Regulatory capital arbitrage is the avoidance of regulatory capital charges through the sale or securitization of bank assets for which the capital requirement that the market would impose is less than the current regulatory capital charge. For example, low-risk residential mortgages are often securitized rather than held on a bank’s books in part because the market requires less capital than does Basel I.
This behavior is perfectly understandable, even desirable, in terms of improving economic efficiency. But it means that banks engaging in such arbitrage retain the higher-risk assets for which the regulatory capital charge, calibrated to assets of average quality, is on average too low.