Haircut In Finance

Haircut in finance is a percentage reduction due to the difference between the asset value and the collateral used in the loan. The primary purpose of haircut is to serve as a margin to save the lenders from the potential risk arising due to default.

During mortgages, haircuts play a vital role in securing loan amounts. It provides safety to lenders during the sale of collateral. It is usually in percentage form. Haircuts are commonly used in various financial transactions, such as margin lending, repurchase agreements (repos), and securities lending. Hence, this reduction in percentage strikes to achieve a balance between providing financing or liquidity and managing risk.

• Haircut in finance refers to the reduction in the asset's value that acts as collateral in a loan agreement. 
• It is the difference between the loan amount and the collateralized asset. In the stock market, it refers to the gap between the purchase and selling price of financial instruments.
• Various factors affect the calculation of haircuts. They include size and amount of collateral, risk associated, borrower credibility, market volatility, and liquidity. 
• Thus, they are primarily applied to account for potential market fluctuations and mitigate the default risk.

Haircut, in finance, refers to the margin that estimates the difference between the loan amount and the market value of the collateralized asset. In short, it is the ratio of the loan amount to the asset value. But, if we sum both the amounts, the resulting answer is the haircut. Besides, it is mainly a risk management technique to protect lenders, investors, or counterparties from potential losses.

Hence, financial institutions mostly use it as an effective tool during default payments. As borrowers tend to fail to repay, the lender can sell the asset kept in collateral. However, if the asset's value is lower than the loan amount, it may result in a loss. Therefore, using a haircut to cover the gap between the actual accrued loan and collateral becomes vital.

Furthermore, the computation of the haircut in finance differs slightly from others. Here, the central banks or lenders will try to reduce the value of the collateral by a certain amount. This deduction is known as collateral. For example, if the asset value is $100,000, the collateral will value at only $80,000. It means there is a 20% haircut, less than the original value. Thus, various causes of haircuts in finance can cushion lenders. However, they serve a different purpose.

Additionally, the specific percentage depends on various factors, including the type of asset, its liquidity, historical price volatility, and the risk appetite of the parties involved. Therefore, investments considered riskier or less liquid generally receive larger haircuts.

Although lenders can deduct from collateral, there are certain factors influencing it. So, let us look at the various factors that decide the haircut for financial instruments:

#1 - Size Of The Collateral

Before deciding on the haircut rate, it is essential to consider the collateral type. Depending on the asset's value, the lender charges it. Thus, assets with higher value may possess a similar risk. Therefore, the haircut (%) will be slightly higher than the other collateralized assets.

#2 - Risk Associated With The Asset

The default risk is always inclusive of the sale value of the asset. If the lender cannot recover the accrued loan amount from the asset, it might lead to a loss. So, investments with higher risk will tend to owe higher haircuts. Thus, the collateral value may reduce to an increased extent.

#3 - Market Volatility

Among the significant causes of haircuts in finance, volatility of asset prices influences the most. The lender may charge a higher haircut if the prices are volatile or sensitive to market sentiments. It will only create a pillow for them during the sale of the collateral.

#4 - Liquidity Of The Collateral

The ability to sell the collateral at a fair value takes a lot of work to approach. Many variables (micro and macro) affect its liquidity. If the collateral has no buyers, the seller may be unable to recover the potential losses.

Let us look at the examples of haircuts and their application in the financial industry:

Example #1

Suppose Pennify Ltd is a financial institution that provides mortgage facilities to customers. James, a businessman, approaches the bank to gain a loan amount of $100,000. The latter further scans the credit score and other documents before lending. But while verifying the collateral, the asset seems to be illiquid. Still, the lender agreed to provide funds but a haircut. It means the collateralized asset of $120,000 will be reduced by 25%. Therefore, the current loan amount will be $90,000.

Therefore, in the mid-duration of the agreement, Pennify Ltd recognized the missed payments by James. After a few warnings, the bank agrees to sell the asset. At the moment, the accrued amount is $50,000. Now, when the lender tries to sell the collateral, it receives a sale value of $65,000. As a result, the losses occurring on the collateral are quickly recovered.

Example #2

According to Bloomberg Intelligence, the $2 trillion venture capital industry could face 25% to 30% portfolio price cuts — a "haircut." of up to $500 billion — due to the Silicon Valley Bank catastrophe.

Following SVB's fall, we anticipate increased valuation scrutiny and disclosure. Given the substantial amount of "fiduciary" capital from pension funds that have poured into these markets, in particular. Hence, unlike endowments and family offices, there are no routes to extend and pretend." Gaurav Patankar, a Bloomberg Intelligence analyst, wrote in a note on March 24, 2023.

The significant difference between market-based, model-based, and risk-based haircuts that focus on asset reduction should be addressed. Therefore, it is necessary to look at the differences between them:

This article has been a guide to what is Haircut In Finance. Here, we explain its examples, factors, and a comparison between model-based and risk-based haircuts. You may also find some useful articles here -

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