As Basel III comes into force, we look at the impact of the Net Stable Funding Ratio (NSFR) on the gold market.
There has been much debate about the implications of Basel III on the bullion industry. What is clear is that the under the current rules the cost to banks of holding gold on balance sheet will increase – the NSFR requires 85% of required stable funding. This is punitive and does not acknowledge the highly liquid nature of gold, and the way gold is often transacted as a currency. The World Gold Council and London Bullion Market Association recently wrote1 to the Prudential Regulatory Authority (PRA) setting out our concerns about the NSFR and the 85% Required Stable Funding (RSF) in particular:
- The current clearing and settlement system could be undermined – without an appropriate exemption, the increased costs may make participation in the clearing and settlement regime commercially unviable, potentially leading to some banks existing the system
- Liquidity could be drained – the cost of taking on gold deposits as unallocated gold would increase compared to the cost of custody services for allocated gold. Unallocated gold is an essential source of liquidity for the effective functioning of the clearing and settlement system.
- Financing costs would increase – stable funding costs could be passed through to non-bank market participants such as miners, refiners and manufacturers using gold.
- Central bank operations would be curbed – the clearing banks facilitate gold deposit, lending and swaps operations; essential sources of market liquidity.
The joint LBMA-WGC letter can be found on the LBMA’s website here.
Impact on the London Clearing Regime and the Prudential Regulation Authority Interdependent Precious Metals Position
Following this consultation, the Prudential Regulation Authority carved out an exemption for clearing members of the LPMCL. In the July 9th announcement clearing banks can apply for an exemption, which in turn will reduce the size of the capital buffer required. Under the interdependent precious metals permission, “firms would apply a 0% RSF factor to their unencumbered physical stock of precious metals, to the extent that it balances against customer deposits”.
Whilst this is a welcome development as it will ensure the clearing regime in London can continue to operate, it still does not recognise the highly liquid nature of the gold market. We will continue our advocacy and research efforts to demonstrate gold’s fulfilment of HQLA criteria.
The evolution of the Basel Accords
To understand how we got to an 85% RSF, we need to look at the evolution of the Basel Accords. The treatment of gold by regulators has evolved as the Basel Accords developed. The Basel Committee on Banking Supervision (BCBS) introduced the first iteration of the Basel Accords in the late 1980s to establish minimum capital requirements for banks. This was enforced by the “Group of Ten” economies – countries that agreed to participate in the IMF’s General Agreements to Borrow (GAB). Basel 1 was primarily focussed on credit risk, with bank assets grouped according to risk-weighting. Bullion carried a risk weigh of 0% and was therefore treated like cash.
Basel II extended the focus to include a larger element of counterparty risk – additional capital was required to mitigate the risk a bank takes on due to its trading, investment or financing initiatives. Launched in 2004, bank assets were divided into three tiers depending on the perceived level of risk, with tier 1 assets deemed the least risky. Under these rules, national authorities had the discretion to treat gold as either tier 1 or tier 3. The BCBS stated that “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%.2” Under Basel II, a limiting ratio is placed on the amount of tier 3 capital that a bank can hold – tier III must not be more than 2.5x a bank’s tier 1 capital.
Basel III and the NSFR
Basel III eliminates tier 3 capital and places new liquidity ratios on banks, specifically the Net Stable Funding Ratio (NSFR). This introduced an RSF factor of 85% for gold held on a bank’s balance sheet.
NSFR and RSF definition under the current rules
The Net Stable Funding Ratio seeks to calculate the proportion of Available Stable Funding (ASF) via the liabilities over Required Stable Funding (RSF):
NSFR = Amount of available stable funding / amount of required stable funding
Another innovation was the Liquidity Coverage Ratio (LCR). The LCR promotes the short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets (HQLAs) to survive a significant stress scenario lasting for one month. It basically sets the minimum liquidity buffer to bridge liquidity mismatches for one month in a crisis scenario. The NSFR has a time horizon of one year and requires that banks maintain a stable funding profile in relation to the composition of their assets and off-balance-sheet activities. Gold was not considered HQLA due to a lack of trading data at the time but it is our view that gold should be recognised as a very high quality liquid asset.
The LBMA Trade Data3 gives an indication to the size of the London OTC market, the world’s largest financial market for gold. To complement this the WGC has commissioned a number of academic studies into the market liquidity of gold, most recently covering the disruptions triggered by the COVID-19 outbreak, and in all cases our analysis indicates that gold appears to exhibit the attributes and behaviour of well-established high quality liquid assets (HQLA) such as long-term US Treasuries.