Regulatory arbitrage (often abbreviated to regarb) is financial engineering that uses differences between economic substance and regulatory position to evade unwelcome regulation. The term is also sometimes used to describe firms structuring or relocating transactions to choose the least burdensome regulator, but this is better described as regulator shopping.
Perhaps the most significant area of regulatory arbitrage is the avoidance of capital adequacy requirements by banks. The typical transaction is a securitisation of assets that have a high risk weighting. Banks may either cherry pick safe assets to sell (keep high risk and high risk premiums) or securitise on terms such that default risk is not transfered, but merely taken off-balance sheet. Securitisation may also involve other transfers of risk such as credit default swaps.
Regulatory arbitrage can transform how assets are treated (for example, securities with a high credit rating may have a lower risk-weighting than the assets backing them). This means that the capital requirement for the banking system as a whole fall, even though the same risks are being absorbed, leading to an increase in systemic risk. The credit crunch made this very evident.