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.
ormally 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 US investment bank Lehman brothers in September 2008 and the earlier collapse of Bears Sterns, another US investment bank in 2007. Both banks experienced large losses on investments tied to US subprime mortgages.
This led to panic in the global interbank lending markets beginning around mid-September 2008, and the associated bailing out of US banks.
However, the effects of this crisis hit the UK earlier than most in the form of the panic surrounding Northern Rock in 2007. As the credit crisis began to hit in August 2007, Northern Rock, which primarily used the money markets to fund itself, found that it could not get the required funding due to increased interbank borrowing costs, and it therefore needed to ask the Bank of England for emergency funding. This caused a bank run on Northern Rock, the first British bank run in over 100 years, and the intervention of the Chancellor to provide a guarantee to all UK bank deposits.
On a wider scale, banks around the world stopped lending to each other and wholesale money markets froze up, creating liquidity problems throughout 2008. 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.
Since the interbank lending market is global, there was a systemic shock in the form of the credit crisis and many UK banks found it difficult to raise financing. This caused insolvency risk and a fear of illiquidity for bank depositors. The Government had to step in by recapitalising banks and giving loan guarantees. Some of the better known recipients of these bank recapitalisations were Royal Bank of Scotland, Lloyds TSB and HBOS.
The gold price rose strongly before and during this 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 continued and in 2013 in Cyprus in a watershed moment, the Cypriot government was forced to nationalise the banks which resulted 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. It is therefore prudent for investors to hold some gold as a portfolio diversifier and a hedge against future systemic risks.