Basel III – Implications for Gold and Silver

So, what is Basel III?

Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09. The measures aim to strengthen the regulation, supervision and risk management of banks and is a set of banking reforms designed to help enhance the resilience of the banking system to help prevent the same failures as those experienced in 2008 and to ensure that banking institutions are robust enough to withstand any future financial crisis.

In layman’s speak it is a set of international banking regulations developed by the Bank for International Settlements in order to promote stability in the international financial system. The purpose of Basel III is to reduce the ability of banks to damage the economy by taking on excess risk.

So why is everyone so excited about these technical banking regulations which normally send all but the most seasoned banker to sleep?

Well it’s the aspect of the regulations which has seen the recategorization of gold from being assessed as a Tier 3 asset to a Tier 1 asset.

Let us explain

As part of prudent regulation, banks are expected to keep a certain level of assets in certain forms in-order to prove and maintain their financial stability and we have all heard about bank stress tests which is an analysis conducted under hypothetical unfavourable economic scenarios, such as a deep recession or financial crisis, designed to determine whether a bank has enough capital to withstand the impact of adverse economic developments.

Well these assets or what the bank terms eligible regulatory capital were split into 3 tiers under Basel II the predecessor of Basel III the latter being published in 2009 following the 2008 financial crisis.

Tier 1 capital is intended to measure a bank’s financial health; a bank uses Tier 1 capital to absorb losses without ceasing business operations – It is regarded as a bank’s core capital.

It consists primarily of shareholders’ equity and retained earnings and is assessed at 100% of current value.

Tier 2 capital is supplementary (e.g. less reliable than tier 1 capital.) and includes revaluation reserves, hybrid capital instruments, and subordinated term debt and is assessed at 85% of current value.

A bank’s total capital is calculated as a sum of its tier 1 and tier 2 capital. Regulators use the capital ratio to determine and rank a bank’s capital adequacy.

Tier 3 capital consists of Tier 2 capital plus short-term subordinated loans which in essence means security that ranks below other loans or securities with regard to claims on assets or earnings and is assessed at 50% of current value.

Gold has historically been classified as a Tier 3 asset. When determining how much money a bank can loan, (as a bank’s capital or reserve requirement is taken into account in this assessment) the bank’s gold holdings have traditionally been discounted 50 percent of the current market value. Its movement under Basel III from a Tier 3 category to a Tier 1 category means that the 50% valuation reduction is removed and so gold is accounted for at full current price.

So what does this mean in practical terms – well to bankers a lot and to the rest of us not quite so much as we go about our every-day lives. But underlying, it does suggest that whereas traditionally banks were generally not too keen on gold holdings as an asset, as their value was cut in half for assessment and reserve purposes, this may now change and in fact this could potentially lead to banks becoming keener to acquire gold.

Basel III was agreed upon by the members of the Basel Committee on Banking Supervision in November 2010 and was scheduled to be introduced from 2013 until 2015; however, implementation was extended repeatedly to 31 March 2019 and therefore the excitement as we are only days away.

Now of course the pumpers are claiming that this is going to send the price of gold through the roof. We don’t think so, as banks have been aware of these regulations for years and have been quietly adapting, however it certainly does no harm to the underlying gold price.

With regard to silver, of course its not mentioned or covered in these regulations. However, investors are fully aware that whilst gold is a primary monetary metal, silver is a secondary one and of course ultimately, we can see it benefiting in positive price movements whilst Basel III is fully implemented.

So our conclusion – yes positive directly for gold certainly longer term and for silver because of its association. As bankers we have been aware of these provisions since 2009/2010 which is one of the many reasons why we have stated time and time again that longer term we are positive gold and to a lesser extent silver but positive, nevertheless. What we have always cautioned is not to be persuaded to jump too early while prices were relatively high and as with all investment formats to consider them as a long-term venture.