After a number of shortcomings in Basel II financial regulations were identified during the 2007 subprime crisis, members of the Basel Committee on Banking Supervision began working on BASEL III between 2008 and 2009, which was finally approved in November 2010. Simply put, the latter is a set of international banking regulations developed specifically for the stability of the international financial system. These regulations were originally proposed for implementation between 2013 and 2015, but following a number of delays, implementation was postponed until between March 2019 and January 2022.
Why the history lesson? This agreement (Basel III) comes into force on 28 June 2021 for European banks, and on 1 January 2022 for British banks, and it could create a few opportunities. For me, one of the most interesting passages in this 1600-plus page agreement, is found on page 192 (source: BASEL III Framework): “However, at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%. In addition, cash items in the process of collection can be risk-weighted at 20%.”
That means that according to BASEL III, gold will be seen as a Level 1 or Zero-risk (risk-free) asset for banks, which in my opinion, can be regarded as an extremely positive factor for holding physical gold. Since 1994, Gold was considered only as a Level 3 bank asset with a 50% Risk Weight Assessment (RWA). This meant that central banks could only show/value 50% of their gold reserves in their balance sheets. With the implementation of BASEL III, gold as a Level 1 asset means that central banks can value their gold reserves as 1:1, thus being able to revalue their physical reserves upwards.
When we have a look at the total gold reserves held by central banks internationally, you can already see the contribution that BASEL III possibly may have made to the demand for physical gold. Between 2000 and the centre of the 2007 financial crisis, central banks were net sellers of their gold reserves. Since then, however, that has changed, with central banks adding 383.5 tons per year to their gold reserves between 2008 and 2018. For the past two years (2019 and 2020), central banks have increased their gold reserves by 519.9 tons per year.
The new BASEL III also addresses the Net Stable Funding Ratio (NSFR) for banks. Many may consider this to be a not-so-positive aspect, but I personally feel that it may very well have long-lasting positive effect on gold. In simple terms, the NSFR will be used to compel banks to finance their long-term assets with long-term cash to prevent liquidity failures. Without explaining in too much detail, the NSFR requirement will mean that banks will have to hold 85% Required Stable Funding (RSF) for the settlement and financing of precious metals transactions. It was not a requirement to hold RSF in the past.
Why do I think that this will be a good thing? Let’s use a Settlement and Finance Bank holding unallocated gold to the value of R2 billion as an example. Just as a point of interest, the simplest difference between allocated and unallocated gold, is that allocated gold is owned by the investor, whereas unallocated gold remains the property of the bank, with the investor only being a creditor of the bank and not the actual owner of the gold itself.
Back to my example. Of the R2 billion in unallocated gold, only R1 billion is held in physical gold. Before BASEL III, this bank would not have been forced to hold any RSF, but they will now be forced to hold 85% (or R850 million) collateralisation in cash, with a time horizon greater than a year, to cover their liability. This will definitely drive up the banks’ costs of borrowing and lending gold. So again, why do I think this is a good thing? If it’s going to cost more to facilitate transactions in the short selling gold, it may just relieve the selling pressure on gold itself.
The final effect of BASEL III on gold will only be established once it has been fully implemented. However, my opinion is that if gold will be regarded as a risk-free bank asset, it definitely is a positive thing and it could possibly ensure that the recent increase in central banks’ gold reserves can continue.
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