Covered bonds look set to be excluded from liquidity coverage ratios (LCRs) in the US by the Federal Reserve Board, which yesterday (Thursday) released a proposed rule including details of what will be eligible as high quality liquid assets (HQLA) under its Basel III framework.

Fed Board member Daniel Tarullo

Covered bonds were included as Level 2 assets under the Basel Committee on Banking Supervision’s initial proposals, meaning that they would be subject to limits and haircuts.

However, unlike in Europe where covered bonds have been seen as having a strong chance of being upgraded to Level 1 assets and being treated similarly to government bonds (see here, for example), outside Europe – where they are less established and less liquid – they have faced being excluded altogether.

The proposals announced by the Fed yesterday go a long way towards doing this.

“The proposed LCR we review today is ‘super-equivalent’ to the Basel Committee’s LCR standard,” said Daniel Tarullo, a member of the board of the Fed. “That is, the proposal is more stringent in a few areas, such as the transition timeline, the definition of high-quality liquid assets, and the treatment of maturity mismatch within the LCR’s 30 day window.”

While the door has not been completely closed to covered bonds, they have been left out for now.

“The proposed rule likely would not permit covered bonds and securities issued by public sector entities, such as a state, local authority, or other government subdivision below the level of a sovereign (including US states and municipalities) to qualify as HQLA at this time,” says the Fed proposal. “While these assets are assigned a 20% risk weight under the standardised approach for risk weighted assets in the agencies’ regulatory capital rules, the agencies believe that, at this time, these assets are not liquid and readily-marketable in US markets and thus do not exhibit the liquidity characteristics necessary to be included in HQLA under this proposed rule.

“For example, securities issued by public sector entities generally have low average daily trading volumes. Covered bonds, in particular, exhibit significant risks regarding interconnectedness and wrong-way risk among companies in the financial sector such as regulated financial companies, investment companies, and non-regulated funds.”

RBS analysts noted that the covered bond market in the US remains of relatively low significance versus Fannie Mae and Freddie Mac, and also relatively small compared with the euro market.

“As it currently stands, this proposal would be negative for US dollar denominated covered bond spreads as a significant part of primary issues has typically been sold to the US,” they said. “However, the share of bank treasuries is lower in US dollar covered bonds than for the euro, market which should limit the impact.”

The Fed’s proposed rule can be found here.