Financial Stability Board publishes principles to reduce reliance on Credit Rating Agency Ratings

The Financial Stability Board (FSB) believes that the use (or “hard wiring”) of Credit Rating Agency (CRA) ratings in regulatory regimes for banks and other financial institutions has contributed significantly to mechanistic market reliance on ratings. This in turn is a cause of herding and cliff effects from CRA ratings changes that can amplify pro-cyclicality and cause systemic disruption.

More widely however, the official “seal of approval” implied by the use CRA ratings in regulatory rules has contributed to an undesirable reduction in banks’, institutional investors’ and other market participants’ own capacity for credit risk assessment and due diligence.

The goal of the principles is to reduce mechanistic reliance on ratings and to incentivize improvements in independent credit risk assessment and due diligence capacity. Banks, market participants and institutional investors should be expected to make their own credit assessments, and not rely solely or mechanistically on CRA ratings. The design of regulations and other official sector actions should support this. Accordingly, authorities should assess references to CRA ratings in laws and regulations and, wherever possible, remove them or replace them by suitable alternative standards of creditworthiness.

The principles aim to catalyze a significant change in existing practices. They cover the application of the broad objectives in five areas:

• prudential supervision of banks
• policies of investment managers and institutional investors
• central bank operations
• private sector margin requirements, and
• disclosure requirements for issuers of securities.

The FSB has asked standard setters and regulators to consider the next steps that could be taken to translate the principles into more specific policy actions to reduce reliance on CRA ratings in laws and regulations. It recognizes that changes in market practices cannot happen overnight. This means incentivizing a transition to a reduced reliance over a reasonable timeframe extending into the medium term, taking into account the need for market participants to build up their own risk management capabilities to replace reliance on CRA ratings, and the particular circumstances of products, market participants and jurisdictions. Such actions have already been taken or are being considered by some international standard setters and in some jurisdictions. The FSB will monitor progress in this transition.

The FSB’s report was endorsed by G20 Finance Ministers and Central Bank Governors at their meeting in Gyeongju, Korea, on 22-23 October.