When regulatory capital requirements are significantly greater than the economic capital banks would otherwise assign to a given loan, banks either have to find ways to lower those capital charges, shift the risks associated with those loans elsewhere, or get out of the business of making such high quality loans.
In the absence of such adjustments, the capital standards might otherwise drive banks out of the business of making high quality loans and therefore toward increased risk-taking. Regulatory capital arbitrage can therefore be a safety valve that allows banks to continue in the business of lending to high quality counterparties.