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Last year, Monetary Metals’ CEO Keith Weiner wrote an article debunking the idea (popular at the time) that Basel III regulations would send gold’s price to the moon. The focus of that piece was on the investors and individuals who own gold.
This time, we’ll look at the same subject, but from the perspective of companies who use gold to earn their profits. Since the bulk of this activity occurs at, with, or through bullion banks, that’s where we will begin.
What Do Bullion Banks Do?
Bullion banks are generally divisions of investment banks that provide services specifically around precious metals. They can be market-makers with activities such as clearing and trading, or they can finance gold businesses, such as miners, refiners, and mints. They use proprietary gold, client gold, or leased gold from a central bank and other entities.
However, holding gold on the bank’s balance sheet is not the same as holding cash. It’s more expensive and therefore requires the bank to earn a return sufficient to justify holding it.
What Do Regulators Focus On? Enter the NSFR
Regulators want to make sure that in times of stress, banks remain solvent. In other words, a bank’s assets must cover its liabilities, and they need to consider that those assets are more likely to be withdrawn during times of panic.
The Net Stable Funding Ratio (NSFR) is an attempt to measure this. If the NSFR is at least equal to 1, then the bank should be able to withstand short-term withdrawals in times of market stress.
According to its methodology, some liabilities can’t be withdrawn immediately. This makes them stable. Examples include equity and long-term bonds. On the other hand, demand deposits and interbank overnight loans can be withdrawn immediately. This makes them unstable.
Similarly, some assets are more reliable than others. Short-term assets, such as cash, are completely reliable. You can use its full value in a crisis. Long-term assets, such as 30-year mortgages, are less reliable. You may not be able to sell them at all, or only at a steep discount.
The most unreliable assets have their full value discounted when calculating the bank’s NSFR. This is represented in the Required Stable Funding (RSF) number. Cash has a 0% RSF. 30-year mortgages have a 100% RSF.
Other assets fall somewhere between these two extremes, such as loans to financial institutions maturing in six to twelve months. These have a 50% RSF.
Cost Implications of the RSF
The most reliable sources of funding are also the most expensive, such as equity and long-term bonds. The bank may hold a 100% RSF asset against them, since 0% of their value is subject to short-term redemptions in times of crisis.
Conversely, demand deposits are one of the most unreliable sources of funding and one of the cheapest. Therefore, only assets with a 0% RSF can cover them in times of crisis.
Thus, the higher the RSF, the more expensive the liability must be to fund it.
Gold under Basel III
Which brings us to gold. Currently, gold has a 50% RSF. The cost of its liability counterpart is somewhere above a demand deposit but below equity or a long-term bond.
If a bank cannot earn a sufficient return on its gold assets to cover the cost of funding, then it doesn’t make sense to have the gold. This fact puts a floor under the rate banks require when leasing or lending gold.
When Basel III becomes active in January 2022, gold’s RSF will change. It will increase from 50% to 85%, making it more expensive for banks to hold. At the very least, banks will require an even higher return on their gold leases and loans.
What This Means for Gold-Using Companies
Two related consequences follow from this change.
First, some bullion banks will close because their former business model for leasing gold will no longer be viable, or sufficiently attractive. Scotiabank is an example. After 23 years of operating, it plans to shut down its bullion bank business by 2021.
Secondly, the banks that remain will be forced to increase their financing rates not to profit, but just to break even.
So, businesses on the other end of this financing – such as mints, miners and refiners – will be faced with higher funding costs. Or they will lose their banking relationship altogether. These are often low margin businesses, so any increase in interest expense will eat into an already slim profit margin.
Ultimately, the higher rates will move some businesses from the “viable” category, into the “no longer viable” one.
An Alternative to Bullion Banks
Monetary Metals offers secure, predictable, and reliable sources of funding for gold-producing and gold-using businesses. We are not a small department within a large institution, but a growing, entrepreneurial business – focused exclusively on financing companies that use precious metals productively.
If your business uses precious metals, you may soon need to make a decision – with limited options. You can either compete for scarcer and more expensive bullion capital, or find a new source of funding.
Monetary Metals is an attractive alternative to traditional forms of funding. Our gold and silver leases are reliable, flexible, and safe.
We can supply the capital you need as your business grows, and be your long-term financing partner.
To learn more about how we compare to other financing options, visit this page. Or schedule a call with one of our team members.
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