Discussions are still under way on how the entry into force of the third Basel Agreement ("Basel III") will affect the gold market. In addition to changing the requirements for bank capital, Basel III contains two completely new conditions for the liquidity of bank assets: a net stable financing ratio and a liquidity coverage ratio. According to the new rules, for unallocated gold, mandatory stable financing of 85% is required, which will increase the cost of storing gold on the balance sheet of banks.
The World Gold Council and the London Association of Precious Metals Market Participants sent a joint appeal to the Prudential Regulation Authority (United Kingdom), in which they justified the need to abolish the mandatory stable financing of undistributed gold at 85%. The document indicates the negative consequences for banking assets of the entry into force of this rule, namely:
1. The cost of raising deposits in the form of unallocated gold will increase compared to the cost of distributed gold storage services. Unallocated gold is an important source of liquidity for the effective functioning of the clearing and settlement systems.
2. Only a few large banks will be able to use the existing clearing and settlement system in the new conditions. For most financial institutions, this will be economically unprofitable due to high costs.
3. The costs of financing unallocated gold will be transferred to non-bank participants in the yellow metal market - gold miners, processors and manufacturers.
4. Central bank operations will be significantly limited.
Evolution of the Basel Agreements
To understand where the need for mandatory stable financing of undistributed gold in the amount of 85% arose, we will show the history of the Basel agreements. As they evolved, regulatory attitudes towards gold evolved. In the late 1980s Basel Committee on Banking Supervision presented the first version of the agreement - Basel I. It was developed in 1988 against the backdrop of large losses and bankruptcy of financial intermediaries in the 1970-1980s. The document established minimum requirements for equity for banks. The key idea of Basel I is to limit credit risk and possible losses of banks through a system of monitoring that banks have a sufficient amount of capital.
The second agreement, Basel II, was adopted in 2004: a norm was established regarding the need to own additional capital to reduce risks in order for banks to implement trade, investment or financial initiatives. The main idea of Basel II is to improve the stability and quality of risk management in the banking sector by complying with the requirements of financial institutions for minimum capital and maintaining market discipline. Bank assets placed in 2004 were divided into three groups according to the expected level of risk. First-level assets were considered the least risky. The authorities had to attribute gold to the first or third risk group. Gold ingots in their own repositories or used as investment liabilities were treated as zero-risk assets. According to Basel II, the assets of the third group were set a limiting coefficient. The bank assets of the third group in the amount should not have been more than 2.5 times the size of the assets of the first group.
During the financial crisis of 2007-2008, several banks, including British Northern Rock and American Bear Stearns and Lehman Brothers, suffered from a liquidity crisis due to excessive dependence on interbank lending. Therefore, the G-20 countries began to revise banking regulations by creating Basel III.
Basel III excluded "risk level 3 assets" and established new liquidity ratios for banks, in particular, a ratio of net stable financing. In accordance with the new rules for gold on the bank's balance sheet, a new liquidity cover ratio of 85% will be applied.
New coefficients in accordance with Basel III
The net stable financing ratio is designed to calculate the share of available stable financing through liabilities compared to mandatory stable financing for assets. To calculate the net stable financing ratio, the amount of available stable financing is divided by the amount of mandatory stable financing.
Another innovation was the liquidity coverage ratio. This indicator indicates the short-term sustainability of the bank's liquidity risk profile and the presence of a sufficient number of high-quality liquid assets or a minimum buffer of monthly liquidity in the event of a crisis.
The ratio of net stable financing has a time horizon of one year and assumes that banks should maintain a stable funding profile depending on the composition of their assets and off-balance sheet activities. According to the new rules, gold does not belong to highly liquid assets due to the lack of trading data on precious metal during the development of the third version of the agreement. However, experts are sure that gold should be attributed to this group of assets.
An analysis of the London OTC market and the results of recent academic studies on the market liquidity of gold show that the attributes and behavior of precious metal correspond to the characteristics of high-quality liquid assets such as long-term US Treasury bonds. Yellow metal indicators during the pandemic once again demonstrated that precious metal is more liquid than many other major asset classes.
Distributed and unallocated gold
The impact of the net stable financing ratio on distributed and unallocated yellow metal markets continues to be debated. Some commentators noted that distributed gold may refer to assets of group 1 with a zero risk ratio. However, this is not news. Gold in its own storage or on a distributed basis has always been a Level 1 risk asset under the Basel Agreements. The fact is that such gold has no credit risk, is neither an asset nor an obligation of the ingot custodian bank and, therefore, is not considered part of its balance sheet.
Thus, Basel III does not radically change the approach to distributed gold, but increases the cost of storing unallocated precious metal. Unallocated gold will not disappear anywhere, but the cost of its ownership will increase. Unallocated gold is an important source of market liquidity. The clearing and settlement mode depends on it. Without an unallocated gold market, it will be very difficult to finance the activities of producers and processors of precious metal, jewelers and manufacturers.
In this appeal, the World Gold Council and the London Association of Precious Metals Market Participants proposed a number of solutions, including the exclusion of the clearing and settlement regime from the net stable financing coefficient. There is a precedent for this. For example, Swiss regulators exempted assets from precious metals derived from loans from the net stable financing ratio.
Yellow metal is used as money in many of its borrowing and lending transactions, and interest is expressed and paid in ounces of gold. The coincidence of loan maturity leads to a symmetry between affordable stable financing and mandatory stable financing. Recognizing the use of gold as money in such transactions would reduce the negative impact of the need for mandatory stable financing at 85%.
The appeal also states that the decision not to consider gold a highly liquid asset, adopted in 2013 by the European Banking Authority, should be revised in connection with updated data on trading transactions with precious metal. Recognition of gold as a highly liquid asset would provide greater symmetry between available stable financing and mandatory stable financing, reducing the negative impact of the net stable financing ratio.
Gold is a protective asset with zero credit risk, capable of mitigating the effects of any economic crises. This means that it can function as a tool to stabilize the financial system. Any obstacles to its retention in banks can increase the vulnerability of the financial system during liquidity crises.