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Gold and Basel III

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Gold and Basel III

The price of gold has been weak of late, but many commentators expect that to change as the implementation of new bank capital rules under Basel III will support demand for physical gold. In this Macro Flash Note, GianLuigi Mandruzzato looks at the outlook for the price of gold considering both the new Basel III rules and long-term economic fundamentals.

Many commentators believe that the price of gold will soon rise due to the implementation of new rules on banks’ capital requirements under Basel III.1 First announced in 2017, the Basel III rules apply to banks operating in the US, the European Union and Switzerland since the end of June 2020. Notably, as of 01 January 2022 they will also apply to UK banks and hence to a dominant share of financial transactions related to gold settled on the London Bullion Market.

The new regulation distinguishes between allocated and unallocated gold accounts. Gold in allocated accounts is held in custody in a bank’s vaults but belongs to the bank’s clients. Unallocated gold accounts reflect financial transactions linked to gold including gold lending, swaps, futures, and hedging for producers and refiners as well as jewellers and other corporate users. Unallocated gold accounts belong to the bank. 

Under the new regulation, allocated gold will be considered a Tier 1 asset and will continue to have zero risk weighting. Conversely, banks’ unallocated gold and exposures due to other financial transactions will be considered a Tier 3 asset subject to a Required Stable Funding (RSF) ratio of 85% like other risky assets such as equities. Under the new rules, banks are required to hold physical gold or other liquid assets for an amount equal to at least 85% of the value of unallocated gold on their books.

Unallocated gold accounts, often referred to as paper gold, are attractive to banks because they can leverage on the gold actually held in the vaults: some estimates put the ratio of unallocated gold to physical gold at up to 400 times, making it potentially very profitable to bullion banks. A likely, and probably intended, consequence of the Basel III rules will be a drop in the volume of financial transactions linked to gold. The increased cost of these activities will encourage bullion banks to reduce their exposure or to increase the price they charge clients, who may reduce demand for those products. 

The new rules give physically held gold a preferential treatment over paper gold, and that should increase demand for bullion and support the price of gold. Many commentators see as no coincidence that since 2017 central banks have purchased large volumes of physical gold and that gold prices have generally risen (see Chart 1). Because of the new rules, banks are expected to advise clients to turn unallocated into allocated gold positions, increasing, at least temporarily, the demand for physical gold. However, since this would mainly be an accounting effect rather than a real increase in demand for the yellow metal, the impact on gold prices looks uncertain.

Chart 1. Official sector demand and gold price


Source: World Gold Council, Refinitiv, and EFGAM calculations.

Rather, the price of gold should benefit from the lower volume of unallocated gold accounts. As these financial transactions are often used to speculate on a downward movement of the price of gold, a reduction in their size should be supportive of prices. 

The calendar also matters and the effect of the new regulation on gold prices is expected to emerge in the latter part of 2021 if the implementation of the new rules goes ahead as planned also for UK banks. The London Bullion Market is the world's leading gold trading hub with a daily turnover of nearly USD30 bn, and UK bullion banks are among the major players in the market (see Chart 2).2 There is still uncertainty as to whether the new regulations will be implemented in the UK. LBMA, supported by the World Gold Council, the association of gold producers, has asked the UK Prudential Regulation Authority (PRA) to review the Basel III terms or postpone its implementation. On 09 July, PRA said clearing activities will be exempted from the 85% RSF and left open the possibility of reducing the required capital buffer against unallocated gold positions, without providing further detail.

Chart 2. LBMA monthly average of daily transactions


Source: LBMA, Refinitiv and EFGAM calculations.

While the enforcement of the new Basel III rules is expected to drive the price of gold higher in the next few months, other fundamental factors also favour higher prices. Notably, expectations of continued expansive monetary policy for some time to come (as shown by the US 10-year government bond yield close to 1.30% at the time of writing this note) a relatively weak US dollar, and the level of the VIX index of implied equity market volatility together suggest the gold price should trade above current levels of around USD1800 per ounce (see Chart 3). 

Chart 3. Gold prices could be higher


Source: Refinitiv and EFGAM calculations.

1 The Basel Committee on Banking Supervision, which sets standards for regulation of banks, developed what is called Basel III. It is an internationally agreed set of measures that aim to strengthen bank regulation, supervision and risk management.

2 About 150 firms are members of the London Bullion Market Association, including producers, refiners, and traders, and 43 banks, of which only ten are European or Swiss.