Gold: A Review Of Possible Effects Of The Proposed Regulatory Risk Changes On Its Price

Includes: GLD, UUP
by: Vision Capital M.

Gold price is subject to numerous factors which at the end could all be summed up to two - supply and demand. While generally supply of new gold on the market depends on the economically reasonable price, in times of cash constrains supply could significantly increase due to the needs of institutional participants, including banks, of fresh money. Usually such sell-offs of gold are combined with a flight to the safety of government bonds. Last month as part of the Basel III implementation, changes in the risk weight of gold bullion were proposed in the United States. According the new rule gold should have a zero weight as a risk asset. This news has the potential to bring a significant change to banks' attitude and behavior towards gold.

A bit of history before we elaborate on the effects of such reclassification.

Basel III is an international regulatory framework for banks. It is developed by the Basel Committee on Banking Supervision. Its main purposes as stated on the Basel III web page and which concern this analysis are:

  • to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source

  • to improve risk management and governance

A committee's note on the minimum capital requirements (pdf) dated back to around the end of 2007 reads that "at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%."

Almost 5 years later, on June 18, 2012, Federal Deposit Insurance Corporation (FDIC) together with the Federal Reserve Board issued a letter to financial institutions concerning proposed changes in regulatory capital rules. These proposed changes dwell on the Basel committee ideas and are scheduled to take effect on January 1, 2015, with an option for early adoption. Comments on the proposed changes may be submitted till September 8, 2012 so by that time it should be more clear what the banks think on the subject.

In the summary of the proposed changes located on the website of FDIC we read:

A. Zero Percent Risk-Weighted Items

The following exposures would receive a zero percent risk weight under the proposal:

  • Cash;

  • Gold bullion;

  • Direct and unconditional claims on the U.S. government, its central bank, or a U.S. government agency;

  • Exposures unconditionally guaranteed by the U.S. government, its central bank, or a U.S. government agency;

  • Claims on certain supranational entities (such as the International Monetary Fund) and certain multilateral development banking organizations

  • Claims on and exposures unconditionally guaranteed by sovereign entities that meet certain criteria (as discussed below).

The proposal also includes gold as a financial collateral along with cash on deposit, investment grade long- and short-term securities, publicly traded equities and others. The standard haircut applied to gold prices when used as a collateral is 15%.

What would these changes mean for gold and banks, if implemented?

Currently the banks' exposure to gold has a 50% risk weight assigned. This means that for every $1 invested in gold banks have to set aside $0.5 of regulatory capital. At the same time cash and some countries' government bonds have a risk weight of zero. In "flight to safety" times the banks are generally more willing to invest in assets with a risk-weight of zero because doing so they wouldn't worry about impairing their regulatory capital ratios. On the other hand they would sell higher risk-weighted assets in order to gain cash or improve their regulated capital ratio.

The proposed reclassification of gold bullion would put it in a whole different risk group of possible investments and on a level with those assets, which are considered to be free of counterparty risk from a regulatory point of view. This would lower the willingness of banks to sell gold in order to improve ratios or acquire cash and would expand the universe of available zero risk-weighted assets as investment options. As John Butler - head of Amphora Commodities Alpha Fund, put it in a recent article of his:

If implemented, this will be an important step in the re-monetisation of gold and, other factors equal, should be strongly supportive of the gold price, both outright and relative to that for government bonds...

Another incentive for the banks to increase their demand for gold could come from the expected raise of the minimum required Tier I capital ratio under the Basel III framework. The Tier I risk-based capital ratio is the bank's Tier I (or "core") capital - which consists of bank's equity and retained earnings - divided by its risk-weighted assets. There are two ways to increase the ratio - either by increasing the common equity or by decreasing the risk-weighted assets. The reclassification of gold to a zero risk-weighted asset would effectively decrease the amount of risk assets for banks that have invested in gold. As a direct consequence of the decrease of those banks' risk-weighted assets their need of raising more equity to support viable Tier I capital ratio would also decrease.

So basically the proposed change of the risk weight of gold has the potential both to decrease the "safety flight" supply of gold by banks and to increase further the demand for it. In both cases the down pressure on the gold price from banks' actions in the gold market should be lower.

In the meantime data from the World Gold Council show that as for Q1 2012 the average increase in gold as a percentage of total reserves for the world during the last year (QoQ basis) has been about 21%. As for Q4 2011 the same measure was about 39% (down from 48% for the previous period), which would suggest there was a continuation of the slowdown of the increase of gold as part of countries' reserves. It seems the gold price during the recent year was not as attractive to the demand as it used to be.

Considering the proposed regulatory risk changes however, we could have a foundation for a long-term positive change in the price of gold. Given this happens to be the case a long position in either physical gold bullion or an ETF like SPDR Gold Trust (NYSEARCA:GLD) could show to be a profitable one in long term. GLD is an ETF designed to track the spot price of gold bullion and has only one holding - physical gold bullion. The fund has an expense ratio of .40%.

Given the current weakness of gold price and the fact that the proposed changes are still not in effect, short- or near-term decreases of gold price are also possible. The changes are scheduled to be effective not later than January, 2015 in the United States with the comments on them accepted by FDIC and other agencies till September 8, 2012. The Basel III framework could be implemented sooner in Europe as almost all of the countries there have already published draft regulations with Switzerland expected to have decided on final texts before the end of 2012. Japan is in the process of implementing the final rules.

In order to protect any long investment in gold till the time the changes become effective an investor could use an asset with a negative correlation to gold such as the DB USD Index Bullish (NYSEARCA:UUP) ETF. This ETF tracks the performance of being long in the U.S. dollar against six major currencies and has an expense ratio of .50%. The correlation for the last five years between UUP and GLD is -.72.

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