The big new thing in gold

My Dear Extended Family,

The following was sent in by CIGA Luis Ahlborn Sequeira.

Jim,

This is the new big thing in gold - capital adequacy ratios.

CIGA Luis Ahlborn Sequeira

The big new thing in gold - capital adequacy ratios

Ross Norman looks at the implications for gold of an increased focus on the assets banks are allowed to hold as tier one capital.

Author: Ross Norman
Posted:  Tuesday , 29 May 2012 

LONDON (SHARPS PIXLEY) - Forgive the hyperbole in the headline but we wanted to get your attention as something quite profound is happening that could propel gold to record new highs. Yes, potentially the biggest thing since the birth of the gold ETF and the liberalization of the Chinese gold market in 2003. A decade on and we have grounds for saying that gold may well see a significant leg higher... the big new thing in gold. I'll explain...

Banking capital adequacy ratios, once the domain of banking specialists are set to become centre stage for the gold market as well as the wider economy. In response to the global banking crisis the rules are to be tightened in terms of the assets that banks must hold and this is potentially going to very much favor gold. The Basel Committee for Bank Supervision (or BCBS) as part of the BIS are arguably the highest authority in banking supervision and it is their role to define capital requirements through the forthcoming Basel III rules.

In short, they are meeting to consider making gold a Tier 1 asset for commercial banks with 100% weighting rather than a Tier 3 asset with just a 50% risk weighting as it does today. At the same time they are set to increase the amount of capital banks must set aside as well. A double win potentially.

Hitherto banks have been much dis-incentivised to hold gold while being encouraged to hold arguably riskier assets such as equity capital, currencies and debt instruments, none of which have fared too well in the crisis. With this potential change in capital adequacy requirements. bank purchases of gold would drive up its value relative to other high quality qualifying assets, increasing its desirability for regulatory purposes further. This should result in gold being re-priced to bring it on a par with all other high quality assets. 

Currently banks have to have core Tier 1 capital ratio of 4% of which will rise to 6% from the beginning of next year. In addition to its store of value merits, central to the argument in favor of gold as a bank reserve is its countercyclical nature to most other assets in that it tends to be inversely correlated. Gold is ideal as it bears no credit risk. it involves no other counter-party and it is no one's liability. It is a reserve asset diversifier if you like. 

This is a treble win for gold - it would be a major endorsement of its role in preserving wealth and as a store of value from the highest financial authority, it would lead to significant purchases of gold by major financial institutions and it would lead to a reappraisal of its value with respect to other Tier 1 capital such as quality sovereign debt. Under the new rules gold could become a very significantly larger proportion of a reserve pool which is about to grow very much larger. 

More...