BASEL 3.1 AND GOLD / MACLEOD FINANCE

Basel 3.1 and gold

There is confusion over the treatment of gold in Basel 3 bank regulations, with rumours that when Basel 3.1 is adopted in the US it will lead to physical demand. It is barely relevant.

ALASDAIR MACLEOD

This article is written at the prompting of some of my Substack subscribers, following an article by Rafi Faber, admitting that he was confused by banking regulations with respect to gold bullion. 

It is hardly surprising, because the only people who fully understand Basel 3 and Basel 3.1 (sometimes referred to as Basel 4) are banking regulators and the financial officers of banks. 

It is certainly beyond the lighter grasp of investors.

In this article, I attempt to unravel this mystery in language as non-technical as possible. 

Please bear in mind that the relevant Basel regulations cover bank balance sheets, which have assets on one side, which includes loans to customers and other banks, ownership of government securities, and corporate bonds. 

On the liabilities side is the bank’s equity capital comprised of shares, shareholders’ funds, and qualifying bonds. 

It also includes customers’ current accounts and deposits and loans by outsiders to the bank.

These regulations concern banking activities, not to be confused with market-making in securities. 

I also leave derivatives out of this article, notwithstanding their importance in precious metals markets, which is a complicated topic on its own.

Read this twice to banish any doubts about the role of gold in banking.

Gold is hardly relevant in Basel 3

Before I embark on gold’s regulatory status in the latest iteration of Basel regulations, it is important to downplay the importance of gold to commercial banking. 

It is almost irrelevant. 

There is an exception in the latest version, Basel 3.1 which I will come to later.

The most accurate definition of a bank is that it is a dealer in credit. 

Full stop. 

It lends money into existence for interest, creating matching deposits paying zero interest. 

The only interest a bank pays is that which is sufficient to keep its balance sheet balanced. 

Therefore, it has no interest in gold, which as an asset earns no interest, merely taking up balance sheet space at considerable cost.

Talk of gold being a Tier 1 asset is actually nonsense. 

Tier 1 applies to shareholders’ equity, which being a liability is on the other side of the balance sheet from gold, being an asset. 

More correctly, gold is a high-quality liquid asset (HQLA). 

And even then, it is valued beneath cash, deposits at the regulating central bank, government debt, and receivables in the process of settlement and various other asset categories.

An HQLA is nothing special. 

According to the Bank for International Settlements which oversees the Basel Committee, it is simply an asset that can easily and immediately be converted into cash with little or no loss of value. 

Depending on an HQLA’s risk status, its value is modified by a “required stable funding (RSF)” factor.

According to Basel 3,

“A bank's total RSF is the amount of stable funding that it is required to hold given the liquidity characteristics and residual maturities of its assets and the contingent liquidity risk arising from its off-balance sheet exposures.”

The highest category of HQLA has an RSF of 0%. 

This means that no RSF is applied. 

Along with physical traded commodities, gold has a punitive RSF or 85%.

The total RSF is calculated by applying individual RSF factors as laid down by Basel 3 to all the assets on a bank’s balance sheet. 

That is the amount required to be funded by the bank’s liabilities. 

These liabilities are also ranked, this time by their relative permanence to give a further factor, the available stable funding (ASF). 

Thus, permanent liabilities such as equity capital are valued 100% towards a bank’s ASF, while less permanent liabilities, such as large deposits maturing in less than one year that can be redeemed with little or no notice are valued at 50% of their balance sheet value.

Then, total available stable funding divided by required stable funding must be at least 100%.

The bullion bank exception

The position of gold as an asset bearing an RSF of 85% actually matters little, because as stated above, banks are not interested in holding an asset which yields nothing. 

Banks make their profits by being dealers in credit. 

The exception is bullion banks dealing in gold, which is not banking per se. 

It is buying and selling a commodity and related derivatives.

The latest iteration of Basel 3, Basel3.1, is sometimes referred to as Basel 4. 

And here in #96, there is a special case:

96. A 0% risk weight will apply to (i) cash owned and held at the bank or in transit; and (ii) gold bullion held at the bank or held in another bank on an allocated basis, to the extent the gold bullion assets are backed by gold bullion liabilities.

In other words, bullion held as an asset can be matched against liability to deliver bullion, taking it out of the ASF/RSF calculation.

This clause was added following lobbying by the LBMA in particular, so that the four bullion banks as owners of London Precious Metals Clearing Limited were able to maintain bullion balances as part of daily clearing obligations. 

In addition, it allows bullion banks offering unallocated accounts to customers with a general entitlement to fungible metal to maintain a bullion reserve without the penalty of an 85% RSF.

Finally, it should be noted that none of this applies to custodial gold; that is gold which is the property of a bank’s customers and not recorded on its own balance sheet.