Tuesday , 5 March 2024

What Is Basel III? What Will Its Impact Be On the Gold Price?

Gold investors are right to wonder what effect, if any, Basel III will have on the gold price. Our take is that…

What is Basel III?

Born out of the global financial crisis, Basel III is an international regulatory accord intended to mitigate risk within the banking system and make banks more resilient to financial stress, thereby preventing system-wide failure

Originally written in 2009, over 28 central banks participated in drafting the regulation. It has been repeatedly delayed and is now set to go into effect on January 1, 2022.

What does Basel III have to do with Gold?

The answer to this question requires an understanding of a bank’s balance sheet. Without this fundamental understanding, the regulatory framework of Basel III will be misconstrued (for example when someone says that gold is a “tier 1 asset,” or says that banks can own “allocated gold” without penalty).

Basel III and the Bank Balance Sheet 101

Basel III Regulation attempts to ensure banks remain solvent during difficult times. For a bank to remain solvent, its assets must cover its liabilities like any other business. However, banking is not like any other business, it’s a very particular kind of business.

A bank borrows to fund a portfolio of assets, typically loans. In a bank, its capital is the liability side of its balance sheet. This is what it borrows from depositors and other entities (though it may sell equity too). The loans it makes with that capital are its assets. For the bank’s assets to cover its liabilities, the value of its loan portfolio must exceed the value of its capital.

Where does Gold fit into Basel III?

To understand how gold fits into all this, the following selection from Keith’s article spells it out:

“For the liabilities—again, this side is called “capital”—there are tiers. The regulator’s goal with capital is to estimate how much capital the bank can rely on, when it’s under stress. That is, how much of its funding will not or cannot be pulled by investors who are under their own stress or simply panicking.
For the assets, regulation sets risk weightings. The regulator wants to assess the likely liquidation value of each asset, not in normal times but when the market is under stress. This includes the risk that the issuer of the asset (e.g. bond) will default, and the risk that the value of the underlying collateral or the instrument itself, could be lower.
The essence of this idea is captured in the concept of Net Stable Funding Ratio. This is a calculation of how much funding (liabilities) will be there relative to how much funding each assets need.
  • Equity capital and long-term bonds are considered very stable.
  • Demand deposits and interbank overnight lending are not.
  • T-bills are considered not to need stable funding, as they can always be liquidated or will mature quickly.
  • Mortgages need a high ratio of stable funding.

Gold Under Basel III

Gold is an asset. Under the new regulations, gold is assigned a Required Stable Funding of 85%. This is up there with equities. In other words, regulators see it as risky to hold gold, so they want to make sure that banks fund it mostly using liabilities, like equities, that cannot be pulled.
The gold community should not be cheering this as good for gold. We should be screaming bloody murder. Gold is not risky, like equities. Gold has no default risk, and its price risk is not that high. In fact, if a balance sheet holds a small amount of gold, it acts as a hedge. It reduces drawdowns (we plan to publish a paper on this soon).
The World Gold Council submitted comments to the Federal Reserve, on the proposed rule “Enhanced Prudential Standards and Early Remediation Requirements…” It argued that gold should be included in the definition of “highly liquid assets”, and should not require term funding under the Net Stable Funding Ratio.
The World Gold Council included quotes from HSBC, UBS, and other banks and banking associations, as well as the London Bullion Market Association. They each argue for a low or zero Required Stable Funding.
Basel III assigns gold an 85%, which is the opposite of low.”

Thus, the net effect of the Basel III regulations on gold is that it now costs more for banks to own gold.

Basel III Impact on Gold and the Gold Price

Gold investors are right to wonder what effect, if any, Basel III will have on the gold price.

  • Our take is that it’s not immediately clear if Basel III will drive the gold price one way or the other.
  • What is clear, is that Basel III introduces new regulatory costs and burdens to participating in the gold trade. In other words, it increases friction in the gold market. Regardless of whether the price is rising or falling, nobody likes increased friction in a market.
  • If we were to make a call, it would be for greater volatility in gold going forward.
  • For further analysis on the impact of Basel III on gold, we highly recommend Keith’s latest video: Basel III: Causing Gold’s Volatility?

Videos on Basel III and Gold

Here are two videos of Monetary Metals CEO, Keith Weiner discussing Basel III and gold. The first was published in June 2019 and has over 60k views. The second was published last month and has over 30k views.

June 2019 – Basel III, Not Good for Gold

For a transcript of this video, please click here: Basel III, Not Good for Gold

June 2021 – Basel III: Causing Gold’s Volatility?

For a short summary of this video, please click here: Roundtable on Basel III and Gold

Editor’s Note:  The above version of the original article by  , has been edited ([ ]) and abridged (…) for the sake of clarity and brevity to ensure a fast and easy read.  The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.  Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

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