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There is sometimes a tendency to confuse ends and means. For example, in traveling through an airport there is extensive inspection of passengers. Before you are allowed to board an airplane, you must go through a process that is intrusive and increasingly invasive. This is deemed to be security. How do we know it makes us secure?
Because it is annoying.
See the switcheroo? The degree of disruption of your schedule and possessions bears only a faint relationship to the degree of safety.
So it is with many other regulated areas. Banking is no exception. It’s worse, actually, as the governments and their central banks offer trillions of perverse incentives for banks to act in ways that are most unsafe. Ultra-low interest rates provide both the means and the motive to take risk. The means is that leverage is cheap. The motive is that profit margins are compressed, and banks cannot survive without leverage.
So the banks respond to these perverse incentives by taking perverse trades. And this causes all sorts of problems. The kinds of problems that lead to the 2008 global financial crisis.
And governments respond to this by imposing what they call “macro prudential regulation.” They don’t remove the perverse incentives. No, that is a matter of policy (and inexorable necessity of irredeemable currency). Instead, they think to compensate for it by controlling what banks can do.
Basel III as Macro-Prudential Compensation
Compensation is doing the wrong thing, on purpose. Purportedly to address something else, that you cannot or will not properly correct. Like letting the air out of the other three tires, when you have a flat.
Or imposing macro prudential regulation, when you have a failing regime of irredeemable paper and a pathological falling interest rate that both makes it possible, and necessary, for banks to take risks such as extreme leverage, extreme duration mismatch, and chasing risk to obtain a few basis points of yield.
Does macro prudential regulation make the banks safer? Does someone pawing your toothbrush with the same gloves that just touched the previous passenger’s dirty underwear make you safer?
Does a life jacket make you safer working in 10 inches of water? “Don’t argue. Safety first.”
Basel III makes the financial system safer more compliant by forcing the banks to use so-called “stable” funding sources for their gold assets. Instead of interbank lending, or demand deposits, they are supposed to sell more long-term bonds (or even equity). Like wearing all the mandatory personal protective equipment may load you down, and make it harder to see, hear, and breathe… using more expensive capital to finance gold makes it more difficult to clear gold market transactions.
The above addresses the mainstream idea of banking system risk and safety. However, many gold commentators make a different error. Michael Crichton, in discussing the Gell-Mann Amnesia Effect says the newspaper is full of headlines blaring “wet roads cause rain.”
Some gold commentators claim that Basel III only affects when banks hold so-called “unallocated” or “paper” gold. Worse, are those who say it labels gold a “tier 1 asset”. Tier 1 applies to the liabilities side of the balance sheet, not the assets side. Tier 1 Capital refers to the stability of the bank’s funding, not the price risk of the asset. Tier 1 capital includes equity from sale of shares, as well as retained earnings. Calling gold a “tier 1 asset” is not even wrong.
If you force a business to add another useless ingredient, it adds cost and the business will try to raise its prices to preserve its margins. In the case of bullion banks, this means wider bid-ask spreads (and also higher interest rates charged for gold leases and loans).
On Friday the UK regulator, the Bank of England’s Prudential Regulatory Authority, gave banks a slight reprieve. It said that banks can apply for a special permission to reduce the required expensive capital reserved for gold. At least for clearing.
However, the regulator said that it would “not classify gold as a high-quality liquid asset”. This means that the banks still face higher costs for leasing and lending.
Full disclosure: Monetary Metals provides gold and silver leases and loans, and would stand to benefit from regulation that discourages banks from remaining in this business.
Basel III making gold more costly?
We have a stunning graph to share. This is a five-year chart of the bid-ask spread in both gold and silver. This spread is how much you would lose if you bought and immediately sold without the market moving either up or down.
The bid-ask spread for gold was stable for nearly three years, at around $0.15 per ounce. This is extraordinary, by the way, as a percentage of the price of the asset.
Then, in March 2019, it goes to $0.30. Double. It remained at this elevated level until Covid hit.
Then, it launches like a skyrocket. We documented that it hit $25, on March 25 2020. It began to come down, as the precious metals logistics industry started to figure out how to operate under lockdown measures. By June, it was down to a mere 80 cents. Then, in October, 50 cents. Which is more than triple what it had been for years, by the way.
It has held steady at this quite-elevated level, but compared to the recent past, half a buck is downright tight.
Is Basel III’s higher “Net Stable Funding Ratio” to blame? We don’t know for sure. But it is logical that the new cost-increasing regulations would have an effect. Plus perhaps some lingering lockdown whiplash.
Gold and Silver Supply and Demand Fundamentals
Here is the only chart of the true fundamentals of gold supply and demand.
You can see the (relatively) big decrease in abundance (i.e. basis, the blue line) and increase in scarcity (cobasis) when the price of the dollar moves up sharply from around 16.5 milligrams gold to 17.5mg (inverse to the drop in the price of gold, measured in dollars as most people think of it).
From around 0.5%, the continuous basis drops to 0.4%. From around -0.6%, the continuous cobasis rises to around 0.5%.
As the price of the dollar has fallen, the basis and cobasis are moving back to where they had been. In other words, this is just leveraged speculators positioning and repositioning themselves.
Here is the silver chart.
The silver chart basically shows the same thing as gold, with more noise. The price has not moved back to its prior level, and neither has the basis or cobasis.
Could price and basis return to their early-June levels? We must wait and see.
Thanks, Keith, I’ve been wondering about the Basel III thing.
Yes you’ve hit the nail on the head. The key section that people seem to miss is “to the extent the gold bullion assets are offset by gold bullion liabilities“.
Correct me please if I am wrong : Basel III compels banks holding gold to neutralize the worth and the eventual leverage through gold holdings by imposing an equal a liability on his superb asset ?
In others words Basel III penalizes banks for holding gold ?
Is it unfair or is biased to scare banks from holding solid gold ?
So the best place for holding gold should be in a parallel system , where me, you and many friends can enjoy receiving extension of cash credit based upon the evolution of the spot price of Gold ?
The kind of credit card Peter Schiff with his euro-pacific bank located in Australia tries to promote , but it seems it does get very popular .
I look forward to read your observations
“According to the FDIC, as of this writing, the national average for checking accounts is 0.06%. According to the St. Louis Fed, a 30-year mortgage is 4.28%. A bank could make 4.22% by funding 30-year mortgages with checking deposits (before expenses). Not a bad business.”
But, Keith, isn’t it actually much better business than that due to fractional reserve banking?
With a reserve ratio of ten to one, the Bank could lend out what it borrows ten times over, so it could effectively be getting 42.8% against the 0.06% it pays out making an arbitrage profit of 42.72%.
Matrerial I read some time ago maintained that, in modern banking on both sides of the Atlantic, there is effectively no limit on the ratio that banks may operate. I mentally went on to append, “. . . other than the solvency and funding requirements laid down in the Basel accords”.
Notwithstanding, as you go on to explain, that this (demand deposit v mortgages) is not the way banks actually fund their lending, I would be very interested in your take on the effect or otherwise of fractional reserve on your arguments here.
The Net Stable Funding ratio is precisely a “reserve fraction” (for the asset class) considered acceptable under Basel conventions. So, saying gold has a 85% requirement is like saying: to lend out $100 of gold, a bank would need to have $85 of deposits in its reserves. That is far more than private 19th century banks kept (between 25% and 50%) in fractional reserve, and thus makes gold-based banking unprofitably stable.
It is interesting that fully hedged gold and a T-bill have the same regulatory risk profile. Stability within the bank’s numeraire (presumably the global reserve currency US dollar) seems to be the only objective. Why is such an agreement being reached in Basel Switzerland, ex domain of said legal tender?
Good question Gregory and thanks for the explanation of Net Stable Funding ratio.
Since reading your reply I have read through Keith’s whole series of articles on The Unadulterated Gold Standard. It certainly turns a lot of my previous understanding on its head, and begins to address my original question in part 3, where, in writing about fractional reserve, he trashes the idea ‘that banks “create money” ‘.
Whereas this does seem to contradict a lot of what I’ve previously read – including certain publications by the Bank of England, the Federal Reserve and a monetary reform group in the UK called Positive Money, I’ve learned over the years of reading Keith’s material that his approach to all things monetary possesses a simple underlying logic that often explains what is happening in the real world so much better than the guile of politicians, the projections of many economists and the hype of gold and silver ‘bugs’, whose announcements that gold and silver are about to skyrocket have been growing ever more shrill since I began to be interested and yet without any real fulfilment. It makes one wonder why anyone still listens to them. I certainly stopped paying them any serious attention some years ago after I discovered Keith’s more intelligent analysis whose correspondence with reality seems far better.
It will probably take me several re-readings and some careful thinking to glue my comprehension of money mechanics back into a complete entity including this disruptive new material.
What are the Net Stable Funding ratios under Basel 3 for other types of banking ‘assests’?
Hi, I’m trying to better understand the regulation.
On the liability side: https://www.bis.org/bcbs/publ/d424.pdf
Here it says a 0% risk weight will apply to gold but further on, a haircut of 20% is specified in all models.
Moreover, we have the minimum capital requirements: https://www.bis.org/bcbs/publ/d457.pdf
We can read that gold is a commodity with a risk weight of 20%: “7 Precious metals (including gold) Gold; silver; platinum; palladium 20%”
But further on, it says:
40.53 This section sets out the simplified standardised approach for measuring the risk of holding or
taking positions in foreign currencies, including gold.[19]
Footnote
[19] Gold is to be dealt with as an FX position rather than a commodity because its volatility is
more in line with foreign currencies and banks manage it in a similar manner to foreign
currencies.
For both forwards and options, gold is considered foreign exchange, not commodity:
(b) For options on equities and equity indices: the market value of the underlying
should be multiplied by 8%.[38]
(c) For FX and gold options: the market value of the underlying should be
multiplied by 8%.
(d) For options on commodities: the market value of the underlying should be
multiplied by 15%.
Is it correct to say that the 0% (or 20%?, multiplied by 8% if gold forwards/options) risk weight applies when a bank uses gold as collateral when borrowing (including demand deposits) ?
O the asset side: https://www.bis.org/bcbs/publ/d295.pdf
Gold has an RSF (required amount of stable funding) factor or 85%.
Does that means that one needs 100 ounces of gold as collateral to take a loan of 15 ounces of gold equivalent in dollars from a bank ?
What’s missing here is price. You only have to see that the BIS assigns a risk factor of only 50% on mortgage-backed securities and 85% on gold itself to realize that it feels that the risk of large defaults of home loans to an overleveraged public is LESS than the risk of the price of gold going down in price (pp 9-10). Thing is, if the price of real estate drops far enough (layoffs, herd mentality) people are going to jingle-mail their house keys even if they can afford to make the monthly payments because no one wants to pay off a loan that is worth substantially more than the value of the house! So once again they have characterized the wrong thing as risky under an avalanche of a PhD level word salad.
https://www.bis.org/bcbs/publ/d295.pdf