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BASEL III and the gold effect

So, what is BASEL III, and how does it affect… Continue reading BASEL III and the gold effect

So, what is BASEL III, and how does it affect the gold market? Put simply, it’s a new set of financial regulations designed to make sure that we don’t have another 2008-style financial crisis. These new regulations may well affect the cost of gold.

More than a decade in the making and repeatedly delayed, 2009’s BASEL III international regulatory accord finally began its global rollout a few weeks ago. So far, the impact on the gold trade is unclear, and it may yet force prices up and availability down.

Could BASEL III avoid future banking crises?

The basic premise behind BASEL III is to avoid another financial crisis. When the US sub-prime mortgage market imploded, banks were left with worthless loans and nowhere near enough capital to fulfil their obligations.

How does BASEL III work?

Financial regulators want banks to have a certain amount of cash at hand to satisfy an immediate requirement for liquidity (for example, if lots of people want their money back). It works the same way as someone having savings for an unexpected bill or repair, but on a much larger scale. It’s a catch-22, though, because, in a financial crisis, people become worried and want to take back control of their own money. So, they withdraw their cash which tightens a bank’s liquidity potential as fewer people want to entrust banks with their money.

No more surprises

BASEL III is designed to force banks to hold enough capital and manage their equity to debt ratios to cover a similar financial shock. As a result, it should limit the risk-taking that led to the 2008 crisis in the first place.

The regulatory regime follows on from BASEL I and II. However, banks have been aware of and planning for the implementation for over a decade. The final stage of BASEL III was originally due to be implemented in 2022 but has been delayed to 2023 to allow for the impact of the COVID-19 pandemic. But some parts of the regulation have already come into force in Europe and the US and will be implemented in the UK in January 2022. These regulations change how gold is classified as an asset which could have lasting effects on the gold market.

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Classifying gold

Under the BASEL III regime, banks have to hold enough liquid assets to cover their illiquid or riskier assets like property, equities, loans, mortgages, bonds and shares in other companies. Cash counts as a liquid asset, but holding cash doesn’t earn the banks any money and is subject to inflation.

Allocated gold

Physical, allocated gold is on a par with cash, a liquid asset that counts towards that bank’s allocation. But this is only true of allocated gold which are coins or bars that are physically stored, traceable and allocated to an owner.

Unallocated gold

Meanwhile, under BASEL III, unallocated gold is now classified as a risky asset. This is the ‘paper’ gold that isn’t represented by a physical amount of gold equivalent to what is traded.

Do you own your gold?

In most gold transactions, the buyer does not become the ‘owner’ of the gold. Instead, they become creditors, with the dealer (usually a bank) owing them gold rather than selling it directly. This allows the bank or dealer to remain the current owner of the gold, storing it in its vaults, allowing it to treat the gold as part of its liquid reserve. Useful as an emergency measure in the event of a liquidity crisis.

The risk of unallocated gold

This means that in the event of a bank failure, the bank may well ditch your ‘unallocated’ gold to pay its debts. Indeed, in some cases, it is mandated to do so. Liquid reserves exist to be sold to protect the bank’s general creditors. They all must receive a proportionate share of whatever it makes from selling off its assets if it becomes insolvent. Under BASEL III, banks who trade in unallocated gold will have to hold extra reserves against it to limit the risk of insolvency in a crisis.

So, the new regulation means physical or allocated gold moves from a risky tier 3 asset to a tier 1 asset on a par with cash, and banks would do well to hold it.

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The physical gold advantage

Allocated gold is safe. It can be a hedge against inflation. It grows in value during times of uncertainty. It is also instantly liquid, so it complies with the new regulations. The regulations are a resounding endorsement of the importance of allocated gold, and as banks move to own more of the metal, the value is further underpinned.

How will this impact gold price?

The change of classification will impact the willingness of banks and institutions to trade in unallocated gold because it now comes with the reserves caveat. This may affect liquidity and the ease of trading metals, which may have a knock-on effect on prices. The actual longer-term impact on the market is not certain, though.

The picture so far

Europe and the US enacted the new classification regulations a few weeks ago. There hasn’t yet been a major change in the gold price, which has fluctuated around the $1,820 mark throughout July. The many other drivers of gold price movements, like interest rates, financial policy and economic indicators, remain at play. However, BASEL III is yet another weight on the scales of the gold price.

Banks may choose to limit unallocated gold activity to avoid the reserves requirements. They can also increase reserves to meet the regulations but raise the costs for market participants. Unallocated gold is used often to lend to industrial precious metal market participants. Trades are made and repaid in metal, facilitating “precious metals refining, fabrication and manufacturing of consumer goods and jewellery”, the LMBA says. If this metal is unallocated, it will come at a greater cost in a post-BASEL III market.

An investment opportunity?

Retail investors who want to benefit from physical ownership and circumvent the banking system should buy from a reputable dealer to ensure their gold is allocated. If the new regulations drive prices up, that will be a boon to physical gold holders. Gold has performed very well over the past five years, almost doubling from 2016 lows to 2020 highs. The outlook remains strong as the global economic recovery staggers under repeated COVID-19 setbacks. BASEL III will make the banks safer, but physical gold is the ultimate safe haven.

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