A Simple Explanation Of Capital Adequacy Ratios And How They Impact The Gold Market

Includes: GLD, PHYS
by: Simit Patel

The big story in the gold market today is a change in banking capital adequacy ratios that would give banks greater regulatory incentive to hold gold. This article from Ross Norman explains the story in greater detail.

Here's my simple interpretation on what's going on and what it means for the price of gold:

1. The Basel Committee for Bank Supervision - also known as the BCBS - is a monetary authority that helps to shape the rules for how banks operate. Specifically, banks profit by making loans; accordingly, organizations like BCBS help ensure banks have assets needed to make loans.

2. BCBS is considering giving banks a higher score for holding gold. If BCBS implements such rules, banks will want to hold gold to meet BCBS the required capital adequacy ratio - in other words, to meet regulatory requirements regarding liquid assets banks must hold.

3. If BCBS does decide to create a policy whereby banks are regarded as more stable for holding gold, it is unclear on the specifics on when the rules would kick in. Ross Norman cites a period between 2013 and 2018, perhaps scaling in along the way.

4. If the rules do kick in, this will create significant demand for gold. Basically, banks everywhere will have incentive to buy gold - and potentially lots of it, depending on how the rules are structured.

5. Most importantly, a BCBS ruling that equates gold with capital adequacy brings us one very large step closer to gold being officially re-monetized; it is, in a way, like a gold standard. This is what I regard as one of the most bullish factors possible for gold; the closer it gets to being formally recognized by prevailing monetary authorities, the higher the gold price will go. That gold has gone past $1,500 without any formal recognition speaks volumes; the real price move hasn't even begun. If we can get formal recognition from BCBS or someone else that has the power to influence the global banking system, I think a five-digit gold price comes much closer to reality.

The one caveat is that I consider it somewhat possible that the influence of the BCBS will decline significantly in the years to come. As the global sovereign debt crisis gets resolved, the end result could be a transfer of power to supranational institutions like the World Bank and BCBS - or it could mean a collapse of all these big institutions and the rise of non-state networks like Hezbollah and Anonymous. If we see the latter, we will need the monetary authorities that emerge out of those groups to respect gold.

For the time being, though, a transfer of power to supranational institutions seems more likely (unfortunate as that may be to those who equate liberty with local governance). And so, a BCBS policy equating gold with capital adequacy is thus very significant.

For those looking to play this opportunity, buying gold ETFs like (NYSEARCA:GLD) and (NYSEARCA:PHYS) are options - although I favor owning the bullion via vault storage services and through taking physical delivery of the metal. Remember the timeline, though; investors should expect to wait a few years, perhaps as much as six more. Hold until price goes parabolic, and when there are sharp retracements like what we are currently seeing, use that as a buying opportunity. If BCBS equates gold with capital adequacy, you'll be quite glad you did so.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.