6. Regulatory capital arbitrage

Suppose that Second Republic Bank's assets consist of only four mortgage loans made to Akshay, Brian, David, and Felix. All of the loans are five-year loans of $100,000 with annual payments of $20,000 each.

Loans	Year 1($)	Year 2($)	Year 3($)	Year 4($)	Year 5($)L	Total Loan($)	Risk Weight(%)
Akshay	20,000	20,000	20,000	20,000	20,000	100,000	20
Brian	20,000	20,000	20,000	20,000	20,000	100,000	20
David	20,000	20,000	20,000	20,000	20,000	100,000	20
Felix	20,000	20,000	20,000	20,000	20,000	100,000	20
Total	$80,000	$80,000	$80,000	$80,000	$80,000	$400,000

If each loan has a risk weight of 20%, then the value of Second Republic Bank's risk-weighted assets is:

$400,000

$80,000

$100,000

If Second Republic Bank is required to hold 10% of its risk-weighted assets as capital, then its regulatory capital is (40,000/ 8,000/ 10,000) .

Now, suppose the bank pools together all four loans and then divides the pool into five tranches in terms of yearly payments. The tranche with Year 1 payments is considered the least risky, while the tranche with Year 5 payments is considered the most risky. See the following table for the amount and risk weight of each tranche.

Tranche	Amount($)	Risk Weight(%)
Year 1	80,000	5
Year 2	80,000	10
Year 3	80,000	15
Year 4	80,000	25
Year 5	80,000	30
Total	$400,000

The new value of Second Republic Bank's risk-weighted assets is:

$88,000

$68,000

$80,000

The securitization (decreases/ does not change/ increases) Second Republic Bank's regulatory capital. The bank's leverage ratio is likely to (not change/ increase / decrease) .