In financial markets, a haircut refers to a reduction applied to the value of an asset. It is expressed as a percentage. For example, if an asset – such as holdings of a particular government bond – is worth €1 million but is given a haircut of 20%, it means it is treated as though it has a value of only €0.8 million.
When are haircuts used?
One example of when haircuts are used is when central banks lend money to commercial banks. In return for the loan, as a form of insurance, the central bank will ask for collateral (find out more about collateral). However, it will apply a haircut, i.e. a reduction, to the value of this collateral. Taking the example above, an asset worth €1 million at fair market price, but given a 20% haircut, would only be sufficient to receive a loan of €0.8 million.
Why are haircuts used?
Central banks need to be sure that the money they lend will be paid back. Of course, the first line of defence is the agreement with the borrower regarding repayment. But if the borrower fails to repay the loan, the central bank will sell the collateral. It therefore needs to be sure that it will be able to sell the collateral at a price that will cover the amount of the loan. But assets can go up and down in value and central banks may need some time to sell specific assets. A haircut therefore provides a kind of safety buffer against any loss in value and the time it takes to sell the collateral.
To illustrate this, let’s consider a €1 million house. It may be worth €1 million now, but there is no guarantee that, when the time comes to sell it, it will actually be possible to get €1 million for it. Maybe the house has been damaged in a storm or the area it is in has become less desirable. The Eurosystem, which is made up of the ECB and the 19 central banks of the euro area, does not accept real estate as collateral, but the reasoning is the same for the assets it does accept, such as high-quality bonds and other shorter-term securities. These too could, for several reasons, decrease in value. This is why assets with a current market value of €1 million are not sufficient to receive a loan of the same amount.
What determines the size of a haircut?
The lender must consider what size buffer is sufficient to cover the risk of not being able to sell the asset at its current value. This will depend on the factors mentioned above, including how risky that type of asset is, i.e. how volatile its price is, and how “liquid” it is, i.e. how easy it is to sell it quickly without a loss of value. Coming back to our example, an old manor house (for which there is little demand) in an area known for its thunderstorms (putting it at risk of damage) would receive a larger haircut than a brand new two-bedroom flat in a city centre. Similarly, in a central bank context, government bonds tend to be relatively safe, liquid investments and receive a smaller haircut than bank loans, which can also be used as collateral and tend to be less liquid.
What haircuts does the Eurosystem apply?
The Eurosystem carefully decides what haircuts to apply to the collateral it accepts. It always makes sure that the haircut is sufficient and proportionate to minimise the risk of losses.
When accepting collateral, the Eurosystem does not favour any particular kind of asset, provided it meets its requirements. As collateral for a €1 million loan, the borrower could provide, for example, €1.7 million of bank loans with a 40% haircut or €1.06 million of government bonds with a 5% haircut, as both have a collateral value of just over €1 million. What is essential is that the total value of the collateral, after accounting for the haircuts, is equal to (or above) the total loan amount, whether that means the borrower provides a larger amount of assets with bigger haircuts or a smaller amount of assets with lower haircuts.
The Eurosystem has a strict risk management process in place and the use of haircuts is just one measure among several that it takes to ensure that it does not take on any undue risk.
The ECB publishes a list of the haircuts it applies to collateral, which is reviewed regularly.
Source: European Central Bank
Published: 3 November 2016
The above presenation was created for educational purposes.