The Australian Prudential Regulation Authority has excluded covered bonds from Level 2 assets in a statement released today (Monday) on its implementation of the Liquidity Coverage Ratio, taking a stricter approach than that required by the Basel Committee on Banking Supervision.

The Basel Committee had allowed covered bonds to be included as Level 2 assets in liquidity buffers under Basel III alongside certain sovereign and quasi-sovereign bonds, and some corporate bonds, as long as these have a track record as a reliable source of liquidity even during stressed market conditions.

However, after comparing a range of instruments in the Australian dollar market with the Basel Committee’s criteria, APRA has said that none qualify as Level 2 assets.

Covered bonds are yet to be issued by Australia banks, with the Australian government having only in December agreed to create conditions to allow their issuance. They had previously been prohibited under Australian depositor protection legislation, which had been staunchly enforced by APRA.

APRA’s announcement today nevertheless held out the possibility that covered bonds could in future become eligible as Level 2 assets given the timescale for implementation of Basel III.

“The LCR requirement comes into effect on 1 January 2015,” said the regulator. “During the preceding ‘observation period’, the Basel Committee will be testing a number of additional qualitative and quantitative criteria to evaluate the liquidity characteristics of Level 2 assets.

“Depending on the outcome of this work and on market developments over this period, it is possible that some instruments may become eligible as Level 2 assets, or the range of qualifying Level 1 assets may expand, by the time the LCR requirement is introduced in Australia.”

APRA has restricted Level 1 assets to cash, balances held with the Reserve Bank of Australia, and Commonwealth Government and semi-government securities.

APRA’s stance contrasts with that of the majority of European regulators, which have accepted covered bonds as Level 2 assets and are considering industry lobbying for better treatment of the asset class. The UK Financial Services Authority initially left covered bonds out of liquidity buffers, but relented after the Basel Committee announced its framework.