Gold and Basel III Endgame.
The core issue facing gold under Basel III is its inconsistent classification under High Quality Liquid Asset (HQLA) regulation, which is in stark contrast to Central Bank's own beliefs and actions.
In recent weeks, there has been much discussion on-line about gold becoming a Tier 1 High Quality Liquid Asset (HQLA) under the Basel III banking regulations to be implemented in the US commencing 1st of July. These discussions appear to be blurring the lines between capital and liquidity regulation.
The LBMA (HERE) and the World Gold Council (HERE) have both written articles clarifying that this is not the case, with the LBMA noting “no official announcement has been made or is expected on gold gaining HQLA status.”
There is a strong case that gold should be made a HQLA, but don’t hold your breath. The decision on whether gold is considered a HQLA under Basel III rests in the hands of decisionmakers selling a competing product (bonds).
It’s hard to see why policymakers would elevate the status of gold to that of liquid government bonds, when it would almost assuredly syphon off demand from bonds while boosting the value and price of gold.
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Why is Basel III important?
Basel III is a series of banking rules negotiated in the post-Global Financial Crisis world (2009-10) in response to the noted shortcomings of the previous Basel II framework, which allowed banks to create off-balance sheet vehicles to add leverage, allowing banks to buy longer-dated lower credit quality products (e.g. mortgage-backed securities) funded through the short-term wholesale market (e.g. borrowing on the LIBOR market). While this financial engineering juiced-up bank earnings, boosting their share prices, it did so at the expense of increasing financial fragility, with the increased risk exposure only becoming truly apparent as the financial crisis intensified.
The financial plumbing of an economy may seem a dull topic full of confusing acronyms, but it matters. Basel III sets the framework from which banks must operate, affecting the cost of capital and the availability of credit to every sector of the economy, impacting all our lives in blunt and subtle ways.
Gold plays a part in banking under both capital and liquidity rules.
While there is some debate about how gold should be viewed within capital rules, these aren’t really the primary concern of gold market participants. What matters is the treatment of gold under liquidity rules, which don’t make a lot of sense. Under Basel III gold is not considered a High-Quality Liquid Asset (HQLA), even though in the real world, it is. Why would government classify gold as just another commodity like wheat or oil? Those with a less charitable disposition may argue it’s because government is in the business of selling bonds, which compete directly with gold. Changing the liquidity status of gold versus bonds will make gold more attractive, and bonds less.
Gold as capital.
It is important to make the distinction between banking rules governing capital and liquidity. Rules around capital refer to the solvency of a bank while liquidity rules govern the amount of capital a bank must hold in the form of highly liquid assets that can be quickly and easily disposed of to meet short-term financing needs. Under Basel III regulations, bank capital is broken down into Tier 1 and Tier 2 assets, the first comprising common equity and retained earnings and may include other assets such as a bank’s own gold holdings, while Tier 2 assets include items like convertible bonds (bonds issued by the bank that can be converted into stock), revalued reserves (e.g. revaluation of land holdings) and other hybrid capital instruments. Banks can also be asked by regulators to hold extra reserves as a ‘counter-cyclical buffer’ and there is an additional credit charge of 1% for those banks determined to be globally systemically important financial institutions. Under Basel III, banks must hold these reserves at a set minimum percentage of their Risk Weighted Assets (RWA). Tier 1 capital must be at least 6% of RWA while Tier 2 capital must be at least 10% of RWA (plus those additional credit charges). Determining what constitutes Tier 1 and Tier 2 capital is a straightforward affair but determining how to risk weight assets and what constitutes an appropriate ratio for prudent lending is a much slipperier slope and one subject to a good deal of debate.
Under all three Basel regulatory frameworks, gold held on a bank’s own account in its vault has always been considered a Tier 1 asset enjoying a zero-risk weighting.
While the rules around allocated gold (gold that is earmarked in the bank’s vault to a specific owner) are straightforward, those around unallocated gold are less clear-cut. A significant portion of the gold held in bullion bank vaults is unallocated, meaning that there is no clear owner assigned. Banks treat unallocated gold as a form of liquid reserve on their own balance sheet, with those trading with the bank merely owning a paper claim on the asset. Banks are then free to consider this gold as part of their capital reserves, assigning a risk weighing. Some critics argue that the ability of bullion banks to leverage their holdings of unallocated gold creates ‘turtles to the sky’, with financial claims far exceeding the ability of any bullion bank to net settle in physical gold. Under Basel III, the unallocated gold risk weighting has been increased, reducing the attractiveness of holding it on a bank’s balance sheet.
Discussion about the appropriate holding of gold in allocated versus unallocated accounts is probably as old as banking. Even before the Merchant of Venice discussed fleet insurance with Shylock, he probably had an argument with the banker about whether his gold was allocated, or not.
Gold as a liquid asset.
Basel III sets two liquidity requirements, a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR). The former requires banks to hold enough liquid assets on their balance sheet to meet their total cash outflows over a thirty-day period, with those assets being HQLA (i.e. LCR = HQLA/total net liquidity outflows over 30-days ≥100%. The latter requires banks to hold sufficiently stable funding to meet a stress scenario lasting twelve-months (NSFR = available stable funding/required stable funding >100%.
The LBMA note “as gold sits outside of the High-Quality Liquid Asset list, it suffers from an 85% required stable funding ratio (RSF) factor and a 0% available stable funding factor under the Net Stable Funding Ratio (NSFR) rules.” What this means is that for banks to hold unallocated gold on their balance sheet, they need to hold HQLA approved assets covering 85% of its value, effectively treating gold as a commodity, not as a monetary instrument, significantly reducing its attractiveness to banks.
What constitutes a HQLA?
Under the Basel III framework, a HQLA is an asset that can be easily and immediately converted into cash, with little or no loss of value, even in times of stress.
A high-quality liquid asset should be viewed as high quality collateral, with little-to-no default risk, that is widely accepted, acting as a store of value in times of financial market stress. The World Gold Council breaks these attributes down into metrics – volatility, spreads, and trading volume – and compares the performance of gold to that of US Treasuries. The WGC notes that the volatility of gold is “comparable or superior… to intermediate and long US Treasuries during recent shocks” while “gold’s bid-ask spreads remained narrow – or normalized quickly – during periods of market stress, rivalling those seen in 10-and 30-year US Treasuries” and that “gold’s robust trading volumes rival that of 10-year US Treasuries.”
Putting some numbers to these claims, the WGC notes the intra-day (minute-by-minute) volatility of gold on a daily average basis is 0.027%, higher than the 10-year on-the-run US Treasury note but in line with the US 30-year Treasury (0.28%). The intra-day bid-ask spread was estimated at “roughly 2.2bps” slightly wider than the US 10-year Treasury bond, but lower than the 30-year bond (3.3bps). And average daily turnover volume between November 2024 and April 2025 was USD 145bn/day. This compares with USD 143bn for US Treasury bonds of duration between 7-10 years and significantly higher than the trading volume of long-dated (>20-years) US Treasuries (USD 72bn).
The trading volume in gold is vast, with the LBLA noting total reported transactions in gold over the twelve weeks to the 11th of April were USD 738.6 billion, almost 10-fold more than Silver (USD 87.5bn).
And the irony of all of this is…
The Basel III regulations were constructed under the auspices of the Bank for International Settlements (BIS), often referred to as the Central Bankers Central Bank. While Basel III classifies gold in the same category as other commodities, the World Gold Council’s 2024 Survey of Central Banks shows that the bankers themselves don’t see gold in the same vein. The WGC asked Central Bankers what factors dominated their decision to hold gold in their reserves. The most important factors (highly and somewhat important) are the fact that gold is seen as a ‘store of value’ as well as ‘performing well in a crisis’ acting as a ‘portfolio diversifier’ and suffering from ‘no default risk’.
And over the past decade, Central Banks have purchased 6,677.1 tonnes of gold, 1,019.7t (20.4% of total supply) in the past twelve months alone. It is clear from their views and actions that Central Bankers view gold as a liquid asset with limited systemic risk and a valuable source of collateral. All factors one would look for in a High-Quality Liquid Asset.
In my opinion, the case for gold to be classified as a HQLA is compelling, but don’t hold your breath.
“Therefore, all that they tell you to observe, observe and do, but do not do according to their deeds; for they preach, but do not practice.” Matthew 23:3
The information in this publication is provided by Redward Associates Private FZCO for informational purposes only. The insights contained in this publication are not investment advice and should not be construed as such, nor as a recommendation for any specific investment product. Our full disclaimer can be found HERE.
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