By Anna Brunetti

LONDON (IFR) - A draft by the European Commission setting out rules for banks to build up liquidity buffers against short-term shocks is the first piece of legislation globally to spell out how non-sovereign sukuk bonds should be treated.

The EU regulator is due to publish its version of the Liquidity Coverage Ratio set out under Basel III by the end of September.

The original Basel III LCR framework already gave local supervisors the clout to come up with arrangements allowing sharia-compliant banks to build highly liquid cushions with assets alternative to Western-style interest-bearing bonds.

In June, Reuters reported that the Malaysia-based Islamic Financial Services Board (IFSB) was readying guidelines for the end of the year to enable Islamic banks to do so.

And now the Commission text, circulated last week and seen by IFR, sets out such rules. It will allow Islamic banks operating in Europe to use sukuk exposures as lower tier liquidity buffers at the level of other corporate bonds, but under more generous conditions in terms of minimum issue size and maximum time to maturity.

Even if the Islamic bonds in question fall below the 250 million euro (200 million pounds) size threshold and exceed the 10-year maturity limit set out for banks and corporate bonds, they can still be LCR-eligible if “there’s sufficient evidence of insufficient availability of sukuk meeting these requirements...(and if they are) adequately liquid in private markets,” the draft says.

The liquidity level of these bonds will be judged on their trading volumes, bid-offer spreads and price volatility, but also on the historical depth and the variety of buyers and issuers in their market.

This may mean that, despite regulators’ attempts to make it easier for Islamic banks to comply with European rules, the lack of deep secondary markets in sukuk trades may nullify the effort.

Meanwhile, sukuk rated double A or higher would be subject to a minimum 15 percent haircut; for every $100 million held, only $85 million would count towards the stock of liquid assets.

Securities rated triple B or higher would be discounted by as much as 50 percent, and sukuk with a stand-alone rating of single B would also qualify with the same haircut if guaranteed by a central bank or government.

(This story was refiled to change the byline)