, financial firms reduce transaction costs in comparison with a system that passes each exposure directly into the financial marketplace.

However, while traditional financial firms reduce transaction costs associated with direct market access, by no means do they minimize the transaction costs of warehousing. Indeed, when compared with special purpose vehicles, financial firms may actually subtract liquidity in the warehousing of assets they originate. There are a number of reasons for this.

First, pools of claims are not very transparent when held by banks. Often, little in the way of specifics is provided on the composition of the portfolio of assets or on the risk characteristics of that portfolio. This is not the case in many special purpose vehicles that provide investors with considerable detail about the composition, historic performance, and risk characteristics of pooled assets.

Second, inside financial firms, the pools change over time according to the discretion of managers. Managers receive salaries, perks, bonuses, equity, and options and are therefore not likely to have incentives that are perfectly aligned with those of any specific capital provider and certainly not those of equity holders. In addition, for a variety of reasons, managers do not provide details on how their firms’ asset pools will evolve over time. Such dynamic discretion is especially important for financial firms, since their risk balance sheet profile can change far more quickly than it can for nonfinancial firms. Many special purpose vehicles have clearly-defined rules circumscribing dynamic managerial discretion, sometimes eliminating it completely.

Third, capital providers historically have no choice but to fund the pool of assets (i.e., the warehouse) together with the associated origination and distribution activities. Banks make loans and take on credit exposures, insurance companies warehouse their underwriting opportunities, etc. In some instances it may be more profitable to separate the warehousing from the origination and distribution. As I discuss below, this contributes to considerable inefficiency and lack of information production about the asset pool and about financial firm performance.

Fourth, traditional financial corporations have a tax status that resembles other corporations, rather than that of pass-through vehicles that are not subject to corporate taxes. This adds an extra, but unnecessary, layer of taxation to the warehousing function when it is located within a standard bank or insurance company.

Finally, traditional financial firms are highly regulated. In some instances regulation may be a justifiable cost – it makes financial firms behave more prudently than they otherwise would. However, in other circumstances regulations may make firms behave more conservatively than markets realistically require. By asking markets to provide collateral dedicated to specific warehousing portfolios it is possible to use market prices to gain a better gauge on the appropriate level of conservatism at the same time as shifting any implied performance guarantees away from governmental institutions and towards investors.

All these factors contribute to additional costs of warehousing in traditional financial firms, costs for which capital providers necessarily charge. A higher cost of capital makes the warehousing function of financial institutions relatively inefficient.

In recent years, there has been an enormous increase in the rate at which forward-thinking financial institutions have been responding to these inefficiencies. Essentially, they have been diversifying into fee businesses associated with origination and distribution, at the same time as they have trimming their traditional warehousing functions. Securitization of assets and asset pools and the creation of special purpose vehicles to warehouse them occurred on a wide scale, and will continue for many financial institutions over the next decade. In addition, there has been considerable growth in off-shore activities which are designed to provide warehousing in tax-advantaged and friendly regulatory environments.

Securitized pools in principal avoid many of the inefficiencies mentioned above. They exhibit far greater transparency – both static and dynamic – for their capital providers. Given their dedicated, special purpose nature, they provide for little or no managerial discretion, and therefore far less opacity. Furthermore, there is typically no layer of corporate taxation, since such entities are mere pass-through vehicles.

This change in the mix of financial firm activities has far reaching implications for both the capital markets and the definitions of economic and regulatory capital at financial firms.

First, for capital markets, the dynamics change the reliance on markets versus institutions to deliver liquidity. For example, for claims that were warehoused by banks, liquidity arose through the central bank providing funds to financial firms to avoid their needing to call in loans. Liquidity was in part provided through the use of deposit insurance which, by guaranteeing depositor liquidity, stemmed the bank run phenomenon. However, even with deposit insurance, banks under financial pressure reduce liquidity by failing to lend, as evidenced by Japan over the last decade.

Second, the proliferation of arms’ length capital market transactions between originators and warehousers changes the norm surrounding book versus market valuation. If portfolios of loans that back CLOs are implicitly valued in the market on a daily basis through the daily pricing of the CLOs, why shouldn’t one do the same for portfolios of loan that back bank liabilities? And if one marks to market the assets of banks, wouldn’t we use market values for measuring bank capital?