In October 2010, the FSB issued Principles for Reducing Reliance on CRA Ratings. The goal of the Principles is to end mechanistic reliance on CRA ratings by banks, institutional investors and other market participants. The “hard wiring” of CRA ratings in regulation has been wrongly interpreted as providing those ratings with an official “seal of approval” and has reduced incentives for firms to develop their own capacity for credit risk assessment and due diligence. As demonstrated during the financial crisis, reliance on external ratings to the exclusion of internal credit assessments can be a cause of herding behaviour and of abrupt sell-offs of securities when they are downgraded (“cliff effects”). These effects can amplify procyclicality and cause systemic disruption.
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