Regulatory arbitrage

Regulatory arbitrage

Regulatory arbitrage "is an avoidance strategy of regulation that is exercised as a result of a regulatory inconsistency". In other words, where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position. For example, if a bank, operating under the Basel I accord, has to hold 8% capital against default risk, but the real risk of default is lower, it is profitable to securitise the loan, removing the low-risk loan from its portfolio. On the other hand, if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it, provided it is priced appropriately. Regulatory arbitrage can result in parts of entire businesses being unregulated as a result of the arbitrage.