Basel III – A Damp Squib for Gold So Far

Many gold buyers will have been waiting for the initiation of the latest phase of the Basel III banking accord to come into force for European banks, as it did on Monday June 28th. They will have had varying expectations of its likely effects on the global gold market and on precious metals prices in general.

Some analysts and commentators had been hugely bullish for gold and silver prices on the likely outcome once the strictures on the banks, and the possible impact on precious metals markets, had been fully implemented.

This writer had remained mostly neutral, assuming there would be little change in prices – a view that seems mostly to have been correct so far as European and US markets have been showing so far, but it is early days yet and any changes in precious metals price perception may take time to sink in and take effect.

So what is Basel III, and how might it affect precious metals prices? In short, the latest phase represents an imposition on the banking sector to implement asset policies designed to reduce the likelihood of the kind of banking meltdown which led to the 2008 financial crisis reoccurring. The whole package has been a long time in the making and not due for final full implementation until 2023, although its application to global bank liquidity structures is now mostly in place.

However, it should be noted that the important UK banks (probably the world’s second largest state-independent banking sector after the US), and some other global banking institutions, are not due to fully comply until January next year, if then.

As far as the banks are concerned, the Basel III accord comprises a suite of financial reforms aimed at strengthening regulation, supervision, and risk management within the sector, and by reducing counterparty risk. It is being introduced in an attempt to improve the banks’ abilities to handle systemic shocks from financial stress and to strengthen their transparency and disclosure.

It is part of a continuing process to enhance regulation in the global financial sector. The accord aims to prevent banks from hurting the global and domestic economies by taking on more risks than they can safely handle.

One aspect of the reforms as they directly impact gold is that banks are now allowed to classify allocated physical gold as a Tier 1 (the safest level) asset, but unallocated gold remains only a Tier 3 level asset (the riskiest asset level). (All gold holdings used to be classified in Tier 3.)

Some analysts believe that this re-classification will put additional demand into the market for physical gold and consequently drive prices higher – much higher in some views.

Much of the information set out above and below is covered in more detail on the CFI (Corporate Finance Institute) website – recommended reading on Basel III and its detailed implications and criticisms.

In effect, the Basel III accord raises the minimum capital requirements for banks from the 2% of the previous Basel II accord to 4.5% of common equity, as a percentage of the bank’s risk-weighted assets. There is also an additional 2.5% buffer capital requirement that brings the total minimum requirement to 7%.

To conform to this requirement, the US Federal Reserve fixed the leverage ratio at 5% for insured bank holding companies, and at 6% for Systematically Important Financial Institutions (SIFI).

Basel III has also introduced the usage of two liquidity ratios – the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR requires banks to hold sufficient highly liquid assets that can withstand a 30-day stressed funding scenario as specified by the supervisors.

On the other hand, the NSFR requires banks to maintain stable funding above the required amount of stable funding for a period of one year of extended stress. The NSFR was designed to address liquidity mismatches and started becoming operational in 2018.

The requirement that banks maintain a minimum capital amount of 7% in reserve will, however, make banks less profitable. Most banks will try to maintain a higher capital reserve to cushion themselves from financial distress, even as they lower the number of loans issued to borrowers. They will be required to hold more capital against assets, which will reduce the size of their balance sheets, and could make physical allocated gold more attractive as a ‘safe’ asset.

The demand for secularized assets and lower-quality corporate bonds will decrease due to the LCR bias toward banks holding government bonds and covered bonds. As a result, banks will hold more liquid assets and increase the proportion of long-term debt, in order to reduce maturity mismatch and maintain minimum NSFR. Banks will also tend to minimize business operations that are more subject to liquidity risks.

The re-classification of physical gold into the safest asset form should help the market for allocated gold while potentially making that for unallocated gold less desirable. Some see this as a move towards interrupting any tendency towards gold price manipulation in the futures markets, which primarily deal in unallocated gold.

These are often claimed to be manipulated according to a major tranche of gold market investors, while others deny such manipulation exists. This writer is somewhat undecided here, but does suspect that many financial sectors indeed see a degree of manipulation by the big banks to support their own interests and it would not be strange if the precious metals markets were similarly affected.

Basel III has not had a totally smooth ride through the regulatory approval process. For example, in the US, the Institute of International Finance protested its implementation due to its potential to hurt banks and slow down economic growth. (A study by the OECD revealed that Basel III would likely decrease annual GDP growth by 0.05% to 0.15%.) Also, the American Bankers Association and a host of Democrats in the US Congress argued against the implementation of Basel III, fearing that it would cripple small US banks by necessitating the increase of their capital holdings supporting mortgage and SME loans.

It has also created dissension in a number of other jurisdictions – notably in the UK where that major global gold trading entity, the London Bullion Market Association (LBMA), continues to oppose its introduction in part as a matter of self-interest as it fears that its trade, which is mostly in unallocated gold – and can reach $200 million or more in a single day – may be considerably adversely affected given the likely pressure on banks to re-classify much of their unallocated gold to the more desirable allocated classification.

The gold market activity on June 28thshowed little propensity to be strongly affected due to the wider imposition of the Basel III accord. Maybe when more jurisdictions fall in line at the beginning of next year we will see a greater impact, but so far it’s a case of plus ça change, plus c'est la même chose.

No change so far, but whether there’s any medium-or-long term effect on precious metals markets is not yet apparent.

by Lawrence Williams

Lawrence (Lawrie) Williams is a highly regarded London-based writer and commentator on financial and political subjects, specializing in precious metals news and commentary. He graduated in mining engineering from The Royal School of Mines, a constituent college of Imperial College, London. He has contributed articles on precious metals to the Financial Times, Sharps Pixley, US Gold Bureau and Seeking Alpha among others.

The opinions expressed in this article are the author's own, do not necessarily reflect the opinions or views of Rosland Capital LLC or its employees, and do not constitute financial or investment advice or recommendations from the author or Rosland Capital or its employees. The author is compensated by Rosland Capital for his articles.