Given the evolution of financial institutions away from basic warehousing functions, the notion of ‘capital’ becomes more involved. Functionally, it is useful to think of capital as a buffer against negative shocks to firm value. In a world in which warehousing is overwhelmingly the most important function, a complete definition of capital would be as above – the market value of the tangible assets less the liabilities. In such a world, the regulator is perhaps appropriately focused on measuring the risks associated with warehoused exposures – market, credit, liquidity risk, etc., all take center stage.

However, in a world where warehoused assets may turnover – and rapidly – and where rents are earned from origination and distribution, tangible assets do not constitute the entire market value of the firm. There may be profits that accrue to dynamic portfolio management and origination and related service activities. If such profits are important, why wouldn’t we consider them as part of the buffer against which loss events might be tallied? After all, if a loss is offset by profits, then balance sheet capital need not be called upon.

Reciprocally, if trading, origination and related service activities become important as sources of income, they may also become important as sources of firm-wide risk. Firms may experience stress events because of losses in these activities. So isn’t it important to include these risks in measures of economic and regulatory capital?

With this in mind, recent papers have therefore turned toward expanding the concept of the buffer beyond traditional measures of balance sheet capital to include earnings and profits.