The coming revaluation of gold as it becomes accepted as collateral.

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The coming revaluation of gold as it becomes accepted as collateral. To
paraphrase Winston Churchill: “You can always count on governments to do the right
thing—after they’ve tried everything else.” Although the debt crisis has seen more
capital flee reflexively to the (perceived) safety and liquidity of the U.S. dollar, the
rejection of austerity and election of pro-growth candidates in Europe have raised
concerns that future governments may choose to renege on commitments and default
on their debts. As a result, financial authorities are assigning new urgency to collateral
and considering an expanded role for gold as a key constituent of bank assets.
With cross-holdings of banking and sovereign debt magnifying risk in Europe and
throughout the global banking system, the Basel Committee for Bank Supervision is
working to establish new capital sufficiency rules in an effort to strengthen the
solvency of the banking system. Yesterday, the European Commission warned: “Evenmember states that had been regarded as financially sound became affected and the
crisis became system-wide in the second half of 2011… This reveals the strength of
spillovers in the euro area… and is a call against complacency for those seemingly
unaffected.”
In the past, currencies and sovereign debt have been treated as a low-risk “Tier-1”
asset for commercial banks—with 100% of holdings factored into capital adequacy
requirements. However, as the ability and willingness of countries like Greece, Spain,
and Italy to repay their debts becomes more suspect, balance sheets dominated by
sovereign debt and interbank-holdings seem increasingly inadequate to
backstop banks.
In the past, gold has been considered a Tier-3 asset credited to bank reserves at only
50% of market value—but that may soon change. In an effort to diversify capital and
reduce risk, the committee tasked with overseeing Basel III implementation is
considering redefining gold as a Tier-1 asset for commercial banks.
Since gold prices tend to be inversely correlated with currency strength, adding gold to
reserves would help diversify and stabilize the value of bank reserves. The fact that
physical gold holdings have no counterparty further bolsters its appeal. Last
Thursday, the European Parliament’s Committee on Economic and
Monetary Affairs unanimously voted to accept gold as collateral.
The World Gold Council (WGC) notes that the global financial crisis highlighted
“inadequacies in counterparty risk management” that are being addressed through
reforms that are increasing demand for collateral assets. Noting that the credit quality
of European government bonds has deteriorated, the WGC is touting gold as a
solution. “We now look forward to the European Parliament and Council of the
European Union upholding the inclusion of gold in the next stage of negotiations
around [European Market Infrastructure Regulation] which will now take place after
the July plenary vote,” the WGC notes, “The ratification would mark a significant step
forward in redefining what constitutes a highly liquid asset under the Capital
Requirements IV Directive, due in the coming month, from the European
Commission.”
In an effort to reduce systemic risk, Basel III requires banks to increase their capital,
with minimum capital requirements gradually rising from 2013. Increasing the coreTier-1 capital requirement from 4% to 6% would require banks to increase their
reserves by half—at a time that gold is increasingly recognized as one of the
most preferred holdings.
Ross Norman, the CEO of London bullion broker Sharps Pixley, notes that if
commercial banks moved just 2% of their $4.3 trillion capital reserves to gold, more
than 1,700 metric tons of gold would be needed. While the premise may seem
fanciful, the move would simply align commercial bank reserves with central
bank reserves. WGC data shows that before even considering holdings of the
International Monetary Fund and Bank for International Settlements, 12.5% of
reported global central bank reserves are held in gold. The European Central Bank
already holds 502.1 tons of gold representing more than one-third of its reported
reserves, Germany’s 3,396 tons of gold represent 73% of its reserves, and OECD
central banks on average hold 26% of their reserves as gold. Adding gold to
commercial bank reserves would align policy with the central banks that
regulate them.
While there is no assurance of when gold may be recognized as a Tier-1 asset or how
quickly commercial banks may move to strengthen their reserves with gold holdings,
1,700 tons of new demand would be material even if spread over many years.
All the gold mines in the world were able to produce only 2,818 tons of gold last year,
according to Thomson Reuters GFMS, so at even 2% of commercial bank reserves,
new demand would represent 6% of global mine supply for a decade. Mr.
Norman proclaimed in an article this week: “For those [anxious] about the lackluster
market—this could well promise to be [a] game-changer of epic proportions.”
If the Basel III committee raises gold to a Tier-1 asset, gold bugs will point to it as
proof of the return of gold’s monetary role. Given the power that governments gain
by issuing fiat currencies, they may be reticent to enhance the role of gold. However,
as the unity of the Eurozone becomes suspect with a possible Greek exit, lenders
must be increasingly concerned with collateral and banks must increasingly
consider their ability to raise capital.
The reserves of many of the most vulnerable European banks primarily consist of debt
in other Eurozone banks and bonds, along with devalued property and equities that
could plummet with recession. If the debt crisis deepens, the banks will struggle even
more to raise money as the quality of their collateral withers. Nations desperate to
spur their economies are at risk of having reserves devalued—undermining their abilityto raise capital. The greater the risk of a Eurozone breakup: the greater the need for
banks to hold alternative assets. In times of currency crisis, gold’s status as a hard
asset coveted the world over makes it particularly well suited as collateral—helping
attract lenders and lower rates.
Collateral is not needed only for new debts—banks must roll-over trillions of dollars
in borrowing each year as debts mature. Bloomberg notes that G-7 nations alone must
roll-over nearly $7.25 trillion of debt this year—potentially pushing borrowing costs
up as much as 39% this year. When economies were growing and debt levels were
manageable, lenders were more inclined to trust cash flow to service debts. Now, with
austerity undermining growth and the risk of a Eurozone break-up, lenders are increasingly
demanding high-quality collateral.
Noting that bond yields have been driven near zero because of a lack of safe
collateral, former Federal Reserve economist, Lew Spellman, recently noted the
growing appeal of gold: “[The] great corollary of over indebtedness is the relative
scarcity of good collateral to support the debt load outstanding. This imbalance of
debt to collateral is impacting the ability of banks to make loans to their customers, for
central banks to make loans to commercial banks, and for shadow banks to be funded
by the overnight Repo market. Hence the growth of gold as a collateral asset to debtheavy
markets is inevitably in the cards and is de facto occurring. Gold is stepping up
to the plate as ‘good’ collateral in a world of bad collateral.”
Leading commodity exchanges and clearing houses have increasingly recognized gold’s
value as collateral over the last 18 months. Last October, CME Group began allowing
members to post up to $500 million in gold as collateral for margin requirements—
more than double the previous limit of $200 million. ICE Clear Europe began
accepting gold as collateral in December 2010, and LCH Clearnet has pledged to also
accept gold as collateral once regulatory requirements are met. The World Gold
Council reports that JP Morgan became the first bank to accept gold bullion as
collateral via its tri-party collateral management arm in February 2011.
Although all major currencies used to settle international trade are issued by nations
that maintain substantial gold reserves, many people have forgotten the importance of
gold as collateral underpinning national debts. Nevertheless, the Basel committee is
not the only group looking to gold to help stabilize the financial system.