When Gold Becomes Tier 1 Capital

Usually gold is rejected as an investment because it doesn't contain the potential for growth. However, gold does certain jobs that currencies cannot do. First, it acts a safe haven in times of turmoil and second, it preserves your purchasing power.

By Richard Mills
05/25/2012
Financial Sense

Institutional investors tend to prefer investments that are thought to contain the potential for growth: growth = sprouts. An investment has to produce a growing revenue stream - if it doesn’t grow it doesn’t compound. Gold is rejected as an investment because it doesn’t produce sprouts, meaning the steady income and systematic growth so sought after by institutional investors just isn’t there.

Gold performs two jobs that fiat currencies, or any other financial innovation, cannot do; gold acts as a safe haven in times of turmoil - to escape Nazi Germany, or buy food and water in a crisis. Perhaps even more important, gold, for the last couple of thousand years has acted to preserve your purchasing power. In 1913 (the year the US Federal Reserve was born) the US dollar was well a dollar, gold was US$20 an ounce. Today, at almost the 100 year anniversary of the Fed the dollar has lost 95 percent of its purchasing power and gold is $1600 an ounce.

That’s gold, sprout-less yes, but irreplaceable in its functions.

Because of the upcoming massive debt rollover, and a collapse of faith in traditional collateral values, gold is quickly becoming a core banking asset.

Lenders loan money based on the criteria of:

-The borrower’s ability to service the debt - cash flow -The borrower’s collateral -A combination of both cash flow and collateral

Debt has a maturity, and when maturity is reached borrowers look to roll it over. Unfortunately for borrowers the value, and high levels of esteem, of what has traditionally been thought of as good collateral (sovereign obligations – currencies) has collapsed.

“Given the regulatory pressure to collateralize exposures, regardless of transaction type, there is a greater need for collateral. But going forward, there may be a risk of a shortage of good-quality collateral.” Olivier de Schaetzen, director, Euroclear

The following list, compiled by Bloomberg, shows the amount of debt that various nations must roll over in 2012:

Japan - 3 trillion, U.S. - 2.783 trillion, Italy - 428 billion, France - 367 billion

Germany - 285 billion, Canada - 221 billion, Brazil - 169 billion,

U.K. - 165 billion, China - 121 billion, India - 57 billion, Russia - 13 billion

According to Bloomberg borrowing costs for G-7 nations in 2012 will rise as much as 39 percent from 2011.

“The great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as “good” collateral in a world of bad collateral.” Professor Lew Spellman, former economist at the Federal Reserve and former assistant to the chairman of the President’s Council of Advisors

In February 2011, J.P. Morgan Chase & Co. said gold is at least as good an investment as triple-A rated Treasuries. J.P. Morgan started allowing clients to use gold as collateral in some transactions where traditionally only Treasury bonds and stocks have been accepted.

On May 25, 2011, the European Parliament's Committee on Economic and Monetary Affairs (ECON) agreed to accept gold as collateral.

triangle

John Exter is known for creating Exter's Pyramid - useful for visualizing the organization of asset classes in terms of risk and size.

When the credit system is expanding most money flows to the top of the pyramid - the increasingly speculative and illiquid investments. When the credit system comes under pressure and debt cannot be repaid, the items at the top of the pyramid get sold and money flows to the bottom items.

“Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital which consists primarily of common stock and disclosed reserves (or retained earnings) but may also include non-redeemable non-cumulative preferred stock. Banks have also used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital." Wikipedia

The Basel Committee for Bank Supervision (BCBS), the maker of global capital requirements and whose Basel III rules form the basis for global bank regulation, is studying making gold a bank capital Tier 1 asset.

“Gold has historically been classified as a Tier 3 asset. 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.” Frank Holmes, usfunds.com

The BCBS is a committee of banking supervisory authorities established by the central bank governors of the Group of Ten countries in 1974. The Committee's members currently come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

If gold is made a Tier 1 Capital asset banks could operate with far less equity capital than is normally required. Gold would be the new backstop for debt, currencies and bank equity capital.

"Anyone who understands gold’s historic role will grasp the importance of the argument behind extra bank leverage. Direct ownership of bullion by a bank is superior to holding the fiat money issued by a central bank. It should increase confidence in any bank and the system as a whole. Given relative values, bank purchases of bullion will drive the value of gold as Tier 1 capital up relative to other qualifying assets, increasing its desirability for regulatory purposes further without a gold-owning bank doing anything." Alasdair Macleod, resourceinvestor.com

Conclusion

If the Basel Committee agrees to banks using gold as Tier 1 Capital it would create substantial demand for physical bullion and be an important step toward gold’s re-monetization.

Consider:

Gold, if moved from a Tier 3 to Tier 1 asset would be competing as a safe haven investment against un-backed bonds yielding less than zero in inflation adjusted terms and issued by over indebted governments.

Gold is set to become the new “good collateral.”

Gold is unique, it is the only non-Tier 1 asset to be universally regarded by investors the world over as a flight to safety asset.

These considerations should be on all our radar screens. Are they on yours?

If not, maybe they should be.

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