In the world of fiat currencies, any small regulatory changes impacting gold create a major buzz in the market. Gold bugs, among others, remain of the view that the global economy could one day revert to the gold standard. The latest Basel III guidelines mark one such moment.
In recent weeks, there has been a buzz about gold. This is due to the implementation of Basel III accord by the Bank of International Settlements (BIS). Known as the bank of central banks, BIS is an independent body which sets global banking frameworks.
Basel III regulations known as the Third Basel Accord, have been in the works for quite some time. The latest implementation of the Basel III accord started as of the 31st of March, 2019.
The latest regulations basically abolished Tier III capital requirements for financial institutions and banks. This meant that such entities have to reallocate the capital into Tier I or Tier II capital. This is where many gold bugs find it exciting.
Banks could, until now, classify gold as a Tier III asset. Tier III assets are the riskiest assets. But with Basel III regulations, it means that gold allocation has to be moved to either Tier I or Tier II.
What is Capital Requirement?
Capital requirement is the amount of capital that a bank or a financial institution must hold on its books at any given point in time. It defines the level of liquidity that financial institutions must hold for a certain level of assets.
The basic idea behind capital requirements is to ensure that financial institutions do not hold too much risk that could lead to default as a result. Capital requirements are also known as regulatory capital.
There are various tiers depending on the assets held by the bank:
- Tier 1 capital is the most basic of all. It is a measure of the financial institution’s financial strength. Tier 1 or core capital comprises of equity and includes common stock as well.
- Tier 2 capital is also known as supplementary capital or secondary reserves. Assets that fall under Tier 2 capital include subordinated debt, hybrid instruments, and other reserves. This tier is less secured by collateral comparing to Tier 1 capital.
- Tier 3 capital is mostly used to mitigate market risk including commodity and currency exchange risk. Tier 3 capital is even less secure than Tier 2 capital. According to the BIS, Tier 3 capital should not be more than 250% of Tier 1 capital.
Therefore, depending on how risky an asset is, the financial institution could classify it into one of the three tiers.
With Basel III, Tier III capital was abolished. Therefore, as mentioned, this means that gold will need to be reclassified into Tier I or Tier II.
It is important to note that the BIS does not mention a reclassification of gold as a risk-free asset. On the contrary, it is up to the individual banks to recategorize gold into either Tier I or Tier II.
What is the Buzz About Basel III all About?
It is to do with the reclassification of gold from a very risky asset into something less risky. However, even before Basel III came into existence, the BIS already gave the central banks a free hand in regard to gold holdings.
For example, US regulators have been averse to the idea of giving more importance to gold. On the other hand, European banking regulators recognize gold as collateral. It basically comes down to each central bank’s discretion and how they view gold.
Many believe that the Basel III regulation gives gold higher importance, but this isn’t the case. While it is true that gold might move from Tier III to Tier II, the bottom line is that nothing much has changed.
Having said that, investors continue to treat gold as a safe haven asset. Thus, the fundamentals that have dictated the price of gold continues to remain in place.