By StoneX Bullion

Basel III is a set of financial reforms aimed at strengthening regulation, supervision and risk management in the banking sector. Following the impact of the 2008 global financial crisis on banks, Basel III aims to build on previous Basel accords to improve the ability of banking organizations to handle financial stress and strengthen their transparency.

There has been much debate about whether 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 could 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 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 on the previous Basel I and Basel II accords and introduces stricter capital requirements and liquidity standards for banks.

The global financial crisis exposed the shortcomings of the previous Basel accords and made it clear that banks did not have sufficient reserves to weather an economic downturn and cover risks. This was seen with the failure of major banks and the collapse of Lehman Brothers, which led to one of the biggest global economic crises we have ever seen. In response to these perceived shortcomings, the BCBS agreed in 2010 to the new Basel III regulation, which would impose requirements on the banking sector to implement asset policies that would reduce the chances of a repeat of a banking collapse.

The implementation of Basel III has been delayed numerous times, but its rules on bank liquidity began to apply on June 28, 2021, and its reform will take full effect in Europe on January 1, 2025.

The 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), consisting of Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, the United States, Germany and Sweden. The BCBS's objective is to enhance financial stability by setting standards for bank capital, liquidity and funding. These standards are high-level, non-binding principles, which means that members are expected to implement them through national regulation, but are not obliged to do so. Today, the committee has members from some 28 countries.

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

In 2004, Basel II was published, which expanded the rules on minimum capital requirements, introduced a framework for regulatory oversight, and established new disclosure requirements on banks' risk exposures, risk assessment processes and capital adequacy. Under Basel II rules, national authorities could choose to treat gold as a Tier 1 or Tier 3 asset.

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Key features of Basel III

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

Increased capital requirements

Banks must 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 is also an additional reserve capital requirement of 2.5%, bringing the total minimum to 7%. The Tier 1 capital requirement also increased from 4% to 6%, including 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 extent to which banks can finance their activities with borrowed money. This ratio is calculated by dividing Tier 1 capital by a bank's average total consolidated assets.

Liquidity requirements

Basel III establishes two liquidity standards: the liquidity coverage ratio (LCR) and the 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 during an extended one-year stress period. 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 in place to mitigate counterparty credit risk in derivative transactions, such as requiring banks to provide collateral and calculating 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 in Basel III is the reclassification of gold from a Level 3 asset to a Level 1 asset with a 0% risk weighting, similar to cash and government bonds. Gold's previous classification as a Level 3 asset meant that banks had to hold more capital to back their gold holdings. Its change to a Level 1 asset is likely to make gold a more attractive reserve asset for banks, as it will require less capital to back their gold holdings.

This is expected to have a positive impact on the gold market. As banks are increasing their gold holdings to meet the new requirements, demand is likely to increase overall. In addition, lower capital requirements for gold could also encourage banks to lend against gold collateral, which would further increase demand. This is likely to drive up the price of gold.

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Basel III has also issued stricter rules around gold valuation. Banks are now expected to use more conservative valuation methods, such as daily valuation of gold at market price. This daily valuation is likely to cause frequent price fluctuations and make the gold price more volatile in the market. That said, this new regulation aims to maintain transparency and accuracy in the valuation of gold assets, which could actually improve market stability over time.

Concerns about Basel III and the Gold Market

Concerns have been expressed about how the new regulations set forth in Basel III could affect the gold bullion industry, particularly in relation to the NSFR and the 85% Basel III Stable Funding Requirement. These concerns are:

The new rules could undermine the current clearing and settlement system, leading to increased costs that would make participating in the clearing and settlement regime commercially unviable. As a result, some banks could leave the system.

Acceptance of gold deposits as unallocated gold is likely to 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 the rising costs of stable funding, institutions could pass this on to non-bank market participants, such as miners, refiners and manufacturers.

To address these concerns, the World Gold Council and the London Bullion Market Association (LBMA) wrote an open letter to the Prudential Regulation Authority (PRA). This resulted in an exemption for clearing members of London Precious Metals Clearing Limited (LPMCL). This ensures that the clearing system in London can continue to operate normally, but still does not 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 is traceable and assigned to an owner) is held on an equal footing with cash. It is considered a liquid, zero-risk asset that counts towards a bank's allocation.

On the other hand, unallocated gold is now classified as a risk asset. This includes all "paper" gold, such as futures contracts, ETFs and other securities that have gold as the underlying but unallocated amount. This change in regulation is intended to limit the issuance of securities backed by an amount of gold that does not actually exist.

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 that the bank still owns the gold, stores it in its vaults and treats it as part of its liquid reserve. In the event of a liquidity crisis or bank failure, the institution is likely to use this unallocated gold to pay its debts, even though it is technically owned by someone else.

In an attempt to put an end to this business model, Basel III now classifies unallocated gold at the riskiest level, requiring banks to hold capital reserves of 85% to secure precious metals funding and offset transactions, rather than the previous 0%.

The future of gold investments

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

With these new rules, it is likely that banks and institutions will begin to abandon unallocated gold due to the demand for higher reserves. If banks decide to no longer set aside funds for unallocated gold, this could mark the end of forward and futures contracts for precious metals.

While it is still too early to tell how the Basel III reforms will affect the gold price, it is important to remember that there are a lot of 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 activity in gold to avoid reserve requirements. If banks decide to flock back to physical gold, we will see a price increase that will make physical gold investors very happy.

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An investment that will stand the test of time

One thing is for sure: physical gold is a safe 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 that your investment will protect you during periods of economic instability and times of crisis.