How Will Basel III Impact the Gold Market?
One of the aftereffects of the Great Financial Crisis was increased regulation. At the center of many of these new regulations were provisions to help identify and limit systematic risk. For example, The Financial Stability Board (FSB) was designed to monitor systematically important financial institutions (these systematic institutions became known as the financial institutions deemed “too big to fail”). Another is the Basel III agreements.
The Basel Accords had a 10-year history prior to the financial crisis. The first of the Basel Accords was finalized in Basel Switzerland in 1988. It also focused on developing measures to determine the capital adequacy of financial institutions.
This included measures such as international banks must maintain capital equal to at least 8% of their risk weighted assets. A bank’s capital is rated in Tiers, with Tier 1 being the safest assets (cash and cash equivalents) and Tier 3 assets the riskiest.
Effect of Basel III on Gold
The next update came in June 2004, with Basel II. Which focused on incorporating credit risk of assets held by financial institutions to determine the capital ratios.
The most recent update, Basel III was an Accord introduced in 2009. The measures in Basel III focused on ensuring large financial institutions had enough capital to weather downturns, creating stress tests, and keeping markets liquid during times of market stress.
The goal of this update was to set proper leverage ratios and find the correct level of capital ratios to protect the financial system from a repeat of the 2008-09 meltdown. Among, other things the Basel III Accord raised the capital ratio from 8% to 10.5% for Tier I assets.
The questions is: why we are discussing these Basel changes now? First, as with most regulations it takes many years for these changes to be implemented, the Basel III came into force for European Banks on June 28, 2021, and will come into effect on January 1, 2022 for British banks.
Second, and the focus of the rest of this discussion is the reclassification of gold from a Tier 3 asset to a Tier 1 asset, making it a less risky asset and equivalent to cash. However, this reclassification is not quite as simple as it first appears.
A banks gold holdings now fall under two groups – allocated gold and unallocated gold. The difference between allocated and unallocated gold is important.
Allocated gold is physical gold that is sitting in a vault that belongs directly to the customer, in other words the customer is the outright owner of a certain amount of physical bullion that is stored specifically under that customers account. Unallocated gold (also called paper or contract gold) isn’t physically stored for the customer by the bank.
The gold remains the property of the bank, and the customer becomes a creditor of the bank or gold dealer. In other words, the bank gives the customer an “I owe you” for the gold that is purchased.
Since unallocated gold held by a bank is not being reclassified as Tier 1 capital but will remain part of Tier 3 capital banks will now have to hold extra collateral against it. This is because Basel III includes the new Net Stable Funding Ratio requirement. Which, as it relates to gold, states that the value of unallocated gold has to be collateralized by a margin of 85% with Tier 1 assets.
Since this requirement did not exist before Basel III this means that it is much more expensive to hold unallocated gold, which in turn will mean higher fees for customers.
Also, as mentioned above the rule came into effect in some European Banks as of June 28. But the real question is what will be the effect if the rule is implemented as planned in British banks at the beginning of next year. Where US$200 billion in unallocated gold is traded on a daily basis.
Basel III: What Will Impact Banks the Most?
Banks have preferred dealing in unallocated gold because of its convenience. Moreover, it was an inexpensive way for professional counterparts to trade without having to move physical gold bars each trade. Most of the 20 million ounces of gold that is traded daily through the LBMA is unallocated gold.
This means that not only do banks have to increase their Tier I reserves to cover 85% of their current unallocated gold contracts but will also have to continue increasing Tier I if the value of their unallocated gold contracts increases.
The new rules are to prevent banks from having more than one owner for the unallocated gold. Moreover, from saying they have the gold but don’t actually hold the physical gold they state they do on the balance sheet.
The jury is still out on what the ultimate effect these changes will have on the gold markets. Gold market watchers have widely varying views, some do not think these changes will have any affect on the gold price, while others think it will drive the price higher.
And because the change makes gold less of a “paper asset” others believe that it will reduce the appeal of gold as an investable asset and that the rule could create bouts of severe stress in the market.
The LBMA and World Gold Council have said that the new rules
“fail to take into account the damaging effect that the rules will have on the precious metals clearing and settlement system, potentially undermining the system completely, and on the increased costs of financing of precious metals production.”
It is possible that the rules will be delayed and modified before further implementation at the beginning of 2022. However, it’s a good idea to hold onto physical gold just in case.
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GOLD PRICES (USD, GBP & EUR – AM/ PM LBMA Fix)
30-06-2021 1757.80 1763.15 1270.19 1274.40 1477.61 1485.45
29-06-2021 1769.60 1755.45 1277.65 1269.19 1486.29 1477.04
28-06-2021 1774.25 1780.30 1275.51 1279.68 1486.11 1492.78
25-06-2021 1783.25 1786.65 1281.80 1283.17 1493.47 1492.57
24-06-2021 1780.20 1784.85 1275.16 1282.06 1492.52 1493.92
23-06-2021 1782.90 1791.60 1276.56 1280.28 1493.36 1497.24
22-06-2021 1779.10 1775.05 1282.38 1277.50 1496.05 1491.57
21-06-2021 1782.45 1775.05 1285.15 1277.33 1498.51 1490.51
18-06-2021 1792.35 1773.10 1289.24 1281.06 1503.60 1494.01
17-06-2021 1806.75 1778.70 1292.37 1276.04 1511.35 1490.91
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