That paper cast the debate on the potential objectives of such a regime as a choice between ‘protecting banks from the cycle’ and ‘protecting the economy from the banks’. Macroprudential policy could focus narrowly on building resilience in the financial system in a dynamic way, so that it was better able to absorb large adverse shocks. Or it could pursue the broader and bolder objective of smoothing the swings in debt and asset prices associated with the financial cycle. The subsequent academic literature has usefully refined how we think about these goals of a macroprudential regime. One fruitful strand has focused on the pecuniary externalities generated by fire-sales in asset markets (Lorenzoni (2008), Jeanne and Korinek (2010), Bianchi and Mendoza (2010), Benigno et al (2013)). Collateralised borrowing leads to externalities because individual borrowers do not internalise the fact that increasing debt in good times raises the likelihood they will be forced to sell assets following adverse shocks, pushing prices lower, tightening collateral constraints and exacerbating downturns. These feedback and amplification loops can mean that private borrowing in good times is greater than a social planner would choose, facing the same constraints. That is the theory. Experience during the crisis tends to support the importance of these transmission channels. When highly-levered banks were forced to 31  All speeches are available online at www.bankofengland.co.uk/speeches  31  sell illiquid assets at highly discounted prices, this lowered valuations further and tightened constraints for other banks (Brunnermeier (2009)). This contributed to the depth and duration of the economic downturn.

Impact on the supply of credit and capital allocation How do covered bonds impact the supply of credit and capital allocation? Capital requirements under Basel II and III incentivise banks to supply residential mortgage lending. The introduction of IRB models for calculation of capital requirements have resulted in low risk weights for residential mortgages. This may encourage leveraging. Some countries where large shares of covered bonds are backed by residential mortgages, have experienced relatively strong growth in residential mortgage lending and brisk house price growth. The availability of a large and liquid covered bond market may have facilitated this development. One would expect that the emergence of a vibrant residential covered bond market would generally deepen fixed income markets through larger volumes and better liquidity. The cheaper financing of residential mortgages through covered bonds has been reflected in household lending rates. In combination with very low risk weights and corresponding low capital requirements on residential mortgages, banks may have favoured such lending. As a result, corporations seeking financing may be pushed into bond markets through a crowding out effect. In addition, a vibrant market could make bond financing more attractive and pull corporate borrowers to the market. Higher interest rates on banks’ corporate loans may contribute to this effect. In some of the markets in Europe that have seen substantial deleveraging, loans to SMEs have been provided at steep interest rates. However, the economic situation and investment demand in general are probably much more important in determining overall growth in investment financing by banks.