Will Basel III Really Encourage Banks to Buy Gold?

Gold's regulatory status may be set to change. But is this a good reason to Buy Gold...?

DURING the run up to the US Presidential elections, central bankers were very active in telling the market how omnipotent they were, writes Greg Canavan for the Daily Reckoning Australia.

For a time, the market believed them. This squeezed the short traders out of their positions, which provided additional juice to the rally. In what became a self-fulfilling prophecy, everyone seemed to believe the market would rally into the elections. It did.

Now that nonsense is over and done with, the sewerage is coming to the surface: dodgyness in the US military and allegations of CIA stuff-ups in Libya, the realization that Emperor Ben is starkers, Israel unleashing on Hamas.

On top of that, we've just had a pretty ordinary earnings season in the US. As much as the 'Algo' traders might like to think otherwise, it's earnings that are the real driver of company share prices. Owning equity in a company is a claim on the cash flows of that company. Eventually, the market will price a stock based on an assessment of cash flows.

Given all this, the hedge funds – the ones who were previously squeezed out of their short positions – are lining up again to make money on the downside. The momentum of the market has definitively shifted. The bears got the upper hand last night, with the S&P500 breaking through the most watched line in the world – the 200-day moving average. Things could get ugly from here...

Speaking of ugly, check out this Bloomberg article. It details just how mangled the European banking system is. As you probably know, banks need to hold regulatory capital against their assets as insurance against possible losses. The 'capital' is shareholder equity, known as 'Tier 1' capital.

But the interesting point is that banks are not required to hold this capital against all their assets. Rather, they hold it only against their 'risk-weighted assets'. With that in mind, check this out:

'Consider France's third-largest bank, Credit Agricole SA, which today reported a third-quarter loss of 2.85 billion Euros ($3.62 billion), sending its stock down 6 percent.

'The real entertainment can be found in its "core Tier 1 ratio," which it said was 9.3 percent as of Sept. 30. The numerator in that calculation is regulatory capital. The denominator is what the regulators call "risk-weighted assets." The smaller the denominator is, the bigger the capital ratio is.

'Total assets at Credit Agricole were 1.9 trillion Euros as of Sept. 30. Risk-weighted assets, however, were a mere 298.3 billion Euros. In essence, we're supposed to believe that 84 percent of Credit Agricole's assets were riskless, even though that obviously is impossible.'

That's right, dear reader, according to the regulations, not all assets held on a banks' balance sheet are risky. In fact, some are so risk-less that the regulators deem it unnecessary to hold any capital against the assets at all. We have no idea how Credit Agricole managed to pull off this sleight of hand...it must be chock full of French government debt, which is, apparently, risk free.

And this is all under the Basel II regulatory regime. Basel III, with its more stringent capital and liquidity requirements, will put banks under pressure to either raise more capital or sell off assets. The Basel III rules are supposed to come into effect from 1 January 2013 through to 2018.

Supposed to, that is. Last week, the Federal Reserve announced that US banks were not ready to implement the changes. They gave no indication of when they might be.

Here's another Bloomberg article that tells you exactly why the Fed acted as it did:

'Goldman Sachs Group Inc. (GS), the fifth-biggest US bank by assets, would have $728 billion in risk-weighted assets under new capital rules, a 67 percent jump from the amount it had under earlier regulations.'

Which means Goldman must hold more equity capital against that increase in risk-weighted assets. They can do this by selling off assets, raising equity or cutting dividends. That's like showing a stake to a vampire...or a vampire squid. Instead of making tough decisions to strengthen their balance sheets, the regulators just give the banks more time...because can-kicking has been such an effective strategy so far.

One area of the Basel III banking reforms picked up with enthusiasm by the gold community was the change to gold's classification as a risk free asset. It was only a footnote in a Bank for International Settlements update, but it caused some excitement. Here's the footnote:

'...at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%. In addition, cash items in the process of collection can be risk-weighted at 20%.'

The thinking goes that because banks won't need to set aside regulatory capital for gold holdings, it would increase the demand for it.

We're not so sure.

Firstly, we're not a fan of physical gold being anywhere near the banking system. It's just allows bankers to lend it out and create multiple claims on a single ounce.

And banks aren't going to go out and Buy Gold to take advantage of the 'risk-free' definition. Banks make money from their assets generating a better return than their liabilities. Gold doesn't generate a yield in the way other financial assets do. That's because it's actually riskless...hence no need for compensation in the form of an interest payment.

Our point is that banks make money based on a positive net interest margin. Buying Gold with, say, depositors funds (a liability of the bank) would hurt the net interest margin. Yes gold has gone up in price, but it's not actual cash flow, which is important for the banks.

As far as we understand it (which is not much...the more we look into the gold market, the less we know) gold doesn't have a natural home in the commercial banking system. It's not 'money' in the way that paper money is. It's more at home in central bank vaults, being a store of wealth for nations rather than a plaything for banks. It also doesn't hurt for individuals to store some of their wealth, OUTSIDE THE SYSTEM, in the ancient metal either.

So don't rejoice just because gold appears to be gaining some credibility. It's far more powerful 'outside the system'.

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