Haircut

A haircut is the percentage by which a lender reduces the market value of an asset pledged as collateral when calculating how much it will lend against it. If a lender applies a 2 percent haircut to US$100 of bonds, it will advance US$98. The difference is a buffer that protects the lender if the collateral loses value, or takes time to sell, after the borrower defaults.

Haircuts are central to secured funding markets, including repurchase agreements (repos), securities lending, margin lending, derivatives collateral and central bank lending. The word is also used in a second sense, for the loss creditors accept when a debt is restructured.

A haircut can be expressed in two equivalent ways. As a haircut, it is (collateral value - loan amount) / collateral value. As a margin ratio, it is collateral value / loan amount. A 2 percent haircut corresponds to a margin ratio of about 102 percent. Market convention differs by product: repo desks often quote initial margin, while central banks and clearing houses usually publish haircut schedules.

Lenders set haircuts according to how much the collateral could lose before it can be sold. The main factors are:

• Price volatility: equities receive larger haircuts than short-dated government bonds.
• Liquidity: assets that trade rarely, or in thin markets, take longer to sell.
• Credit quality and maturity: lower-rated and longer-dated bonds are more sensitive to shocks.
• Currency mismatch: collateral in a different currency from the loan carries exchange-rate risk and usually attracts an add-on.
• Wrong-way risk: collateral whose value is likely to fall when the borrower weakens, such as a bank's own bonds, is discounted heavily or refused.

A hedge fund wants to borrow cash against US$10 million of corporate bonds in a one-week repo. The dealer applies a 5 percent haircut and lends US$9.5 million. If the bonds fall 3 percent to US$9.7 million, the dealer is still covered. If they fall 8 percent to US$9.2 million, the collateral no longer covers the loan, and the dealer issues a margin call for more collateral or cash. If the fund cannot meet it, the dealer can sell the bonds and apply the proceeds to the debt. The repo rate itself, often referenced to SOFR for dollar trades, is set separately from the haircut.

Central banks publish haircut schedules for the collateral they accept in open market operations and when acting as lender of last resort. A central counterparty (CCP) applies haircuts to the non-cash collateral its members post as margin. In both cases the haircut determines how much liquidity a given pool of assets can generate, so changes to haircut schedules are a policy lever in their own right.

The same logic applies outside securities. A bank lending against receivables, inventory or gold applies a haircut to the asset's value, and a gold swap typically advances less cash than the market value of the gold delivered.

Haircuts tend to be low when markets are calm and rise sharply in a crisis. During the 2007–2009 financial crisis, haircuts on many securitized assets in bilateral repo increased steeply, forcing borrowers to find more collateral or sell assets into falling markets. Economists have described this as a run on repo, in which rising haircuts drained funding from the shadow banking system.

In response, the Financial Stability Board developed a framework of numerical haircut floors for certain non-centrally cleared securities financing transactions, and haircuts also feed into regulatory capital calculations under the Basel III rules, which assign supervisory haircuts to different types of collateral when measuring credit exposure.

In sovereign and corporate debt, a haircut is the reduction in value creditors accept in a restructuring, whether through a cut in principal, lower interest, longer maturities or a combination. The 2012 Greek private-sector involvement exchange, for example, reduced the face value of the bonds held by private creditors by more than half. Restructuring haircuts are often measured in present-value terms, which can differ considerably from the cut in face value. Debates about odious debt concern whether some sovereign debts should be written off entirely rather than merely reduced.