Gold & Basel 3: Gold to Take Flight?

This article addresses the confusion regarding the Basel 3 implementation of the Net Stable Funding Ratio which comes into force in Europe in June 2021 and what this means for gold.

Dear Subscriber

After revisiting my sources on Basel 3 and cross checking everything against the BIS documents, I wanted to provide an update with what Basel 3 really means for gold because there is a lot of confusion out there.

So let’s back up and consider the aims of the Bank for International Settlements - the shady BIS. Ultimately, it’s control and complete monopoly power over currency. To that end, they will seek to ensure that their institutions remain in charge. And of course, gold and silver are enemies of the fiat currency system. 

Sowing the Seeds of the Great Financial Crisis

Previous Basel accords have had a dramatic impact upon economies globally. For instance, each previous round of the Basel Accord has deemed mortgage debt to be increasingly less risky. Where in Basel One, in 1992, 50 percent risk weightings were applied to mortgages. Basel 2 agreed in 2004, saw the risk weighting of mortgages being reduced to 35 percent. They then allowed banks to calculate their own internal risks. House prices took off throughout the western world, as credit flowed to real estate markets. Before a sudden contraction in credit took place. 

Of course, the consequence was the great financial crisis of 2008, and this provides us with a useful case study in understanding the Basel accord’s desires under the Net Stable Funding Ratio which is due to be introduced in Europe at the end of June this year. 

Back in September 2007, a British Bank, Northern Rock suddenly faced an enormous funding crisis. The bank had been providing mortgages for 25 to 30 year periods. Initially, these were financed via demand deposits - that is customer savings deposits. This was the capital or liability financing the bank's asset - the mortgages it offered. 

This is the conventional understanding of a banking system - that the bank takes a customer deposit - a liability to the bank which will need to be repaid upon demand - and relends that in the form of a loan - an asset to the banking system. But Northern Rock, in their desire to expand their business began lending from the interbank lending market to enable them to offer more mortgages. 

However, this posed a complete mismatch in the bank’s capital and its assets. Short term borrowing and longer term lending for 30 year mortgages - a recipe for disaster. In the good times, there was no problem, but as soon as banks trust in one another deteriorated it meant that Northern Rock could not meet its short term obligations to the interbank lending market. 

As news of their illiquidity spread, customers then sought to withdraw their currency from the bank. The lessons here were clear for the bankers that stable funding must be used to finance certain assets. 

This is particularly the case when it comes to mortgage products which may need to be fire-sold at a loss or could even go “no bid” in the event of an all out crisis. We saw just that with the demise of Lehmann Brothers under the weight of their collateralized debt obligations or CDOs. 

By requiring stable funding capital, the BIS is betting that it should help to avert the risks posed by a mismatch in assets and capital on the banks balance sheet.

So if we consider the most stable highest quality forms of capital: This includes the bank selling equity (or company stock) to raise capital, other core capital and disclosed reserves. Ultimately, long term capital is perceived as being less risky, and more costly for that matter, than low cost short term capital. Take demand deposits or interbank lending, they’re both cheap sources of capital but can be withdrawn at any time. This makes financing through these shorter term methods risky when markets are under stress. 

And so by setting a Net Stable Funding ratio it requires banks to finance long term assets with long term money. This is meant to encourage banks to manage risks carefully. But different assets are given different risk weightings according to the percentage of required stable funding needed to finance them.  

And on the spectrum of asset risk - those deemed most risky and therefore requiring the highest required stable funding ratio of 100 percent are equities and non performing loans. 50 percent for high quality liquid assets. While bank reserves, held at the Central Bank together with banknotes and coins have a zero Required Stable Funding requirement. 

Gold: The Original Risk Free Asset

And so what weighting should gold be given due to its available liquidity and lack of counterparty risk? Well, it has some price volatility so 15, 20, 30 percent? Well no. The BIS are never keen to promote the role of gold so it has an 85 percent Required Stable Funding ratio. Meaning financing gold as a bank asset must be done with 85 percent longer term, more expensive funding. To be clear, this is an increase in the risk weighting of gold - the original risk free asset. 

But the BIS have also gone on to state that “at national discretion, gold bullion held in own vaults or on an allocated basis to the extent it is backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%.” Now, on the face of it this seems promising for allocated gold - risk-weighted at zero percent. However, it’s weighted as cash because “it is backed by bullion liabilities.” I.e. a short position against the future price of the metal. So on one hand the bank is long and on the other they are short leaving a net neutral position at zero risk as it is allocated gold. This would only offer a return if they perhaps lease the physical metal out. 

Impact on the LBMA

However, the LBMA have been fighting these changes tooth and nail. This is because most bullion in London is traded & settled on an unallocated account basis, where the customer does not own specific allocated bars and simply has a paper entitlement to metal. This is where clearly the LBMA are upset. As the costs to banks in ensuring a Required Stable Funding of 85 percent for unallocated bullion would significantly increase the cost of doing business. With Scotia Bank leaving the sector last year, there is the possibility that others may follow. 

Does it reduce the LBMA’s global authority? Judging by their fight, unquestionably so. And to that end, we must ask who is really driving such changes? For we know that a dramatic global shift is underway from west to east and China has, of course, been stockpiling gold. 

But all in all, gold is negatively treated under the Basel 3 arrangements. And this makes perfect sense when we consider that this is being driven by the BIS. Clearly, the banking sector does not wish to elevate the position of gold to rival their fiat currencies or even their CBDCs unless they truly have no choice. 

What does it mean for the gold price? Well, on the face of it, if there is less trading of unallocated gold, this may seem price supportive but it is tough to say. As any bank who wants to go long on gold, either allocated or unallocated, must finance this with 85 percent required stable funding, making it far less attractive to do so. Moreover, it remains to be seen how well enforced such rules will be. Given banks, in recent times, are hardly well regarded for their prudence. 

And after all, there are numerous other macroeconomic reasons to be long term bullish on gold in terms of our own wealth preservation.

Thanks for being here.

Miles