Basel III and the Gold Market

Basel III is a set of financial reforms that aims to strengthen regulation, supervision, and risk management in the banking industry. After the impact of the 2008 Global Financial Crisis on banks, Basel III aims to build upon the previous Basel Accords to improve banking organizations’ ability to handle financial stress and strengthen their transparency.

There’s been a lot of debate on if - and how - the implementation of Basel III will affect the gold market. In this article, we look at what Basel III is, its key features, how it might affect the gold market, and our predictions for the future of gold investments.

What is Basel III?

Basel III is an international regulatory framework for banks that was developed by the Basel Committee on Banking Supervision (BCBS). Also known as the third Basel Accord, Basel III aims to strengthen regulation, supervision, and risk management within the banking sector following the Global Financial Crisis of 2007-2008. It builds upon the previous Basel I and Basel II Accords and introduces more stringent capital requirements and liquidity standards for banks.

The GFC illuminated flaws in the earlier Basel Accords and made it clear that banks didn't have enough reserves to handle an economic downturn and cover the risks. This was seen with the failure of large banks and the collapse of Lehman Brothers which cascaded into one of the biggest global economic crises we've ever seen. In response to these perceived flaws, the BCBS agreed on the new Basel III regulation in 2010 which would impose requirements on the banking sector to implement asset policies that would reduce the chances of a repeat banking collapse.

Basel III implementation has been delayed numerous times, but its rules on bank liquidity started to apply on 28 June 2021 and its reform will come into full force in Europe on 1 January 2025.

BCBS and the Basel Accords

To truly understand the implications of Basel III, we should first examine the role of the BCBS and the first two Basel Accords.

The Basel Committee on Banking Supervision (BCBS) was established in 1974 by the central bank governors of the Group of Ten (G10) countries. These are Belgium, Canada, France, Italy, Japan, the Netherlands, UK, US, Germany, and Sweden. The goal of the BCBS is to enhance financial stability through setting standards for bank capital, liquidity, and funding. These standards are high-level, non-binding principles, which means members are expected to implement them through domestic regulation but not obliged to do so. Today, the committee has members from around 28 countries.

Basel I was introduced in 1988, prescribing minimum capital requirements for banks with the goal of minimizing credit risk. Assets were classified and ranked according to their credit risk: for example, gold bullion and cash were given a zero-risk rating while corporate debt was considered 100% risk. Under the Basel I regulations, international banks were required to maintain at least 8% of capital based on their risk-weighted assets. Over time, more than 100 countries adopted these principles.

In 2004, Basel II was released. It expanded the rules for minimum capital requirements, introduced a framework for regulatory supervision, and established new disclosure requirements for bank's risk exposures, risk assessment processes, and capital adequacy. Under the rules of Basel II, national authorities could choose to treat gold as either a Tier 1 or Tier 3 asset.

Read more: Why Central Banks Buy Gold

Key features of Basel III

Basel III is an attempt to avoid a repeat financial crisis of 2007-2008, when many banks were overleveraged and undercapitalized despite the efforts of Basel I and Basel II. While Basel II focused mainly on how much capital banks held and how they managed risk, Basel III encompasses new rules on liquidity, leverage, and systemic risks.

Its key features include:

• Increased capital requirements: Banks are required to hold higher levels of capital to absorb potential losses and increase their resilience to financial shocks. Basel III increases minimum capital requirements from 2% to 4.5% of common equity. There's also an additional 2.5% buffer capital requirement that brings the total minimum to 7%. The Tier 1 capital requirement also increased from 4% to 6%, which includes 4.5% Common Equity Tier 1 and 1.5% Tier 1 capital. Basel III eliminated the Tier 3 capital that existed in Basel I and II.
• Leverage ratio: Basel III also introduced a non-risk-based leverage ratio to limit the degree to which banks can fund their activities with borrowed money. This ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of a bank.
• Liquidity requirements: Two liquidity standards are outlined in Basel III: the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The LCR ensures that banks have sufficient highly liquid assets to meet their short-term liquidity needs during a 30-day stressed funding scenario. The NSFR promotes more stable funding above the required amount for a period of one year of extended stress. Part of the NSFR was a Required Stable Funding (RSF) of 85% for gold held on a bank's balance sheet.
• Counterparty credit risk: There are also measures to mitigate counterparty credit risk in derivative transactions, such as requiring banks to post collateral and calculate exposure based on potential future exposure (PFE).

The impact of Basel III on the gold market

The implementation of Basel III is expected to have significant implications for the gold market. One of the key changes with Basel III is the reclassification of gold from a Tier 3 asset to a Tier 1 asset with a 0% risk weighting, similar to cash and government bonds. Gold's previous classification as a Tier 3 asset meant that banks had to hold more capital against their gold holdings. Its change to a Tier 1 asset is likely to make gold a more attractive reserve asset for banks as it will require less capital to be held against gold holdings.

This is expected to have a positive impact on the gold market. With banks increasing their gold holdings to meet new requirements, demand is likely to surge overall. On top of this, reduced capital requirements for gold might also encourage banks to lend against gold collateral, increasing demand even more. This is likely to drive up the price of gold.

Keep reading: How to Invest in Gold as an Inflation Hedge

Basel III has also released stricter rules around the valuation of gold. Banks are now expected to use more conservative valuation methods, like marking gold to market on a daily basis. This daily valuation is likely to lead to frequent price fluctuations and make gold's price more volatile in the market. That said, this new regulation aims to keep valuation of gold assets transparent and accurate, which could actually enhance market stability over time.

Concerns about Basel III and the gold market

There have been concerns about how the new regulations set out in Basel III might impact the gold bullion industry, namely in regards to the NSFR and the 85% Required Stable Funding outlined in Basel III. These concerns are:

• The new rules could undermine the current clearing and settlement system, leading to increased costs which can make it commercially unviable to participate in the clearing and settlement regime. As a result, some banks might leave the system.
• It's likely that taking on gold deposits as unallocated gold would increase in price compared to custody services for allocated gold. Since unallocated gold is an essential source of liquidity for the clearing and settlement system, the new rules could reduce this liquidity.
• With increasing costs of stable funding, institutions could pass this on to non-bank market participants like miners, refiners, and manufacturers.

To address these concerns, the World Gold Council and London Bullion Market Association (LBMA) wrote an open letter to the Prudential Regulatory Authority (PRA). This resulted in an exemption for clearing members of London Precious Metals Clearing Limited (LPMCL). This ensures the clearing system in London can continue to operate as normal but still doesn't fully address the highly liquid nature of the gold market.

Allocated and unallocated gold

Under Basel III, allocated gold (i.e. gold that is physically stored, traceable, and allocated to an owner) is held on par with cash. It's considered a liquid, zero risk asset that counts towards a bank's allocation.

Unallocated gold, on the other hand, is now classified as a risky asset. This includes all 'paper' gold, such as futures contracts, ETFs, and other securities that have gold as an underlying but not allocated amount. This change in regulation aims to limit the issuing of securities backed by an amount of gold that doesn't actually exist.

See more: What Are the Advantages of Owning Physical Gold?

In most gold transactions, the buyer does not actually 'own' the gold, but is considered a creditor. This means the bank continues to own the gold, store it in its vaults, and treat it as part of its liquid reserve. In a liquidity crisis or bank failure, the institution is likely to use this unallocated gold to pay off its debts - even though it's technically owned by someone else.

In an attempt to put an end to this business model, Basel III now categorizes unallocated gold in the riskiest tier, requiring banks to hold capital buffers of 85% to secure precious metals financing and clearing transactions as opposed to the previous 0%.

The future of gold investments

This change of classification is a resounding reminder that physical gold is the safest investment. It is a hedge against inflation that increases in value during periods of economic uncertainty, instability, and geopolitical tensions. It's highly liquid and the new Basel III regulations can be considered an endorsement of the value of physical gold. As more banks move from unallocated to allocated gold, its value will increase even further.

With these new rules, it’s likely that banks and institutions will start to flock away from unallocated gold due to the demand for increased reserves. If banks choose to not set aside more funding for unallocated gold, this could mark the end of forwards and futures contracts for precious metals.

While it's still too early to tell how Basel III reforms will impact the price of gold, it's important to remember that there are myriad factors at play when it comes to gold price movements, including interest rates and economic indicators. Our projection for the future is that banks will limit unallocated gold activity to avoid the reserves requirements. If banks do choose to start flocking towards physical gold again, we'll see a price increase that will make investors of physical gold quite happy.

Continue reading: How to Store Physical Gold

An investment that will stand the test of time

One thing is for certain: physical gold is a sound investment that has proven its value time and time again. While paper gold may have had its moment, Basel III is a sign that physical holdings are the best way to ensure your investment protects you during periods of economic instability and times of crisis.

If you're ready to invest in your own safe-haven asset, you're in the right place. At StoneX Bullion, we offer an impressive catalog of gold bullion bars and coins from the best-known mints in the world. Every investment-grade gold, silver, platinum, or palladium item on our website is shipped to you securely so you can physically hold it in your home or storage vault. Browse our range of investment-grade precious metals and start growing and preserving your wealth.