Answer: Regulatory arbitrage

## Explanation Regulatory arbitrage is a practice where firms capitalize on loopholes in regulatory systems to circumvent unfavorable regulations. This is often done by structuring transactions in a way that presents lower regulatory capital requirements. In this scenario: - Capital M bank originates mortgages - Securitizes them into asset-backed securities - Invests in these same securities The motivation behind this strategy is largely accounting-driven, allowing the bank to potentially achieve specific accounting advantages through this circular process. **Why other options are incorrect:** - **B. Securitization**: While securitization is part of the process, it doesn't fully capture the complete scenario where the bank also invests in the securities it creates - **C. Irrational exuberance**: There's no indication the bank's actions are driven by market euphoria or irrational behavior - **D. Agency costs**: No evidence suggests this strategy is creating conflicts between principals and agents Regulatory arbitrage can be risky as it may lead to lack of transparency and increased systemic risk in the financial system.

Author: Tanishq Prabhu