(Patrick A. Heller) The Basel 3 accord is a set of global financial reforms developed by the Basel Committee on Banking Supervision under the domain of the Bank for International Settlements, an organization headquartered in Basel, Switzerland. These coming changes in bank system operations are to strengthen regulation, supervision and risk management within the worldwide banking industry.
Work on the Basel 3 changes began in 2008, after the onset of the Great Recession. The original version was adopted in 2010, to be implemented from 2013 to 2015.
Some changes called for in Basel 3 were so extreme that some revisions were made and implementation was repeatedly delayed. As it now stands, some of the impact of Basel 3 takes effect at the end of June this year, while all changes become effective on Jan. 1, 2023.
The goal of the forthcoming Basel regulations is to limit the levels of risk that banks take on in the pursuit of profits, which would hopefully prevent a major worldwide financial crisis if markets turn negative. It’s a wonderful idea in theory. However, in practice, some changes could be so disruptive to the actions of some governments, central banks and financial institutions that there is already pushback.
Many of the world’s largest banks trade them for customers and for their own account. In trading these metals, they are handled as either allocated or unallocated assets.
With allocated precious metals, the customer is the owner of specifically identified and segregated coins or bars. The brand name, weight, purity and serial numbers of bars are recorded. The bank merely provides storage services. When a customer withdraws or sells these assets, the bank releases these exact same assets. Because these assets are property of the customer, the bank does not own them and they are not listed as assets of the bank or as liabilities that the bank owes to its customers.
It is an entirely different matter with unallocated storage of precious metals.
In unallocated storage, the bank’s customer does not own specifically identified coins or bars. Instead, the customer is an unsecured creditor of the bank, who has a claim against some of the assets owned by the bank. For example, a customer may have a 1,000-ounce silver bar in unallocated storage. The bank may be holding hundreds or thousands of these bars in unallocated storage, any one of which would be available to deliver on behalf of a customer if requested for withdrawal or sale.
When banks trade precious metals, the use of unallocated storage has a lot of advantages. Banks don’t have to keep track of each bar and coin by individual owner, which saves a lot of paperwork and shuffling of assets when they change hands.
However, there is a problem with unallocated storage.
Since the everyday turnover of precious metals involves only a relatively small percentage of the assets a bank may hold, the bank can fulfill the delivery needs even if it does not have physical custody and title to all of the precious metals it owes to customers.
You can think of this circumstance as similar to a bank’s cash customers. On a day-to-day basis, banks do not face a high percentage of their customers showing up to withdraw all of their funds. Therefore, the banks are able to hold only a small percentage of their assets in the form of coins and currency when compared to their liability to customers who have checking or savings accounts or certificates of deposit.
So, many banks today engage in what could be called fractional precious metals trading. They hold only a small percentage of their liability to their customers in physical metals in their vaults. They theoretically cover the rest of their precious metals liabilities by leasing gold from central banks, trading derivatives contracts or using other paper forms.
Investment bank Morgan Stanley was caught in such a scam where it sold physical precious metals to customers and collected storage fees to hold them, but did not purchase the actual assets. Instead, this bank used customer funds to purchase other assets, many of them in paper form. Morgan Stanley settled a multi-million-dollar class action lawsuit on this issue in 2007 without agreeing with the charges.
How huge is this paper market, where banks may hold paper contracts to cover their liabilities to deliver physical precious metals? In a Commodity Futures Trading Commission hearing in March 2010, precious metals consultant Jeffrey Christian testified that these institutions may have sold their physical metals as much as 100 times the quantity of metal that they actually owned. Obviously, if all these owners contacted their bank to take delivery, the paper market would crash.
The New York COMEX is the world’s second largest platform for trading precious metals. The COMEX trading of gold futures and options contracts began in the mid-1970s specifically as a means for the U.S. government and the primary trading partners of the Federal Reserve Bank of New York to manipulate the price of gold.
The fractional reserve method trading of unallocated precious metals is the primary means by which the U.S. government, the primary trading partners of the Federal Reserve Bank of New York, allied central banks and the Bank for International Settlements suppresses gold and silver prices.
By selling paper contracts, without having to deliver the physical metals, there is the appearance that there is a lot more gold and silver available on the market than there actually is. The result is that prices are lower than if buyers and sellers of precious metals traded on the basis of actual supply and demand information.
As I have explained in the past, the prices of gold and silver effectively serve as a report card on the U.S. government, U.S. economy and the U.S. dollar. If precious metals prices are rising, that not only reflects poorly on the government, it also forces higher interest rates that must be paid on government debt and pushes down the purchasing power of the dollar.
However, banks would no longer be able to consider any of the liability for unallocated precious metals as part of their required reserves.
Therefore, to comply with Basel 3 regulations, banks would have to either create a huge increase in their shareholders’ equity to provide the required reserves or they will be forced to sharply reduce or completely eliminate their trading in unallocated precious metals.
Will these banks take title and custody to many times the quantity of physical precious metals that they now hold? For all practical purposes that isn’t possible because there just aren’t enough physical metals available. Another obstacle is that these banks simply do not have the storage capacity to hold sufficient inventory to provide sufficient reserves for their precious metals assets.
The practical effect of this part of the new Basel 3 regulation would be to almost completely wipe out the trading of unallocated precious metals in the London and New York markets. About the only trade that would survive would be for allocated metals.
With the elimination of most trading in unallocated storage, the U.S. government could lose its primary tactic of suppressing gold and silver prices.
Between the increased demand for physical precious metals and the elimination of the use of unallocated precious metals to suppress prices, gold and silver prices might undergo huge increases.
This impact of these forthcoming market changes is so enormous that on May 4, 2021, the London Bullion Market Association and the World Gold Council submitted a paper to the Prudential Regulation Authority, the United Kingdom’s regulator of banks and the financial sector, asking for the changes in Basel 3 standards in trading unallocated precious metals be eliminated. This paper claimed that implementing the new regulations would undermine the ability of banks to clear and settle precious metals trading, drain liquidity from this market, sharply increase financing costs of such trades and would limit central bank operations with precious metals.
The claim that the London Bullion Market Association may be almost forced to cease operations without this waiver also means that the COMEX trading of unallocated metals would also come to a virtual standstill.
But, even if the implementation dates are once more postponed, that deferral might only apply to British banks.
Another possible change suggested in the LBMA and WGC paper is to instead adopt the Swiss interpretation which considers it applicable only to unbalanced positions on both sides of a bank’s balance sheet. That might not provide much leeway.
Still, time is running out to try to change the regulations before the first of these standards applies to continental European banks at the end of June this year.
Right now, the COMEX currently has about $24 billion in short sales of gold futures contracts and another $1.6 billion in short sales of silver futures. There will almost certainly be pressures for short sellers to cover these COMEX contracts as continental European banks scramble to cover their short positions.
However this eventually turns out, the ultimate result is almost certain that gold and silver prices will climb far higher, perhaps multiples of current levels, within the next six months to two years.
Why Basel 3 Accords May Not Boost Gold, Silver Prices
(Patrick A. Heller) In last week’s column, I laid out the prospect that new banking regulations called the Basel 3 Accords may pretty much make it impossible for major banks to continue trading massive volumes of unallocated precious metals. These new standards kick in for 10 non-British European banks that are members of the London Bullion Market Association at the end of June this year.
Widespread reduction or elimination of bank trading in precious metals stored in unallocated accounts would severely cripple the ability to suppress precious metals prices, especially for gold and silver.
As I stated in the last column, the U.S. government is the largest beneficiary of lower gold and silver prices. Therefore, it has a huge incentive to find a way to continue to manipulate precious metals prices, despite possibly losing the major strategy it has used thus far to do so.
In a Federal Reserve Bank document from April 5, 1961, an unidentified senior Fed official explained that U.S. foreign exchange and gold trading operations would not have their desired impact at manipulating markets unless the information on such trading was secret. To keep such activity secret, the government could use various tactics. First, it could delay the release of information. Second, it could disguise trading activity by combining it in reports with other financial activities. Even scarier, though, this document hinted that the government might also just not report some activities.
Therefore, in the absence of massive trading in unallocated gold, how else could the U.S. government still hold down gold and silver prices after the new Basel 3 bank regulations take effect?
It turns out that the federal government has multiple tactics to do so.
First, the Secretary of the Treasury could use the billions of dollars of assets of the Exchange Stabilization Fund, created as a provision of the Gold Reserve Act on January 31, 1934. This law explicitly authorizes the government to use its assets to secretly manipulate the price of gold.
It could persuade other central banks to liquidate some gold reserves, to help private banks build up their required reserves to meet Basel 3 reserve requirements. The Bank of England sold half of its reserves from 1999 to 2001 to temporarily hold down prices.
Central banks could also increase their gold leasing and swaps activity, especially if they could avoid reporting such activity or fraudulently refuse to disclose it. In years past, the IMF required that both a central bank that had custody of leased gold and a central bank that had leased out the gold would issue reports that this leased gold was part of their official reserves. Several years ago, the IMF changed this requirement to allow (but still not require) that only the central bank that had title to the physical gold would report it as part of their reserves.
Finally, the federal government could also simply engage in secret behind-the-scenes trading to defraud investors and the American people as to the amount of bank reserves. This would not be the first time it has hidden its financial activities. A major recent example is the Federal Reserve Bank program initiated in September 2019 to inject liquidity into the overnight bank loan system in amounts now totaling more than $6 trillion. The Fed has refused, as required under the 2010 Dodd-Frank Act, to inform Congress of the identity of which banks received these loans, much less how much.
On the surface, it may seem that the provisions of the Basel 3 Accords may collapse the market for trading unallocated previous metals, with the result of pushing up gold and silver prices. But, in practice, the U.S. government could arrange to delay or reduce gold and silver price increases when the Basel 3 bank regulations take effect. However this works out, I still anticipate much higher gold and silver prices in the next six months to two years.