Of course, the extra two factors create a compelling reason for banks to move away from warehousing activities. Increasingly, financial firm P&L’s are driven by origination, distribution and other related service activities. How should we think about pricing and capital budgeting once these activities are important?

In fact, little in the analysis above needs to change. Indeed, all of the above analysis goes through for firms that have no financial businesses. Well-run firms regardless of industry have scarce internal buffers, so the second and third factors remain important. The first factor is traditionally used for capital budgeting in non-financial firms, so it remains as well.

However, there is an important underlying change in emphasis. First, in diversified financial firms, pricing decisions more often apply to business lines or units rather than individual contractual positions. After all, business line risks stress capital more than particular balance sheet exposures. The framework remains useful for benchmarking business lines’ profits against the risks that they generate for the firm overall. And it is important to have hurdle rates for business lines, both for capital budgeting and acquisition/divestiture decisions.

Second, there is a change in regulatory emphasis as well. Clearly, bank-wide capital requirements have to be evaluated based not only on balance sheet exposures, but on the business risk of the firm. Regulators need to be mindful of the externalities associated with marrying a fee or service business with a bank. I discussed the positive externalities of such a marriage when I added the expected profitability of service activities to VaR.

However, this marriage also brings negative externalities. Standalone origination activities, for example, themselves carry little systemic risk. A nonfinancial firm may become insolvent or illiquid, but that is unlikely to spread to other firms or to affect the financial sector at large. However, once warehousing and other services are combined in a single firm, systemic and firm-liquidity risks can be triggered from outside of the warehousing sector. This is the reason that a movement toward greater corporate separation of warehousing and origination/distribution activities is beneficial. And when such activities remain co-mingled, regulators need to ensure these added risks are taken into account.