How Basel III Will Impact Gold Markets

(June 24th, 2021 - Nick Frappell)

Key points:

• Basel III aims to reduce systemic risk via better controls on liquidity exposure.
• NSFR and HQLA (explanations below) are the two mechanisms that affect the gold market.
• Impact will increase cost of doing business along all stages of the value chain.
• Banks have a spectrum of views on the actual impact post-introduction, from ‘BAU’ to ‘rather unsure’.
• Scope for regulators to interpret gold’s suitability as a HQLA and/or implementation of NSFR.
• Impact likely to be felt via wider spreads, increased volatility and higher borrowing costs.

How Basel III will impact gold markets

Basel III aims to address the threat from severe liquidity events that occurred in the GFC.

The trigger for the severe drawdown on liquidity was prompted when the creditworthiness of a category of bonds known as Asset Backed Securities (ABS) were suddenly ‘re-rated’ by the market and market participants questioned the likelihood of ABS obligations being met.

This led to a decline in ABS values.

A subsequent sell-off in ABS as participants sought to reduce their exposure, and a crisis whereby banks or ‘shadow banks’ that borrowed money for the short term to finance long-term (and illiquid) assets that were collateralized using ABS pledged to lenders, saw sudden margin calls and a reduction in short-term lending as the value of their collateral plummeted.

This caused collateral holders to liquidate their holdings even faster, leading to a death-spiral in short term lending markets.

The core problem outlined above was made worse by a wave of defaults that were insured by credit

Understand the regulation

The Basel Committee for Banking Supervision set out the Basel III measures were to protect against those risks the GFC uncovered.

The two risk controls of interest for markets watchers are the Net Stable Funding Ratio (NSFR) and the High Quality Liquid Asset (HQLA) provisions.

There are other protections, such as increasing bank capital requirements, but the above two are the most relevant to the gold market.

The NSFR requires lenders to borrow relatively longer term to fund loans and reduces the ability of banks or non-bank lenders to lend long and fund the loan by borrowing very short term, for example by funding a 12-month loan by borrowing one week and continuously rolling the short-dated borrowing.

By compelling lenders to borrow for longer, the risk that a bank is compromised by a sudden decline in market liquidity, or even by a change in the bank’s own credit standing, is reduced.

The HQLA provision defines an asset that is liquid even in times of stress and is ideally central bank eligible.

The first quality outweighs the second

Liquid means the ability to be immediately converted into cash at little or no loss of value.

How liquid an asset is depends on the stress scenario, the volume of the asset that needs to be monetized and the time frame over which the conversion into cash needs to take place.

Basel III liquidity requirements require banks to hold sufficient HQLA to fund expected net cash outflows during a 30-day period of market stress.

The fundamental characteristics of a HQLA align well with gold, however gold is not yet considered a HQLA as there was insufficient data collected to demonstrate that gold responds well enough to real world shocks.

Accordingly, the LBMA and the RoZetta Institute have gathered data on gold price action over the period 2007-2018 and 2020 to demonstrate that gold should be counted as a HQLA.

Impact on the gold market

There are some concerns, articulated by both the LBMA and the WGC, that the new requirements will have a negative impact on two aspects of the gold market. Namely, the clearing of unallocated gold, and the lending market for gold.

By increasing costs and reducing the leeway for maturity transformation by banks the lending market that is important for financing gold fabrication and refining is at risk of reduced margins for banks and higher costs for end-users.

There are fears that this will impact costs along the entire supply chain from the mine site onward, and indeed will impact the cost of risk mitigation by miners who wish to enter into metal hedges, unless they are significantly longer dated, as hedging creates a ‘borrowing’ scenario that must be funded by the bullion bank.

Certain central banks have indicated that they are happy to return to the market to lend but require a defined ‘hurdle’ rate below which they do not lend.

There is some concern that the cost of financing short term metal could rise sufficiently that there is paradoxically less liquidity available in the settlement system.

The most likely outcome is the widening of spreads in general and an increase in borrowing costs, along with a tendency for lenders to incentivise longer term liabilities to mitigate the effect of the NSFR requirements.

The chance that fewer market participants are active in the market may also increase market volatility if market liquidity diminishes, as some observers believe it may.

Reaction by the financial sector

Reaction has been fairly muted. Banks have examined the likely effect on their business models and judged that the impact will not be as material as some have thought.

In addition, there is a belief that regulators will take a pragmatic view and that NSFR requirements will be eased for gold.

Secondly, the significant data-gathering that demonstrates that gold should indeed be classed as a HQLA may persuade regulators to allocate gold to HQLA status.

Dates to watch

Implementation of the NSFR requirement is due on 28 June 2021.

The key take-away of all the above is that the Basel III provisions for NSFR and HQLA represent a potential cost to doing business along most, if not all points along the supply chain.

This may have unintended consequences, including reducing liquidity in a key investment asset.

It also risks raising costs for all precious metals end-users whose use-cases extend from investment, jewellery, electronics, cracking of key chemicals and pollution reduction in both the petrochemical and automobile industries.