European case study: Enhancing commercial bank liquidity buffers with gold

Published 6th December 2012

Categories: Investment, Central banks/official inst.

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The World Gold Council has conducted extensive research on gold and has demonstrated in past submissions to the Basel Committee on Banking Supervision that gold meets the fundamental and market criteria required to be considered a high-quality liquid asset for Basel III. 

The following case study conducted by the World Gold Council adds to existing research
on this topic and examines the effect of adding gold to the Liquidity Coverage Ratio (LCR). This analysis demonstrates that including gold as an eligible asset in bank liquidity buffers, commercial banks would achieve lower levels of risk and improve their risk-adjusted returns. The study also found that a portfolio with gold outperformed a portfolio without gold
during the majority of the most extreme liquidity stress events over the past eight years. 

Specifically the analysis used conservative assumptions and a statistical approach of resampling to determine the optimal liquidity buffer composition with gold and excluding gold. Back testing the results from 2005, the case study provides the following observations: 

  1. The optimisation study reveals that an allocation to gold is statistically optimal when choosing among the universe of eligible liquid assets with a confidence level of 97.5%.
  2. Including gold as an eligible asset in commercial bank liquidity buffers allows a bank to achieve lower levels of risk and improve its risk-adjusted returns (i.e. expand its efficient frontier).
  3. Through back testing a liquidity portfolio with gold outperformed a portfolio without gold during the majority of the most extreme liquidity stress events over the past eight years.
  4. A commercial bank that held gold in its liquidity portfolio since 2005 would have witnessed similar annualised volatility to a liquidity buffer without gold (2.64% versus 2.62%).
  5. A liquidity portfolio that includes gold has a similar level of maximum loss as a portfolio without gold, as measured by a Value-at-Risk analysis at the 99% confidence level.
  6. A liquidity portfolio with gold outperformed in 6 out of 7 liquidity stress events over the past eight years and outperformed the non-gold portfolio by an average of
11 basis points.
  7. Gold was the best performing asset in 5 of the 7 liquidity stress events, outperforming LCR assets such as German Bunds, US Treasuries and European covered bonds.
  8. An analysis in GBP terms illustrated similar results, namely, that gold is statistically significant at the 97.5% confidence level. It allows banks to reach lower levels of risk and is the best performing asset in the majority of liquidity stress events.