The Financial Stability Board (FSB) says that policymakers need to do more to reduce the reliance on credit ratings by both regulators and financial firms; but coming up with alternatives isn’t easy.

The FSB published a progress report on regulatory efforts to strengthen the oversight of credit rating agencies (CRAs), and reduce the reliance on the ratings they produce.

It finds that authorities “need to accelerate work to end the mechanistic reliance of regulatory regimes and of market participants on external ratings”, which, it says, can lead to herd behaviour by investors and sudden weakness in market prices when downgrades occur.

A peer review of national authorities efforts to implement the FSB’s principles for reducing reliance that was published along with the progress report finds that, “the U.S. has moved the furthest in removing hard-wiring of ratings, and the [European Union] has also made significant progress. Progress in most other jurisdictions has been slower.”

Additionally, the FSB says that financial firms need to improve their own capacity to make their own credit assessments, so that they can safely reduce their reliance on external credit ratings. “This too presents challenges and will take time,” it says.

It calls on policymakers to provide incentives to financial firms to develop their own independent credit assessment processes, and to enhance the disclosure of their internal credit assessment practices.

Within international standards, it says, the greatest reliance on ratings is in the Basel capital adequacy framework for banks. The FSB says that the Basel Committee for Banking Supervision has made proposals to reduce reliance in its securitization framework, and that by mid-2014 it will make proposals on reducing reliance within banks’ capital requirements too. “The challenge is to identify credible alternative standards of creditworthiness,” it says.

The FSB says that global securities regulators, as represented by the International Organization of Securities Commissions (IOSCO), “sees enhanced transparency as playing an important role in market competition and may enhance its transparency standards for CRAs as part of its ongoing revision of its [code of conduct for CRAs].”

The peer review identified a number of challenges that need to be addressed in order to make further progress in implementing its principles, the FSB says, including: identifying suitable alternative standards of creditworthiness; and addressing constraints in the development of internal risk assessment systems, particularly for smaller firms.

The second stage of the peer review will analyze these challenges in more detail, the FSB says. It intends to issue its final peer review report in early 2014.