Model Foundations for the Supervisory Formula Approach
by Michael B. Gordy of the Federal Reserve Board
Abstract: In its proposal for a New Basel Accord, the Basel Committee on Bank Supervision (2004, Part 2.IV) offers two methodologies for assigning regulatory capital charges to securitization exposures under the Internal Ratings-Based (IRB) approach. The Ratings-Based Approach sets capital primarily as a function of an external rating, such as might be assigned by Moody's or S&P, and is to be employed whenever an external rating is available. As many securitization exposures are not externally rated, the alternative Supervisory Formula Approach (SFA) determines required capital as a function of the characteristics of the collateral pool and contractual properties of the tranche. The chapter sets forth the theoretical foundation for the SFA provided by the "uncertainty in loss prioritization" (ULP) model of Gordy and Jones (2003).