Specifically, the experiment was designed to examine how caps on bonuses and “malus” (bonuses that are not paid out if, for example, performance falters in subsequent years) might affect individuals’ risk choices and efforts to seek out the best projects. The experiment showed evidence that, while both schemes tend to reduce risk-taking, they could be arbitraged relatively easily by introducing absolute or relative performance targets. There was also some evidence that a bonus cap might reduce incentives to search for good projects. The Bank of England is considering extending this experimental approach to a wider range of policy design questions and a wider range of financial market participants - risk-takers and risk-managers. In principle, this approach might provide some early indications of how new regulation might reshape risk incentives, including arbitrage incentives, which could help in recrafting regulation before it is introduced. Macroprudential Policy One of the greatest intellectual errors made in the run-up to the crisis was a classic “fallacy of composition”: it was assumed that the resilience of individual financial institutions was both a necessary and sufficient condition to ensure the resilience of the financial system as a whole. Events during the crisis, and  22  See BCBS (2016): http://www.bis.org/bcbs/publ/d362.pdf and BCBS (2013b): http://www.bis.org/publ/bcbs258.pdf 30  All speeches are available online at www.bankofengland.co.uk/speeches  30  subsequent theoretical and empirical work, has shown that the resilience of individual firms is neither necessary nor sufficient for the mitigation of systemic risk (Masera (2014), Crockett (1996)).

Moreover, it was plausibly the case that pre-crisis liquidity may have been too plentiful and too cheap in some financial markets, so some correction in the quantity and pricing of liquidity was to be expected, and indeed was potentially desirable, from a welfare perspective. Research at the Bank of England has sought to identify the impact of leverage ratio requirements on the functioning of UK government bond (‘gilt’) and gilt repo markets, using transaction-level data (Bicu et al (forthcoming)).18 It does find some causal impact of the leverage requirement on various metrics of liquidity, a worsening that is particularly acute at quarter-ends. Significantly, the banks most constrained by the leverage ratio reduced their activity in financial markets most. At the same time, however, dealers unaffected by the leverage ratio requirement also reduced their liquidity provision and, if anything, by more. This suggests factors other than the leverage ratio may have been at work in curtailing liquidity in these markets. It also leaves open the question of whether the correction in liquidity, even if privately costly, came at any social cost. Baranova, Liu and Shakir (2017) assess the costs that could arise from regulation which affects market liquidity at different levels of stress. They find higher costs in benign conditions, but substantial benefits in situations of stress as dealers make markets for longer. Overall Implications for Optimal Capital  How do these research findings tilt the optimal bank capital calculus relative to the LEI study? Table 1 summarises the evidence. They are a mixed bag.