What Is A Haircut?
A haircut in finance has several meanings. It most commonly refers to the reduced value of a financial asset for purposes of calculating capital requirements, a lending margin or collateral level. It also refers to a loss an investor may have to take or accept on an asset. It means the difference between the bid and asked price of an asset as well, with that difference being the handling fee or service charge for the transaction.
Haircut In Central Banking
In the first definition, a haircut is commonly used in central banking for calculating the amount of money the central bank will lend to a commercial bank or the value of assets a commercial bank must post for purposes of calculating its capital requirement. In this instance, a haircut is the inverse of a loan-to-value ratio. Haircuts are usually expressed in percentage terms.
For example, if a commercial bank wants to borrow money from a central bank, it must post collateral that the central bank would be able to sell in the event that the commercial bank can't repay the loan. The central bank will take a haircut on the collateral, which provides it with a cushion in the event the commercial bank defaults on the loan. If the central bank is demanding a 20% haircut in this scenario, and the commercial bank posts collateral of US$1 million, the central bank will only lend it US$800,000.
The level of the haircut the central bank demands depends on the quality and liquidity of the collateral; the better the collateral, the lower the haircut. Generally, government securities would carry a low haircut, because they are unlikely to default and are highly liquid. Other types of riskier assets, such as stocks or loans to less creditworthy borrowers, would carry a higher haircut.
Similarly, central banks use haircuts to determine how much capital commercial banks must hold in reserve in the event the loans they make default. Loans to government entities and highly-rated corporations, for example, would require lower haircuts—and thus less capital—than loans made to lower-rated companies or other risky investments.
Central banks may raise or lower their haircut requirements depending on whether they want to encourage or discourage commercial banks from making more loans to consumers and businesses. By requiring a smaller haircut, and thus less collateral, commercial banks would have more money to lend to their customers.
Haircut In Financial Institutions
Financial institutions use haircuts to determine how much collateral they require from customers to make margin loans. For example, in order to make a margin loan, a bank or securities company may require a 50% haircut on the client's securities portfolio to protect itself in the event the client's assets lose value. If the client has a stock portfolio with a market value of US$1 million and the lender takes a 50% haircut, it will only lend the client US$500,000.
Additionally, a haircut can refer to the difference between the bid and ask prices of a security, with the difference being the handling fee for the transaction.
A haircut also refers to a financial loss an investor may take in order to get some of their money back. For example, as part of the Greek debt bailout in 2012, holders of the country's existing bonds agreed to take a massive haircut on their holdings, exchanging 77 billion euros in old bonds for new debt worth 75% less.
A haircut has several meanings in finance. Most commonly, it refers to the reduced value of a financial asset for purposes of calculating a bank's capital requirements, a lending margin or collateral level. It also refers to a loss an investor may be forced to take or accept on an asset. It can also refer to the difference between the purchase and sales prices of an asset, with the difference being the handling fee for the transaction.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…