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This is a special guest post by Ross Norman, CEO of Metals Daily. This article on Basel III and Gold is republished here with Ross’s permission.
To a man with a hammer, everything looks like a nail, said Mark Twain. So it is that pundits have interpreted forthcoming Basel III rules as simply an opportunity to bash bullion banks and to assert that gold prices are going to the moon. Again … yawn.
Imagine for a moment that your cash at the bank became “allocated” … that is to say your bank holds it in physical form and it moves from account to account to reflect every single transaction you make, instead of the current book-entry system that allows debits and credits to be offset, cleared and settled overnight through a central agency that used to be called BACS. Yes, chaos would ensue … but assuming banks could manage, costs would rise dramatically, and that would be passed on to you. Madness you might think … why would regulators introduce something so retrograde and inefficient … herein lies the story behind the proposed Basel III changes and gold …
The Basel III rules on unallocated gold will require bullion banks to hold more High-Quality Liquid Assets (HQLA) for longer periods of time to offset loans to their clients. It follows that for example gold miners who finance themselves with a gold loan (most do) will find it more difficult to secure funding and it will be more expensive to finance rendering many projects uneconomic or simply difficult to fund. Industrials such as jewelry fabricators, physical gold stockists, and precious metals refineries who also lease metal will find those markets thinner and far, far more expensive. Shortages of physical will become a frequent occurrence, especially when you most want it as pipelines shrink. We don’t yet know for sure, but borrowing costs could likely double or treble. These sectors are very low-margin, high-cost businesses who are highly sensitive to cost increases and they will respond by keeping physical stocks of borrowed metal to an absolute minimum. Some will simply shut up shop. The outcome of the proposed rules is less about the existential issues around the professional market and actually about the broader sector becoming far smaller, less efficient, and by extension far more expensive… and that’s what I believe the BIS wants to achieve. It is my belief the regulators are deliberately locking the fire exits in the theatre and simply looking to make gold less relevant. What next … reverse the decision of Jan 1, 2000, and reintroduce VAT at 20% on investment gold across UK and continental Europe?
We are in a time where significant fiat currency debasement looks to be upon us, and further financial repression a given … how else to relieve the massive debt burden crushing the economy? … and to be effective the BIS needs to render alternatives less appealing. Financial innovation has given us a large number of alternative safe-haven assets and it follows that as inflation takes grip, many savers could and would slip out from under the net. Gold is one of those go-to’s. Perhaps in that light, the war-on-cash and the rising rhetoric by central banks against alternative digital currencies makes sense.
Bullion banks under Basel III will in the future have to set aside more HQLA in order to provide unallocated metal, to oil the wheels of trade, especially around trade settlements. Bullion desks will approach their treasury colleagues for say US treasuries with a 13-month tenure (a HQLA needs to be over a year in tenure) to offset say a rolling 3-month gold lease to a jewelry fabricator and now be expected to pay handsomely for that funding … as costs rise … and this is the important bit … they will be passed onto clients. Without this consignment facility whatsoever the jewelry fabricator could find it difficult to hedge his risk or indeed the price swings in underlying metal prices could render him insolvent – on thin margins they might simply elect just shut up shop. Compromising the services that bullion banks provide will make being in gold less attractive right through the value chain … it would be reducing the lubricant from the machine. Unallocated gold has been necessary because, without it, physical bars will need to move between vaults and across borders to settle trades each day. The BIS seemingly wants to hamstring the bullion markets and we shall all pay the price for these new inefficiencies.
Likely this is price neutral but renders the gold market less relevant as an alternative asset as pipelines shrink. Yes, perhaps a small number of unallocated positions will become allocated (forcing some buying) but this is small in size and there are many offsetting scenarios. More importantly, a significant number of would-be institutional investors will be dissuaded from buying gold simply becomes the market is too small, spreads are too wide and the market shrinking … a lobster pot … easy in, but difficult out.
Yes, there is some irony that Central Bankers are themselves the largest single holders of physical gold at about 90,000 tonnes collectively and they will be rendering their own reserves much less liquid … and they do seem determined to shoot themselves in the foot … but, needs must … and such is the scale of the macro-problem.
In the 1970’s gold represented about 6% of total assets under management. Today it is about 0.5%. Expect that figure to fall further as gold becomes increasingly niche and less relevant.
Tragically too much attention has focused upon the narrow desire to bash bullion banks, which has served as an unnecessary distraction in that it is masking the real story being played out here…
In short, it is my view that the contingent problems are not being fully evaluated … for want of a nail the shoe was lost; for want of a shoe the horse was lost; and for want of a horse the man was lost.
Ross Norman
CEO
Metals Daily Ltd
This article was originally published here: Basel III and Gold – Central Bankers Locking the Fire Exits for Gold
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Thanks, Keith, I’ve been wondering about the Basel III thing.
Yes you’ve hit the nail on the head. The key section that people seem to miss is “to the extent the gold bullion assets are offset by gold bullion liabilities“.
Correct me please if I am wrong : Basel III compels banks holding gold to neutralize the worth and the eventual leverage through gold holdings by imposing an equal a liability on his superb asset ?
In others words Basel III penalizes banks for holding gold ?
Is it unfair or is biased to scare banks from holding solid gold ?
So the best place for holding gold should be in a parallel system , where me, you and many friends can enjoy receiving extension of cash credit based upon the evolution of the spot price of Gold ?
The kind of credit card Peter Schiff with his euro-pacific bank located in Australia tries to promote , but it seems it does get very popular .
I look forward to read your observations
“According to the FDIC, as of this writing, the national average for checking accounts is 0.06%. According to the St. Louis Fed, a 30-year mortgage is 4.28%. A bank could make 4.22% by funding 30-year mortgages with checking deposits (before expenses). Not a bad business.”
But, Keith, isn’t it actually much better business than that due to fractional reserve banking?
With a reserve ratio of ten to one, the Bank could lend out what it borrows ten times over, so it could effectively be getting 42.8% against the 0.06% it pays out making an arbitrage profit of 42.72%.
Matrerial I read some time ago maintained that, in modern banking on both sides of the Atlantic, there is effectively no limit on the ratio that banks may operate. I mentally went on to append, “. . . other than the solvency and funding requirements laid down in the Basel accords”.
Notwithstanding, as you go on to explain, that this (demand deposit v mortgages) is not the way banks actually fund their lending, I would be very interested in your take on the effect or otherwise of fractional reserve on your arguments here.
The Net Stable Funding ratio is precisely a “reserve fraction” (for the asset class) considered acceptable under Basel conventions. So, saying gold has a 85% requirement is like saying: to lend out $100 of gold, a bank would need to have $85 of deposits in its reserves. That is far more than private 19th century banks kept (between 25% and 50%) in fractional reserve, and thus makes gold-based banking unprofitably stable.
It is interesting that fully hedged gold and a T-bill have the same regulatory risk profile. Stability within the bank’s numeraire (presumably the global reserve currency US dollar) seems to be the only objective. Why is such an agreement being reached in Basel Switzerland, ex domain of said legal tender?
Good question Gregory and thanks for the explanation of Net Stable Funding ratio.
Since reading your reply I have read through Keith’s whole series of articles on The Unadulterated Gold Standard. It certainly turns a lot of my previous understanding on its head, and begins to address my original question in part 3, where, in writing about fractional reserve, he trashes the idea ‘that banks “create money” ‘.
Whereas this does seem to contradict a lot of what I’ve previously read – including certain publications by the Bank of England, the Federal Reserve and a monetary reform group in the UK called Positive Money, I’ve learned over the years of reading Keith’s material that his approach to all things monetary possesses a simple underlying logic that often explains what is happening in the real world so much better than the guile of politicians, the projections of many economists and the hype of gold and silver ‘bugs’, whose announcements that gold and silver are about to skyrocket have been growing ever more shrill since I began to be interested and yet without any real fulfilment. It makes one wonder why anyone still listens to them. I certainly stopped paying them any serious attention some years ago after I discovered Keith’s more intelligent analysis whose correspondence with reality seems far better.
It will probably take me several re-readings and some careful thinking to glue my comprehension of money mechanics back into a complete entity including this disruptive new material.
What are the Net Stable Funding ratios under Basel 3 for other types of banking ‘assests’?
Hi, I’m trying to better understand the regulation.
On the liability side: https://www.bis.org/bcbs/publ/d424.pdf
Here it says a 0% risk weight will apply to gold but further on, a haircut of 20% is specified in all models.
Moreover, we have the minimum capital requirements: https://www.bis.org/bcbs/publ/d457.pdf
We can read that gold is a commodity with a risk weight of 20%: “7 Precious metals (including gold) Gold; silver; platinum; palladium 20%”
But further on, it says:
40.53 This section sets out the simplified standardised approach for measuring the risk of holding or
taking positions in foreign currencies, including gold.[19]
Footnote
[19] Gold is to be dealt with as an FX position rather than a commodity because its volatility is
more in line with foreign currencies and banks manage it in a similar manner to foreign
currencies.
For both forwards and options, gold is considered foreign exchange, not commodity:
(b) For options on equities and equity indices: the market value of the underlying
should be multiplied by 8%.[38]
(c) For FX and gold options: the market value of the underlying should be
multiplied by 8%.
(d) For options on commodities: the market value of the underlying should be
multiplied by 15%.
Is it correct to say that the 0% (or 20%?, multiplied by 8% if gold forwards/options) risk weight applies when a bank uses gold as collateral when borrowing (including demand deposits) ?
O the asset side: https://www.bis.org/bcbs/publ/d295.pdf
Gold has an RSF (required amount of stable funding) factor or 85%.
Does that means that one needs 100 ounces of gold as collateral to take a loan of 15 ounces of gold equivalent in dollars from a bank ?
What’s missing here is price. You only have to see that the BIS assigns a risk factor of only 50% on mortgage-backed securities and 85% on gold itself to realize that it feels that the risk of large defaults of home loans to an overleveraged public is LESS than the risk of the price of gold going down in price (pp 9-10). Thing is, if the price of real estate drops far enough (layoffs, herd mentality) people are going to jingle-mail their house keys even if they can afford to make the monthly payments because no one wants to pay off a loan that is worth substantially more than the value of the house! So once again they have characterized the wrong thing as risky under an avalanche of a PhD level word salad.
https://www.bis.org/bcbs/publ/d295.pdf