The choices banks make for funding mortgages and other business activities have an important effect on how efficiently they provide banking services and how effectively they manage risks to their own business and to the financial system. Canadian banks typically use a broad array of funding sources, including equity, deposits and wholesale funding instruments.

Covered bonds are secured senior debt issued by banks. They are claims on originating banks, collateralized by a pool of mortgages that remain on the balance sheet. The pool is ring-fenced (encumbered) and therefore bankruptcy remote. In 2017, covered bonds funded only about 3 per cent of the assets of Canada’s largest banks and 9 per cent of Canadian mortgages.

Our research explores implications of covered bond use for regulation. Issuing more covered bonds allows the bank to raise cheap and stable funding for investment (such as residential mortgages). But this comes at the cost of increasing the bank’s fragility, since the bank cannot use these assets to meet withdrawals of unsecured debt. The optimal levels of covered bond use and bank fragility are excessive, since the bank does not account for the effect of encumbrance in the cost of providing the guarantee of unsecured debt (e.g., retail deposits). We show that, to reduce this excessive risk taking and fragility, a limit on the level of asset encumbrance and minimum capital requirements are effective tools for minimizing the incentive for banks to take excessive risk. In addition, increasing the sensitivity of deposit insurance premiums to asset encumbrance levels would be desirable to reduce asset encumbrance levels and, thus, the risk of runs on unsecured debt.