Haircut, in the financial context, has two meanings:
While sanctioning a loan, when a collateral financial security is accepted by the lender at a lower value than the market value, keeping a margin to cover up the losses in case of fluctuations. Example. A bank gives a loan to Mr. A for Rs. 1,20,000/-, against which the Mr. A pledges stocks of a company worth Rs. 1,00,000/-. The bank will accept this collateral security at probably a 50% haircut, thereby valuing these stocks at Rs. 50,000/-. The margin is kept for the future fluctuation in the values of the stocks. It must be noted that haircut differs for each kind of financial security. For government bonds, the haircut will be lesser than the stocks of a company.
When the debtor is unable to pay the loan, he is allowed to repay lesser than the outstanding loan amount. This mostly takes places when loans are categorised as non-performing assets. In order to recover some of the loan amount, haircuts are given to giant corporates. For example, during the Greek debt crisis in 2008, when the government had failed to repay the loans and declared their inability to do so, they asked for a haircut of about 50% from the private creditors, which means they would have to repay only half of the sum borrowed from the lenders.
The issues with haircut is that the bank is sanctioning loans with the money that comes in as a deposit from customers. When the customers have the knowledge of this haircut, they might have a doubt on the bank’s ability to give the deposit of the customer back. Therefore, all or significant number of depositors might run to the bank withdrawing their deposits and therefore leaving the bank with no money to continue business.
Comments