Gold bullion has long been held by investors seeking protect their wealth from the risks posed by systemic events.
Systemic risk refers to the possibility that the entire financial system could become unstable and potentially collapse. Normally a financial system is stable, and does not transmit shocks through the financial sector or into the wider economy. However, on occasion, the failure or potential failure of a financial firm or institution may create a domino effect and impact the health of similar firms.
Often, if investment or financing problems are perceived at a bank, the broader marketplace will not want to lend to that bank and perceived problems become real problems. If certain assets or investments in one bank become problematic, this can affect the value of similar assets at other banks. This is called financial contagion and can also be responsible for transmitting systemic risk.
These concepts are best illustrated by the events of 2007 and 2008 which most famously led to the collapse of U.S. investment bank Lehman brothers in September 2008 and the earlier collapse of Bears Stearns, another U.S. investment bank. Both banks experienced large losses on investments tied to U.S. subprime mortgages.
This led to panic in the global interbank lending markets beginning around mid-September 2008, and the associated bailing out of U.S. banks.
On a wider scale, banks around the world stopped lending to each other and wholesale money markets froze up, creating liquidity problems. Central banks around the world had to flood the markets with emergency financing and take low quality assets as collateral in return to providing financing to banks.
However, since the interbank lending market is global, there was a systemic shock and Irish banks could not raise new short-term loans to cover their huge property lending exposure. This caused insolvency risk in the Irish banking sector and a fear of illiquidity for bank depositors.
The Irish government then infamously stepped in during late September 2008 with their bank deposit guarantee deal to bail out the Irish banks to the tune of multiple billions, followed by the bankruptcy of Irish finances which then had to be bailed out by the IMF and ECB. This is a classic example of a systemic shock from another market (the U.S.), having a ripple effect on a separate market (Ireland) due to the global interconnectedness of the financial and banking markets.
The collapse of Anglo Irish Bank and the bailouts and restructuring of AIB, Bank of Ireland and Permanent TSB still left, the surviving lending institutions with huge non-preforming loan exposure to the small and medium enterprise (SME) sector. Like in the mortgage market, the Irish banks, in order to survive, were forced to contract credit and increase loan costs to the SME sector. This has had an extremely severe impact on the Irish SME sector which accounts for half of Irish GDP, and nearly 75% of Irish employment.
There is a view that the Irish banks are not accounting correctly for their exposure to the Irish SME sector. The problems with the Irish economy remain despite a return of some economic growth and the exit from IMF and ECB led borrowings.
The gold price rose strongly before and during this credit crisis. Before the crisis broke, gold’s price was bid up by the market in anticipation that these systemic risks were coming to the fore. During the crisis in late 2008, gold price’s performed well as it was correctly seen as a safe haven asset that would provide shelter from the market turmoil.
The problems from the 2008 crisis have never been resolved and are merely being papered over. Central banks continue to intervene to prop up bond markets via quantitative easing. Stock markets increasingly rely on the support and liquidity provided by these central bank interventions. There is still the risk of another Lehman moment, maybe increasingly so.
The crisis has continued and in 2013 in Cyprus in a watershed moment, the Cypriot government was forced to nationalise banks, resulting in businesses not being able to access the critical functions of the banking system. Furthermore, depositors with balances over a certain threshold were penalised in the form of a bail-in tax.
EU-sanctioned bail-ins as opposed to bail-outs may soon become the norm within the EU. The Irish economy is still exposed to these developments despite what some commentators may say. It is therefore prudent for investors to hold some gold as a portfolio diversifier and a hedge against future systemic risks.