This note considers the potential impact of the “Basel 3” regulatory standards of the Bank for International Settlements on the bank’s own gold banking business, which is of interest to gold investors mainly due to the regular trading the BIS does in gold swaps and other derivatives.
These gold transactions by the BIS are perhaps the most obvious sign of regular and often extensive if usually surreptitious gold trading done by central banks.
This trading in gold by the BIS is not consistent with the claim that gold is no longer of significance in the world financial system. A review of the BIS' use of gold swaps as at February 28, 2021, is here:
Documentation relating to Basel 3 is extensive and it reflects the difficulties in regulating banks and other modern financial enterprises. The BIS' summary of the Basel 3 standards is here:
While it is frustrating to read such a vast swathe of bureaucratic pronouncements, regulatory rulings can have a large effect on real economic activity, as is highlighted in the instructive video presentation by Miles Harris here:
An example Harris gives is that a more relaxed regulatory attitude toward mortgage lending has buoyed housing markets in many countries. His presentation deals mainly with how Basel 3 could affect monetary metals:
Despite the difficulties in reading and understanding the documentation on Basel 3, the following conclusions may be drawn about it:
-- Implementation of Basel 3 is being carried out via national regulators adopting the new BIS standards into their rules, with some differences in implementation schedule.
-- The date for implementation of Basel 3 has been delayed by the BIS until January 1, 2023. The U.K. is heading toward implementation a year earlier. This early implementation is still provisional, as representations on its application can be made until early May 2021.
— All forms of gold, including physical, are required to be at least 85-percent funded with Tier 1 capital in accordance with the Net Stability Funding Ratio (“NSFR”) introduced in Basel 3. There is no reference in Basel 3 to physical gold being a Tier 1 asset itself.
— This funding requirement has upset the London Bullion Market Association (LBMA), and the association considers that Basel 3 is likely to reduce gold trading among the association’s members, which is done mostly via unallocated gold accounts. Some historical comments from the LBMA on its desire to reverse the Basel 3 rules on the treatment of gold are here:
-- For those banks that trade gold assets, there are exemptions from the NSFR to the extent that there are gold liabilities to offset the gold assets.
Before considering the impact on the BIS’ gold banking business, note that Basel 3 will also have an effect on the bank itself because of the gold bullion it holds for its own account. The latest published report from the BIS, the half-year report to September 30, 2020, reveals that the bank held 102 tonnes of gold for itself:
This gold will require 85% funding via Tier 1 capital. As a practical matter this seems unlikely to cause any concerns for the BIS, as it already reports extensive margins of safety in all its current risk reporting, which is not yet covered by Basel 3 requirements.
The original BIS gold banking business prior to 2009, before the bank started using gold swaps regularly, was essentially straightforward and allowed central banks securely to deposit unallocated gold via the BIS at major gold trading centers without any political risk.
Hence a central bank would deposit gold in a sight account at the BIS (gold sight accounts are unallocated gold), the BIS would then open a sight account at, say, the Federal Reserve Bank of New York, and the gold would be held by the Fed in unallocated form on behalf of the BIS.
This meant that the BIS had effectively no exposure to gold price risk, and in the eyes of all the Basel accords, including Basel, 3 the bank would have no credit risk or political exposure, since the Fed is always considered sure to return what it holds in custody. The central bank making the original deposit into the sight account at the BIS would have avoided any political risk that the Fed would not return its unallocated gold.
This route protected unallocated German gold held by the Bank of England during World War II, when German gold was placed in a sight account with the BIS, which then placed the gold in a sight account at the Bank of England.
Under these terms of trade it would be quite perverse if Basel 3 treated the BIS as having an exposure to gold price risk, and consequently it seems safe to conclude that Basel 3 will allow this aspect of the bank’s gold banking business to continue without demanding that the BIS commit extra capital to support this activity.
What is less clear is the impact Basel 3 will have on the BIS’ use of gold swaps in its gold banking business. It appears from the BIS reporting that all gold swaps are carried out with commercial banks and not other central banks. Because the LBMA is expecting increased costs to be incurred by complying with the Basel 3 NSFR requirements, it seems likely that bullion banks will be less willing to enter these swaps if they will have to bear higher capital costs because of the NSFR. Under a swap, the bullion bank is due to get its gold back, so it has a gold asset and consequently should be affected by the Basel 3 NSFR capital requirement.
At this point it is important to consider who is driving these swaps: the BIS or its counterparties?
History offers some clues.
Gold swaps were first carried out by the BIS in the 2009-10 financial year and were disclosed in the BIS annual report as involving more than 346 tonnes of gold at March 31, 2010. Here is a link to the annual report, with the relevant disclosure in Note 4 to the accounts:
Although the BIS rarely comments publicly on its own banking activities, its first use of gold swaps was considered important enough to cause the bank to give some background information to the Financial Times for an article published on July 29, 2010, coinciding with publication of the bank’s 2009-10 annual report. The FT report is here:
The general manager of the BIS at the time, Jaime Caruana, said the gold swaps were “regular commercial activities” for the BIS, and he confirmed that they were all carried out with commercial banks and did not involve other central banks.
There was considerable comment on these gold swaps at the time. Their impact on the increase in the BIS’ holdings of unallocated gold was striking because 346 tonnes are not a small amount of gold. Gold market analysts such as Reg Howe and James Turk remarked that the swaps were much more likely to be driven by the gold market than by the BIS wishing “to optimize the return on their currency holdings,” a quote given to the FT.
The FT itself, in the above-mentioned article, commented as follows on the reasons for the swap. “Some analysts speculated that the swap deals were a surreptitious bailout of the European banking system ahead of last week’s publication of stress tests. But bankers and officials have described the transactions as 'mutually beneficial.' 'The client approached us with the idea of buying some gold with the option to sell it back,' said one European banker, referring to the BIS. Another banker said: 'From time to time central banks or the BIS want to optimize the return on their currency holdings.'"
It is notable that none of these comments from the FT article focus on the gold market but implicitly accept that gold was essentially being used as collateral to support a dollar loan. The alternative, that the transaction was driven by the BIS to place more unallocated gold in the hands of certain central banks, is also an entirely feasible explanation, especially as it was at a time when central bank selling of gold had declined and when there was speculation about gold shortages.
Given the lack of transparency from the BIS and central banks in general about their activities with gold, it seems highly plausible that the BIS' trading activities in the gold market, principally via gold swaps, are part of central bank efforts to suppress gold prices.
Consequently, we may draw two tentative conclusions.
-- First, the impact of Basel 3 on gold swaps is likely to develop more slowly than expected by some commentators, given the delays and a more relaxed implementation schedule. The UK may yet decide to implement Basel a year later than current plans and thereby fit in with the BIS’ own date of January 1, 2023. So even if the LBMA cannot reduce the impact of the Basel 3 NSFR on its business, implementation still might be delayed.
-- Second, will Basel 3 reduce gold swaps? There seems to be a broad consensus that Basel 3 will make gold trading more expensive, so efforts to suppress the gold price might become more costly. But it’s hard to know how important any such cost would be to those operating suppression policy.
At this point it is perhaps appropriate to remind readers why central banks are so keen to suppress gold prices and why it seems plausible that they might be ready to reimburse any higher costs of their counterparties to the gold swaps.
The short answer is provided by work done 20 years ago by Reg Howe on "Gibson’s Paradox" and in particular his review of a paper on the paradox by Professors Robert B. Barsky and Lawrence H. Summers. The original Barsky and Summers paper can be found here:
Essentially the conclusion Howe drew from the Barsky and Summers paper is that suppressing gold prices reduces real interest rates. An essay by Howe on this topic is posted at his internet site here:
Given that the U.S. federal debt now stands above $28 trillion --
-- even minor changes in interest rates are of massive importance to those running the U.S. economy. A 1-basis point increase in effective mean annual interest charges increases costs to the U.S. government by $2.8 billion. Hence it seems plausible that the probably higher costs of gold price suppression brought on by Basel 3 may not alone be enough to stop the suppression and consequently stop or severely reduce the use of swaps by the BIS.
Perhaps in the end other considerations will be far more important to gold than Basel 3. Reports of physical gold shortages are increasing. One straw in the wind suggesting that gold price suppression might be close to ending is provided by the recent comment by Summers, a former U.S. Treasury secretary, that the United States has the "least responsible" fiscal policy in 40 years:
Also, the International Monetary Fund is apparently trying to wade into the debate about how to tackle high government debt levels
Perhaps the IMF is going to remind interested parties of its contribution from 2012, which was described by Ambrose Evans-Pritchard of the Telegraph in the UK as follows:
"So there is a magic wand after all. A revolutionary paper by the International Monetary Fund claims that one could eliminate the net public debt of the United States at a stroke, and by implication do the same for Britain, Germany, Italy, or Japan.”
Evans-Pritchard's report on the IMF proposal, which itself is based on ideas offered by Henry Simons and Irving Fisher in 1936, is here:
Given the concerns expressed by Summers and the interest of the IMF in joining a public debate about excessive government debt, it seems that more people are coming to understand the excessive creation of fiat U.S. dollars in recent years (for example, cryptocurrency investors), and reasonable to assume that many governments are becoming aware of the extreme position facing the dollar, in view of the $28 trillion in US Federal government debt, a record that will keep being broken without some form of monetary resent.
Keeping the gold suppression show on the road seems harder than ever, but given the scale of the debt problem facing the United States, Basel 3 may not really matter that much, so it also seems unlikely that the BIS’ use of gold swaps will reduce much because of Basel 3.
Robert Lambourne is a retired business executive in the United Kingdom who consults with GATA about the involvement of the Bank for International Settlements in the gold market.