Will Basel make make gold a Tier 1 asset?

Banking capital adequacy ratios, once the domain of banking specialists
are set to become centre stage for the gold market as well as the wider
economy. In response to the global banking crisis the rules are to be
tightened in terms of the assets that banks must hold and this is
potentially going to very much favour gold. The Basel Committee for Bank
Supervision (or BCBS) as part of the BIS are arguably the highest
authority in banking supervision and it is their role to define capital
requirements through the forthcoming Basel III rules.

In short, they are meeting to consider making gold a Tier 1 asset for
commercial banks with 100% weighting rather than a Tier 3 asset with just
a 50% risk weighting as it does today. At the same time they are set to
increase the amount of capital banks must set aside as well. A double win
potentially.

Hitherto banks have been much dis-incentivised to hold gold while being
encouraged to hold arguably riskier assets such as equity capital,
currencies and debt instruments, none of which have fared too well in the
crisis. With this potential change in capital adequacy requirements. bank
purchases of gold would drive up its value relative to other high quality
qualifying assets, increasing its desirability for regulatory purposes
further. This should result in gold being re-priced to bring it on a par
with all other high quality assets.

Currently banks have to have core Tier 1 capital ratio of 4% of which will
rise to 6% from the beginning of next year. In addition to its store of
value merits, central to the argument in favour of gold as a bank reserve
is its countercyclical nature to most other assets in that it tends to be
inversely correlated. Gold is ideal as it bears no credit risk. it
involves no other counterparty and it is no one’s liability. It is a
reserve asset diversifier if you like.

This is a treble win for gold – it would be a major endorsement of its
role in preserving wealth and as a store of value from the highest
financial authority, it would lead to significant purchases of gold by
major financial institutions and it would lead to a reappraisal of its
value with respect to other Tier 1 capital such as quality sovereign debt.
Under the new rules gold could become a very significantly larger
proportion of a reserve pool which is about to grow very much larger.

The 2 questions that come to my mind are when and how much metal – on
timing Basel III kicks in from January 2013 with a further tightening in
capital adequacy ratios in 2018. That said, it is not yet clear when
gold’s re-rating to Tier 1 might take place.