The Basel Framework and regulatory status of gold

Gold is a commodity like no other.

With its monetary function, gold is commonly used as an alternative to foreign exchange (FX) and performs the role of a “safe harbour” asset for professional and retail investors to hedge against uncertainty and volatility in the markets. Gold’s role in the heavily regulated financial markets means that the use of gold is subject to certain rules and requirements. This includes prudential requirements for credit institutions that deal in gold.

The purpose of this article is to explain in non-technical terms the various prudential rules that apply to gold under the domestic regimes which implemented the global standards for banking regulation (Basel Framework) in the European Union (EU), the United Kingdom (UK) and the United States (US). 

To this end, this article breaks down the regulatory treatment of gold into five separate sections as we appreciate the complexity of the rules may lead to confusion regarding their practical application. Therefore, we look at gold from the perspective of: (1) gold within the perimeter of regulatory capital; (2) gold as a risk-weighted asset for the purpose of the capital requirements of banks; (3) gold as eligible collateral for banks within the perimeter of credit risk mitigation requirements; (4) gold as eligible collateral for central clearing counterparties (CCPs) and derivative counterparties; and (5) gold under rules regarding banks’ liquidity requirements. This article also addresses some recent press commentary regarding the status of gold as a High-Quality Liquid Asset (HQLA). 

This article does not constitute legal advice.   

1. Regulatory capital

Holding a prescribed amount of regulatory capital (or own funds) is one of the basic requirements that the Basel Framework puts upon banks. In short, regulatory capital is the amount of funds that the bank is required to hold to cover its operations and to absorb unexpected losses. In accordance with the Basel Framework, as transposed in the EU via the Capital Requirements Regulation (CRR), in the UK via the post-Brexit retained version of the same, and in the US via parallel implementing regulations (collectively, the US Capital Rules) implemented by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (collectively, the US Bank Regulators), regulatory capital can be composed of high-quality capital (mainly common equity and retained earnings) and other capital instruments. Depending on the quality category, these capital components are referred to as “Common Equity Tier 1” capital (i.e., the category of assets with the highest loss-absorption function), “Additional Tier 1” capital, or “Tier 2” capital. Gold, being an asset, does not fall under any of these capital categories. 

2. Capital requirements: Gold as 0% risk-weighted asset

The original Basel standard (Basel I) adopted in 1988 introduced an option for a national discretion, whereby gold bullion held in a bank’s 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%. The legislators in the EU (the UK was then part of the bloc) wrote this rule into the EU’s prudential framework and it remains unchanged to this date. 

Under the EU’s CRR and the UK’s post-Brexit retained version, the rules on “Standardised Approach” to credit risk allow banks to apply a 0% risk weight to gold bullion held in a bank’s own vaults or on an allocated basis to the extent backed by bullion liabilities.

In practice, therefore, this 0% favourable risk-weight applies to physical allocated gold which is the same treatment applicable to cash.

The same 0% risk-weight is permitted for banks using the “Internal Ratings-Based Approach”.

Gold receives essentially the same risk-weighted asset treatment under the “Standardised Approach” and “Internal Ratings-Based Approach” / “Advanced Approach” as implemented under the US Capital Rules as it does under the EU’s CRR and the UK’s post-Brexit retained version.

3. Collateral requirements: Gold as eligible collateral for banks for purposes of credit risk mitigation

The Basel Framework as implemented in the EU, UK and the US also recognises gold as a form of eligible “financial collateral” that banks can use for the purpose of credit risk mitigation with respect to collateralised transactions. This places gold alongside other assets, such as cash, debt securities, and equities.

As financial collateral, gold is subject to the same eligibility criteria as other assets constituting financial collateral, i.e., certain contractual, statutory, and operational requirements must be met. 

In order to shield banks from losses resulting from fluctuations in collateral asset value, banks must apply a so-called “volatility haircut”, which under the Supervisory Volatility Adjustments (SVA) Approach in the EU and the UK amounts to 20% for gold bullion over a 10-day liquidation period (NB: it is lower for a 5-day, and higher for a 20-day liquidation period). Under the US Capital Rules’ “Standardised Approach”, with respect to certain types of collateralised transactions, similar regulatory requirements apply a 15% supervisory market price volatility haircut to gold bullion based on a 10-business day holding period (subject to adjustments downward or upward based on shorter or longer holding periods respectively, and subject to increased haircuts for transactions involving large netting sets). 

Alternatively, a bank that has received prior written approval from its US Bank Regulator may calculate the applicable haircut for gold bullion and other financial collateral using its own internal estimates of the market price volatilities of such financial collateral subject to certain requirements. The position is broadly similar for banks in the EU and UK under the “Internal Ratings-Based Approaches”, subject to adjustments made based on a bank’s internal models.

4. Collateral requirements: Gold as eligible collateral for CCPs and derivative counterparties

In addition, under a separate set of EU, UK, and US rules governing over-the-counter (OTC) derivatives and setting out the prudential framework for CCPs in the context of OTC derivatives clearing, CCPs are allowed to accept gold as eligible collateral. Secondary legislation developed under the European Market Infrastructure Regulation (EMIR), as retained in the UK post-Brexit, places gold alongside other assets considered “highly liquid collateral with minimal credit and market risk” that a CCP can accept to cover its initial and ongoing exposure to its clearing members. The secondary legislation prescribes conditions that gold must satisfy in order to be accepted as collateral by CCPs. Gold, again, alongside all other assets deemed as eligible collateral for CCPs, is subject to haircuts determined by the CCPs. 

The similar EU, UK, and US rules allow counterparties to uncleared derivatives transactions, who are subject to initial margin and variation margin requirements, to accept gold as eligible collateral. For the purposes of the EU and the UK rules, gold that is eligible collateral must be in the form of allocated pure gold bullion of recognised good delivery. Gold that is eligible collateral for margin exchange purposes for uncleared derivatives transactions is subject to a 15% haircut. 

5. Liquidity requirements 

A separate set of the Basel Framework rules applicable to gold relates to the liquidity requirements for certain banks. This is one of the later additions to the Basel Framework as it was adopted at the international level in 2013 as a part of the so-called Basel III reforms. The liquidity rules for banks consist of two distinct but complementary components: (i) the Liquidity Coverage Ratio (LCR); and (ii) the Net Stable Funding Ratio (NSFR), which was developed subsequently to the LCR. 

The LCR promotes the short-term resilience of the liquidity risk profile of banks by requiring them to hold the appropriate amounts of HQLAs, the characteristic of which must allow their prompt liquidation in a liquidity stress scenario. The NSFR, on the other hand, promotes resilience over a longer time horizon by requiring banks to fund their activities with more stable sources of funding on an ongoing basis.

For the purpose of the LCR rules’ application in the EU and in the UK, a list of assets classified as HQLA is set out in secondary legislation. Under EU, UK, and US LCR rules, gold is not currently considered an HQLA. In practice, this means that banks cannot use gold to meet their LCR requirements under such rules. 

The similar EU, UK, and US rules allow counterparties to uncleared derivatives transactions, who are subject to initial margin and variation margin requirements, to accept gold as eligible collateral. For the purposes of the EU and the UK rules, gold that is eligible collateral must be in the form of allocated pure gold bullion of recognised good delivery. Gold that is eligible collateral for margin exchange purposes for uncleared derivatives transactions is subject to a 15% haircut. 

Elements of ASF generally include a bank’s regulatory capital elements and liabilities with a residual maturity of one year or more, including term deposits. This means that in respect of gold, banks must finance 85% of the holding with stable funding, as gold is considered not sufficiently liquid to qualify for a lower RSF factor. 

Upcoming reforms

Whilst this article focuses on clarifying the status-quo of the regulatory treatment of gold, as every other area of regulation, these rules may change in the future. For the time being, the legislators and regulators in the EU and in the UK have not announced any prospective changes concerning the treatment of gold.

However, the relevant legislation is regularly under review so the industry should keep a close watch.

In July 2023, the US Bank Regulators proposed substantial revisions to the US Capital Rules in a proposed rulemaking (known as the Basel III Endgame). Among other things, the Basel III Endgame proposal would replace the current “Internal Ratings-Based Approach” / “Advanced Approach” with an “Expanded Risk-Based Approach” consisting of new “Standardised Approaches” for credit, operational, credit valuation adjustment, and market risk. The Basel III Endgame proposal has received substantial criticism from the industry, and, as of the date of this article, the US Bank Regulators are expected to re-propose the rulemaking.