Covered bonds are not eligible for US banks’ liquidity buffers under a Liquidity Coverage Ratio (LCR) rule finalised by federal banking regulators yesterday (Wednesday), which confirmed expectations of standards “more stringent” than those set out by the Basel Committee on Banking Supervision.

Federal Reserve Board member Daniel Tarullo had described US LCR proposals as “super-equivalent” to the Basel Committee’s when they were released in October 2013, and the Federal Reserve Board said yesterday that the final rule is largely identical to the proposed rule.

“The rule is generally consistent with the Basel Committee’s LCR standard, but is more stringent in certain areas, including a shorter transition period for implementation,” said the Federal Reserve Board, which finalised the rule with the Federal Deposit Insurance Corporation (FDIC) and Officer of the Comptroller of the Currency (OCC).

US banks will have to be fully compliant with the rule by 1 January 2017 – two years early.

Industry body the Structured Finance Industry Group (SFIG) noted that covered bonds alongside asset-backed securities (ABS) and private label mortgage-backed securities (MBS) are not included in the definition of high quality liquid assets (HQLA) used to calculate the numerator of the ratio.

This is contrary to the Basel Committee approach whereby many covered bonds would be eligible as Level 2A assets and some ABS/MBS as Level 2B. The US – which does not have a native covered bond market – has adopted the opposite approach to the European Union, which is expected to allow some covered bonds to qualify for LCRs as a portion of extremely HQLA, or Level 1 assets. Countries such as Australia, Canada and Singapore have meanwhile included covered bonds as Level 2A.

“The US is so far the only region we know of where covered bonds are not part of the eligible assets for the LCR,” said a covered bond analyst.

In comments published with the final rule, the Federal Reserve Board said that during its consultation a number of commenters had recommended that covered bonds be included as Level 2B assets, citing various reasons including the Basel III framework, their track record of liquidity, and importance to the long term financing of the economy – with some of the above arguments also made in favour of high quality ABS/MBS being included, too.

“The agencies are aware that specific issuances of ABS, RMBS, or covered bonds may exhibit some liquidity characteristics that are similar to those of assets included as HQLA,” said the Federal Reserve Board. “However, the agencies continue to believe that ABS, covered bonds, private label MBS, and mortgage loans do not meet the liquid and readily-marketable standard in US markets, and thus do not exhibit the liquidity characteristics necessary to be included as HQLA under the final rule.”

Commenters had also pointed out that including covered bonds in LCRs would help the instrument develop in the US, although this was dismissed by the Federal Reserve Board.

“As one commenter mentioned, the US market for covered bonds is not highly developed, with few issuances,” it said. “The agencies do not believe that it is appropriate for the agencies to use the LCR as the mechanism for encouraging or developing the liquidity of an asset class.

“Rather, the LCR is designed to ensure that covered institutions have sufficient liquid assets that already have been proven sources of liquidity in the event of a liquidity crisis. Furthermore, the agencies observe that covered bonds, which are typically issued by companies in the financial sector, exhibit significant risks regarding interconnectedness and wrong-way risk among companies in the financial sector.”

Government-sponsored enterprise (GSE) securities continue to be treated as level 2A liquid assets under the final regulation, noted the SFIG, meaning they are subject to a 15% haircut and are subject to a 40% cap that limits the total amount of Level 2 assets that can be included as HQLA – again, in line with the Basel Committee framework.