Could changes to bank collateral send the gold price into the stratosphere?

We all know that gold is set to continue soaring in value over the medium term. All the commodity analysts around the world have revised their expectation upwards now that ‘big spender’ Obama has been re-elected.

It doesn’t take a genius to realise that the weak Dollar, a crumbling Euro and further tensions in the Middle East will all contribute to physical gold rising in value as the natural safe haven asset. But there’s also an unexpected source of fuel to this brightly burning fire. Our old friend – the banks.

Harsh bank collateral requirements

You see, while the banks have been blamed as the cause for your equities and bonds crashing in value, the very same institutions could be set to provide a huge catalyst to your gold holdings. The credit crunch and subsequent global crash have rocked the very foundation of the global economy and how money is leant and borrowed. It’s universally agreed that changes have to be made to ensure this doesn’t ever happen again. The obvious revision is to the way banks themselves lend and just as importantly the prudence they take with bank collateral for bad debts.

When a bank lends out money, it has to put a percentage away as bank collateral, a type of reserve to cover any losses from bad debts. This in theory protects the bank and other lenders/borrowers from suffering losses should a debtor fail to repay debt. The Basel accord is a set of laws set by influential central bankers to determine how much capital banks should hold and in which form this capital can be.

The types of assets financial institutions need to hold are split into three

classifications or ranks. Tier 1 assets are cash and Government bonds. Mortgages qualify as Tier 2 assets, while the bottom rung is made up of assets such as gold. The higher proportion of the ‘safer’ Tier 1 capital a bank holds, the more it can leverage its balance sheet. So over the past 5 years as the spotlight has fallen on the banks and they’ve desperately tried to shore up their balance sheets – we’ve seen them selling assets like gold and increasing holdings in Government bonds or cash.

Gold will be used for bank collateral

However, the financial world we live in has changed beyond all recognition, and the powers who set the capital ratios for banks realise this. So the latest version of these rules, known imaginatively as Basel III, looks set to address this. These rules for 2013 address two areas. Firstly, it increases the overall ratio that banks will need to hold in capital. Secondly it’s set to change some of the asset classifications with the most significant change coming to gold! Gold is set to become a Tier 1 asset alongside cash.

This is the first step towards a gold standard with institutions such as the Bank for International Settlements (BIS) recognising gold’s value alongside cash itself.

As BIS notes in its progress report on Basel III implementation:

“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%.”

Now, we’ve witnessed a steady shift in the holdings of Central banks from holding reserves in Dollars towards a heavier gold holding. They realise that a fast depreciating Dollar does nothing for their reserve levels and only gold can provide a reliable store of wealth. I’m sure banks have also been tempted to shift their reliance on holding paper currency as capital but the traditional tiering ratio has prevented this. Now they have a compelling reason to re-address this balance. With gold set to become the same as cash we will no doubt experience aggressive bullion buying from all the commercial banks in a bid to diversify their capital.

So rather than dwelling on how the banks have destroyed the value of your paper portfolios, recognise the opportunity the banking crisis now offers you.

Buy gold today and watch its value rise, not only from the obvious economic and political instability we’re experiencing, but also from the helping hand the banks are about to offer.