Can Gold Stabilize The Banking System?

Mar 21, 2023

Can Gold Stabilize The Banking System?

International banking rules say yes...

If only there was a way to stabilize the banking system...

Hmmmmmmm...

That would be really great, right?

It would be even more ideal to have an asset:

• With zero counterparty risk.
• That thrives during inflationary periods and in the face of rising interest rates.
• Which commercial banks could hold on their balance sheets.
• To counterbalance the depreciation of bonds that they are required to hold.
• And is permitted by current banking regulations.

Such an asset could provide significant benefits and stability in times of economic uncertainty.

If only there was such a thing…

Oh wait, there is: GOLD.

Over the past few years, we at Bentwood Research have discussed, at great length, the trend of central banks reducing their US dollar holdings while simultaneously increasing their gold reserves. We see the same thing coming for commercial banks.

According to the International Monetary Fund (IMF) data on Currency Composition of Official Foreign Exchange Reserves (COFER), the allocation of US dollars in global foreign exchange reserves has fallen:

• In 2010: The US dollar accounted for approximately 61.3% of the allocated foreign exchange reserves held by central banks worldwide.
• In 2021 (Q2): The US dollar accounted for approximately 59.3% of the allocated foreign exchange reserves held by central banks worldwide.¹

This has occurred while central banks have increased their gold holdings.

• In 2010: According to the World Gold Council, central banks held approximately 30,500 tonnes of gold, which represented around 10.3% of their total foreign exchange reserves.
• In 2021: As of September 2021, based on World Gold Council data, central banks held approximately 36,000 tonnes of gold, accounting for around 13% of their total foreign exchange reserves.²

Source: https://www.visualcapitalist.com/charted-30-years-of-central-bank-gold-demand/

Since 2012, there has been a notable shift in the behavior of central banks from being net sellers to net buyers. In the past two years, this trend has accelerated significantly, with central bank purchases showing a marked increase.

It reflects a strategic move by central banks to diversify their reserve portfolios and mitigate potential risks associated with fluctuations in currency values. By increasing their gold holdings, central banks have sought to enhance their financial stability and hedge against potential economic uncertainties.

We see the trend moving towards commercial banks, pension funds, and sovereign wealth funds.

It’s all been made possible by Basel 3.5.

Basel III is a set of commercial banking regulations developed by the Basel Committee on Banking Supervision (BCBS) in response to the 2008 financial crisis. It builds upon the previous regulatory frameworks, Basel I and Basel II, and introduced new capital and liquidity requirements for banks, among other provisions. Some of the main components of Basel III include:

1. Capital Requirements: Basel III establishes higher capital requirements for banks to ensure they have a sufficient capital buffer to absorb losses during periods of financial stress. These requirements include a higher minimum common equity tier 1 (CET1) capital ratio, a capital conservation buffer, and a countercyclical capital buffer.
2. Leverage Ratio: Basel III introduces a non-risk-based leverage ratio, designed to limit the amount of leverage banks can take on by setting a minimum level of capital they must hold relative to their total assets.
3. Liquidity Requirements: Basel III introduces two liquidity ratios – the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These ratios are designed to ensure that banks maintain adequate levels of high-quality liquid assets (HQLAs) to meet their short-term and long-term liquidity needs, respectively.
4. Systemically Important Financial Institutions (SIFIs): Basel III introduces additional capital requirements for banks identified as global systemically important banks (G-SIBs) to reduce the risk they pose to the global financial system.

Here’s the kicker.

On April 1st, 2019 gold was reclassified as a Tier 1 asset after having been a Tier 3 asset under previous Basel Agreements.

This means that it is recognized as a high-quality liquid asset (HQLA).⁴ This is why we believe commercial banks will move to holding more gold.

Gold has several characteristics that could make it an attractive addition to a bank's balance sheet, particularly during inflationary or stagflationary times:

1. Zero counterparty risk: Gold does not rely on the creditworthiness of any institution or government, which means there is no risk of default associated with it. This can be appealing to banks, especially during times of economic uncertainty or stress.
2. Hedge against inflation: Gold has historically been seen as a hedge against inflation because its value tends to rise when the purchasing power of fiat currencies declines. In an inflationary environment, holding gold could help banks protect their balance sheets from the eroding effects of inflation.
3. Diversification: Adding gold to a bank's balance sheet can provide diversification benefits, reducing the overall risk of the portfolio. In times of market stress or uncertainty, gold can sometimes act as a safe-haven asset and maintain or increase its value when other assets are under pressure.
4. Store of value: Gold has been a store of value for centuries and is widely recognized as such. This makes it a reliable long-term asset to hold as part of a bank's balance sheet.
5. Restore confidence: As bank runs become more common, depositors seek banks with balance sheets that hold non-correlated assets.

Of course, there is an even better reason to hold gold over the U.S. Treasury. It’s one we have argued for since the book Gold Is A Better Way was published.

It’s better.

According to the Barclays US Aggregate Bond Index, which tracks the performance of the U.S. investment-grade bond market, the average annual return for bonds over the last 20 years has been approximately 4.5%.⁴

According to the London Bullion Market Association (LBMA). The average annual return for gold over the last 20 years (2003-2022) has been approximately 9.4%.⁵

The average return on gold has wildly outperformed government bonds.

Over the last five years, government debt has been a straight-up loser. Based on the ETF TLT, long-term treasury bonds have lost more than 12.5% of their value over the last five years.

Source: https://www.google.com/search?q=tlt&rlz=1C5CHFA_enUS941US941&oq=TLT&aqs=chrome.0.69i59i131i433i512j0i131i433i512l3j46i175i199i512j0i131i433i512l5.1397j0j7&sourceid=chrome&ie=UTF-8

This has occurred while gold prices are higher by 45% over the last 5 years.

Source: https://tools.advantagegold.com/

Hmmmm.

You’re a bank depositor, right?

Which asset would you prefer your bank to own?

Think about it...

References:

1. https://www.imf.org/external/error.htm?URL=https://www.imf.org/en/Data/COFER

2. https://www.gold.org/goldhub

3. https://www.bis.org/bcbs/basel3.htm

4. https://www.macrotrends.net/2521/barclays-us-aggregate-bond-total-return-index-historical-chart

5. https://www.lbma.org.uk/

Written by Adam Baratta