why buy gold doesn't help a bank

There has been a lot of discussion about Basel captial requirements and a potential roll for gold in promoting bank stability.

I have been generally critical of this idea because I view gold an asset effectively denominated in its own currency, and placing gold on a balance sheet introduces a form of FX risk (price risk).

I also see a major problem with gold as a guarrentor of solency because it is an asset, and solvency can only be bustered or restored by raising liabilities.

To demonstrate this point, I thought I might post a number of graphics that show what happened to banks in the GFC that caused so much concern and required governments to provide massive bail out programs.

This is a simplified example (Basel ratios are 1:12.5. I have used 1:10 to keep the math on "the back of an envelop".)

The "Basel Compliant bank in normal conditions" owns assets (usually loans) that are paid for with funds taken from depositors and investors.

The amount of money owed to depositors is fixed, so if the value of the asset falls, the amount of capital falls by the same amount. In the example of "A bank in distress" the value of the assets has fallen by an amount greater than the capital, and the bank is insolvent. (When the US Fed was reviewing Capital Returns in 2008, they would have seen a few like this!)

The challenge in a bail out is two fold:
1. Inject sufficient capital is required to cover the short fall between depositors funds and the value of the assets ($5).
2. Raise additional capital required to restore compliance with the Basel ratios ($8.5).

Holding gold as an asset on the balance sheet in such a scenario would provide no help in an insolvency scenario. The only remedy for the distressed bank is a capital injection. Selling the gold would raise funds, but existing depositors have first call over those funds and existing shareholders will have a call over what is left over. The proceeds from gold sale cannot be classed as "new capital".

At best, gold may give deposits and shareholders some comfort that they will get some money back, but it won't provide the new funds required to save the bank.

Cheers


Afterthought: Some of you will have noticed that the level of bank deposits falls in my static scenario. If banks raise new capital, but don't change their existing asset base, they repay depositors ($13.5). In 2008-10, I would speculate that most of this money found its way in to US Government bonds, and it may suggest that the US government bond rally in 2008-10 was not just a "flight to quality", but was driven by the weight of newly available cash.