Gold and Basel III

There has been a lot of chatter over the last few months about the changed status of gold as an asset under the new Basel III guidelines. For those unfamiliar with Basel regulations, Basel is a small Swiss town where the Bank for International Settlements (BIS) is based. The BIS is an international organization which is comprised of global central banks and which provides guidance on international monetary policy and bank regulation. The BIS has periodically issued guidelines through the Basel Committee on Banking Supervision, regulations which are seen as global standards on bank capital adequacy and liquidity requirements.  Most recently the Bank issued the Basel III guidelines which will slowly be implemented from 2013-2019. Many of the guidelines were formulated keeping in mind the causes of the financial crisis of 2008; as such Basel III raises capital adequacy and liquidity requirements for financial institutions.

Before I go any further I would like to define a key term, Tier 1 Capital Ratio which is defined as ( From Wikipedia) “the ratio of a bank’s core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country’s central bank). Most central banks follow the Basel Committee on Banking Supervision (BCBS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while certain loans have a risk weight at 100% of their face value.”  There have been a number of articles published over the last few months which seem to suggest that Gold is being elevated from Tier 3 (Riskier Asset with a larger haircut in calculating bank capital adequacy ratios) to a Tier 1 Asset. However Basel III adds a liquidity requirement to assessing an asset’s risk as well. So Gold could be considered as safe as AAA Government issued Treasuries but it would still have a 50% liquidity haircut. Many people consider this haircut to be too high and they point to the very liquid global market for gold.  In the best article I have read on this issue, an article I highly recommend everyone to read, Eric Sprott and David Baker of Sprott Asset Management highlight the complex treatment of gold under Basel III and make a case for gold’s increased use in the financial system as a quality asset on par with other recognized assets like US Treasuries.  Sprott does manage a very prominent gold fund and has been a very vocal precious metals investor over the past few years but the analysis he presents is still valid.

On the other hand some analysts feel that Gold will see no fundamental change in demand because of new Basel III guidelines but will continue to be valued based on long term demand and supply fundamentals. In another well written article Przemyslaw Radomski  argues that Basel III does not fundamentally change how gold is viewed by US regulators as a low risk asset.  He highlights 4 key points, and I quote “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‘‘. As this article has summarized there are multiple viewpoints regarding the affects of Basel III on gold. I encourage you to read the articles I have linked to in this write up.

In future articles I will continue to look at the role played by gold as an investment asset and how new regulations and global shifts in demand are affecting the market for gold. I am going to explore the growth of gold ETF’s and central bank purchases of gold.

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