Is Gold About to Have Its Status Upgraded?

Central banks have been on a gold buying spree. In “The Rising Financial Gold Market,” I highlighted how countries, such as Mexico, Russia and Thailand, were adding to their gold reserves. And in 2010, central banks became a net buyer of gold for the first time in 21 years, according to the World Gold Council.

Central bank gold buying could soon be matched with other global banks if gold's quality as an asset gets upgraded to Tier 1 status by the Basel Committee on Banking Supervision (BCBS).

The BCBS is an international banking supervisory committee that provides a forum for determining global standards to ensure that banks all around the world have adequate capital. The group is comprised of members from all over the world, including Brazil, Canada, Germany, Hong Kong, Mexico, South Africa, Turkey, the U.K. and the U.S.

After the global economic crisis, its top priority was to increase banks' ability to absorb market shocks. One way to do this was to raise the percentage of common equity–considered the least risky of banks' assets–that banks were required to hold from 2 percent to 7 percent.

The BCBS has three tiers to grade the quality of capital held by financial institutions:

Tier 1 – A high quality, liquid asset that must have exchange-related characteristics. Criteria include low credit and market risk, certainty of value, low correlation with risky assets, and listing on a developed and recognized exchange. There are also market-related criteria to determine whether an asset is a part of an active market, there are adequate market makers and what happens to the asset's value when there's a flight to quality.
Tier 2 – These assets are considered “secondary bank capital.” These assets were never clearly defined and contain a range of assets with varying degrees of liquidity. Many of these assets could quickly lose value if liquidity dries up. Investopedia says this includes undisclosed reserves, general loss reserves and subordinated term debt—those that rate below other securities and are second in line when the debt gets paid out.
Tier 3 – Tier 3 assets are similar to Tier 2, except that securities such as subordinated debt are in greater number. Investopedia says assets must be unsecured, limited to 250 percent of a bank's Tier 1 capital, subordinated and have a minimum maturity of two years.

Historically, securities such as sovereign debt have been considered high quality, liquid assets. As a Tier 1 asset, sovereign debt has been allowed a 100 percent required stable funding factor (RSF) applied in the net stable funding ratio. This means that the bank can lend 10 times the current market value of their Basel Tier 1 asset.

Gold has historically been classified as a Tier 3 asset, with a net stable funding ratio of 50 percent. When determining how much money a bank can loan, the bank's gold holdings have traditionally been discounted 50 percent of the current market value. With value cut in half, banks have little incentive to hold gold as an asset.

After years of being undervalued, a sentiment is building to have gold upgraded to Tier 1 status. This would level the investment playing field for the yellow metal and encourage banks to increase gold's share of their reserves.

One of the best arguments for the upgrade has been put forth by the World Gold Council (WGC), which stated that an upgrade would be “further recognition of gold's growing relevance as a high quality liquid asset …[and] reinforces market demand for a greater choice of assets that can be used as collateral to meet margin liabilities.”

J.P. Morgan was one of the first to upgrade gold's status when the bank announced in February 2011 that it would now be accepting gold as collateral to satisfy securities lending and repo obligations with counterparties.

On May 25, 2011, the European Parliament's Committee on Economic and Monetary Affairs (ECON) agreed to accept gold as collateral. The WGC's Natalie Dempster said the announcement was “very significant that the European Parliament is putting its weight behind the argument that the unique characteristics of gold make it an ideal form of high quality liquid collateral.”

There's been no official word from the BCBS yet on an official upgrade of gold to Tier 1 status but some think it could come as soon as the third quarter of 2011. If an upgrade were to take place, it would likely have a profound impact on gold and gold equities. We anticipate that central banks around the world would add (some of them significantly) to their gold positions, which would further tighten gold supply and increase gold consumption.