GOLD AND BASEL III

GOLD AND BASEL III

Impact of Net Stable Funding Ration (NSFR) on the gold market through enforcement of Basel III which implications were much debated on the bullion industry. NSFR requires 85% of required stable funding under the current rules which means higher costs for banks, holding gold on balance sheet which is inflictive and does not acknowledge the highly liquid gold n-ture and its way of being transacted as a currency.

Concerns about the NSFR and the 85% required stable funding (RSF) were forwarded to the Prudential Regulatory Authority (PRA) by the World Gold Council and London Bullion Market Association particularly the following points:

- The current clearing and settlement system would be undermined, the increased costs may make participation in the clearing and settlement regime commercially unviable, potentially leading to some banks existing the system.
- Liquidity could be drained, the cost of taking on gold deposits as unallocated gold would increase compared to the cost of custody services for allocated gold. Unallocated gold is an essential source of liquidity for the effective functioning of the clear-ing and settlement system.
- Financing costs would increase, stable funding costs could be passed through to non bank market participants such as miners, refiners and manufacturers using gold.
- Central bank operations would be curbed, the clearing banks facilitate gold deposit, lending and swaps operations; essential sources of market liquidity.

To understand how we got to an 85% RSF, we need to look at the evolution of the Basel Accords. The treatment of gold by regulators has evolved as the Basel Accords developed. The Basel Committee on Banking Supervision (BCBS) introduced the first iteration of the Basel Accords in the late 1980s to establish minimum capital requirements for banks. This was enforced by the “Group of Ten” economies countries that agreed to participate in the IMF’s General Agreements to Borrow (GAB). Basel 1 was primarily focussed on credit risk, with bank assets grouped according to risk weighting. Bullion carried a risk weigh of 0% and was therefore treated like cash.

Basel II extended the focus to include a larger element of counterparty risk, additional capital was required to mitigate the risk a bank takes on due to its trading, investment or financing initiatives. Launched in 2004, bank assets were divided into three tiers depending on the perceived level of risk, with tier 1 assets deemed the least risky. Under these rules, national authorities had the discretion to treat gold as either tier 1 or tier 3. The BCBS stated that “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%.” Under Basel II, a limiting ratio is placed on the amount of tier 3 capital that a bank can hold, tier III must not be more than 2.5x a bank’s tier 1 capital.

Basel III eliminates tier 3 capital and places new liquidity ratios on banks, specifically the Net Stable Funding Ratio (NSFR). This introduced an RSF factor of 85% for gold held on a bank’s balance sheet.

The Net Stable Funding Ratio seeks to calculate the proportion of Available Stable Funding (ASF) via the liabilities over Required Stable Funding (RSF):
NSFR = Amount of available stable funding / amount of required stable funding

Another innovation was the Liquidity Coverage Ratio (LCR). The LCR promotes the short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets (HQLAs) to survive a significant stress scenario lasting for one month. It basically sets the minimum liquidity buffer to bridge liquidity mismatches for one month in a crisis scenario. The NSFR has a time horizon of one year and requires that banks maintain a stable funding profile in relation to the composition of their assets and off-balance-sheet activities. Gold was not considered HQLA due to a lack of trading data at the time but it is our view that gold should be recognised as a very high quality liquid asset.

Gold’s performance during COVID-19 has further demonstrated its extremely liquid nature and shows that gold is, on average, more liquid than many other major asset classes.

There has been much speculation about the impact of the NSFR on the allocated and unallocated gold markets. Some commentators have noted that allocated gold can be considered a tier 1 asset and therefore receives a risk weighting of zero. Gold held in own vaults or on an allocated basis has always been a tier 1 asset under the Basel Accords. This is because allocated gold attracts no credit risk, it is neither the asset or liability of the custodian bullion bank and is therefore not considered part of the custodian bank’s balance sheet.

So, whilst Basel III does not materially change the treatment of allocated gold, it does increase the costs of holding unallocated gold. But does this mean the unallocated gold market will disappear? No it won’t, but the costs of holding unallocated gold will go up. Unallocated gold is an essential source of market liquidity. The clearing and settlement regime depends on it, and without an unallocated gold market it will be very difficult to finance (and facilitate) the upstream activities of gold producers and refiners, and the downstream users of gold such as jewellers and fabricators. The real economy demand for gold relies on the unallocated gold market. So whilst the funding cost of unallocated gold will increase, we are unlikely to see a major distortion in favour of allocated metal due to the imposition of the NSFR.

Concerns forwarded to the Prudential Regulatory Authority (PRA) by the World Gold Council and London Bullion Market Association includes a number of solutions proposed including exempting the clearing and settlement regime from the NSFR. There is precedent for this, for example the Swiss regulators have proposed to treat precious metals assets resulting from precious metals loans as interdependent, and therefore exempt from the NSFR .

Gold is used as a currency in many gold lending and borrowing transactions, with interest denominated and paid in gold ounces. Matching maturities leads to a symmetry between the ASF and RSF. Acknowledging the use of gold as a currency in such transactions would mitigate the impact of the 85% RSF.

Finally, the 2013 decision by the European Banking Authority (EBA) to not designate gold as HQLA should be revisited. Improvements in data and reporting since then has led to a com-pelling case for gold to be considered HQLA. Such a designation would provide more sym-metry between the ASF and RSF, mitigating the impact of the NSFR whilst recognising the liquid nature of gold.

Gold is a safe harbour asset and with its lack of credit risk, its role as a risk mitigator, and its highly liquid nature means it can act as a financial system stabiliser. Anything that discourages banks from holding gold may increase the vulnerabilities of the financial system during liquidity crises.

For further information please contact us through our web page www.liemeta.com.cy