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Gold and Basel III

Perhaps you have never heard of the Bank for International Settlements (BIS) located in Basel, Switzerland. Perhaps you have never heard of the Basel Committee on Banking Supervision (BCBS), a separate legal entity with headquarters at the BIS. But these two regulatory bodies play a considerably important role in the development of international banking supervisory standards. And, as it happens, they also put forward propositions on how gold is to be seen by the banks.

The BIS was set up in 1930, its goals and means have changed throughout the years and today its main scope of activity is to provide central banks with credit when necessary and to help in achieving monetary and financial stability on an international level. The BCBS was established in 1974 and is primarily concerned with coordinating banking supervisory activities. Both BIS and BCBS are organizations with history but neither of them have legal power to enforce any changes in the law of its members.

On the other hand, it proves that the BCBS has considerable influence among central banks all over the world. In 1988 the Committee outlined what is currently known as Basel I - a set of recommendations on capital requirements. Long story short, bank assets were divided into several groups based on their perceived riskiness (bonds and gold were in the least risky category) and banks were required to cover 8% of their assets according to a special formula. The intuition was that at least a part of all the assets of the banks should be backed up by assets perceived as "safe" (including gold). Even though the BSCB did not have any regulatory power, its members adhered to its requirements, with the level of adherence varying among the countries.

In 2004, Basel II was introduced with more detailed recommendations on capital requirements, banking supervision and market risk. Bank assets were divided into three categories where Tier 1 encompassed assets perceived as least "risky" and Tier 3 comprised of assets perceived as "risky." The recommendations were amended multiple times; however, they failed to adequately identify the risks associated with structured credit products, like mortgage-backed securities. These risks were severely underestimated or even not identified. As far as gold is concerned, under Basel II it was treated as either Tier 1 or Tier 3 capital, since the BCBS stipulated 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%.

Now, let's make this absolutely clear, this excerpt comes from the Basel II (!) documentation and NOT from the Basel III one. So, depending on the decision of the country gold was either counted as Tier 1 or Tier 3 capital already under Basel II. Gold was also accepted as collateral with a supervisory haircut of 15%.

The financial meltdown of 2008 prompted the BCBS to revise its recommendations and postulate more restrictive capital requirements. In 2010 the BCBS presented the first official version of its new recommendations, which was called Basel III. Basel III abolished the Tier 3 capital class - all assets fell either under Tier 1 or Tier 2 capital. Under these recommendations gold remained eligible collateral with a haircut of 15% just as it was under Basel II. Moreover, the announcement of the U.S. Federal Deposit Insurance Corporation (FDIC) made on June 18, 2012 and stating that gold bullion is a "zero percent risk-weighted items" (an item perceived as "riskless," similarly as Tier 1 capital) brought "no change to banking capital rules with respect to gold" as the FDIC spokesperson claimed. So, gold was considered "riskless" in the U.S. under Basel II recommendations and it will remain considered this way under Basel III provisions. No change has been brought about.

The situation looks slightly different in Europe. If you remember, under Basel II gold could be considered a "riskless" asset at national discretion. The EU consists of 27 countries, each with its different supervisory regulations. The European Commission did not automatically consider gold a "riskless" asset, but charged the European Banking Authority (EBA) with the task of identifying which assets are to be legally deemed "riskless." On the other hand, the European Parliament expressly pointed to gold as a highly liquid asset that should be taken into consideration by the EBA. The EBA review is scheduled to end in 2015, gold is however, already recognized as collateral.

If you feel in any way lost in the jungle of banking regulations relating to gold, do not worry, we have pointed out the most important things you need to know:

• Basel III does NOT, in any significant way, change the way the U.S. regulator sees gold.

• Gold has NOT become the legal tender in any country adhering to the Basel III rules.

• Basel III is NOT a shift toward a gold standard, contrary to what has been rumored.

• The general regulatory trend in the EU seems to point to the inclusion of gold as a "riskless" asset.

What does all of this mean for you? Generally speaking, if gold is officially confirmed as a "riskless" asset by the EBA, then an increase in demand for gold may be seen in the EU. Such an increase, however, would not be a main driver of the price of gold. So, Basel III is not a major factor in the continuing gold bull market. Favorable fundamentals for gold, even without a positive impact from Basel III, are still in place and the long-term trend remains up.

If you have enjoyed this commentary, please check our research essays on gold in Fort Knox and on gold and the dollar collapse. For a more practical view on how we see investments in gold and silver, refer to our essay on gold and silver portfolio.

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