A number of commentators have predicted that the rules of the Basel III bank regulations will cause gold to skyrocket (no, this article is not about our view that gold does not go up, that it’s the dollar going down, that the lighthouse does not go up, it’s the sinking ship going down in the storm).

Will it? It would be easy to say—as with all of their other predictions of gold to infinity and beyond—“wait and see.” But where’s the fun in that? We’d rather look into the nature of the claim, how banks operate, and what the regulation actually says.

So who wants to understand a bank balance sheet, and regulators’ view of bank risk? In other words, who wants to understand whether gold will skyrocket?

If you’re still with us, we assume you do. We will try to keep this brief.

The Bank Balance Sheet

A bank borrows to finance its lending. It makes money, by paying a lower interest rate on its borrowing than it charges on its lending. We can shortcut the language of borrowing and lending, and simply say that banks issue liabilities to fund their assets.

We will not focus on the interest rate differential, as it is not essential to our discussion today. Except one thing is important. Long-term bonds normally pay a higher interest rate than short-term notes (though right now, the market is backwards, called yield curve inversion, where 10-year Treasury bonds pay a lower rate than 1-month Treasury bills).

This gives banks a strong incentive to use short-term liabilities to fund long-term assets. The cost of funding is lower, and the interest earned on the asset is higher. But this creates a risk. To see it, let’s use an extreme case: using demand deposits to fund 30-year mortgages. According to the FDIC, as of this writing, the national average for checking accounts is 0.06%. According to the St. Louis Fed, a 30-year mortgage is 4.28%. A bank could make 4.22% by funding 30-year mortgages with checking deposits (before expenses). Not a bad business. But there’s a catch.

Depositors can withdraw their funds by writing a check!

And they would do so as the slightest suggestion that the bank was risky. The issue is not whether the bank is solvent by conventional measures. The accepted definition of solvent is assets > liabilities. Or, perhaps, revenues > expenses. That’s not the issue here.

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